Blandine Laperche - John Kenneth Galbraith and The Future of Economics PDF

John Kenneth Galbraith
and the Future of

Economics
Edited by
Blandine Laperche and Dimitri Uzunidis
John Kenneth Galbraith and the Future of Economics
Also by Blandine Laperche
LA FIRME ET L’INFORMATION, INNOVER POUR CONQUÉRIR

L’INNOVATION ORCHESTRÉE (Edited)
PROPRIÉTÉ INDUSTRIELLE ET INNOVATION (Edited)
Also by Dimitri Uzunidis
COMMENT ONT-ILS RÉUSSI? L’HISTOIRE DES ENTREPRENEURS DU XVIIIE SIÈCLE

À NOS JOURS (with S. Boutillier)
LA LÉGENDE DE L’ENTREPRENEUR (with S. Boutillier)
LE TRAVAIL BRADÉ, AUTOMATISATION, MONDIALISATION, FLEXIBILITÉ (with
S. Boutillier)
L’INNOVATION ET L’ÉCONOMIE CONTEMPORAINE: Espaces Cognitifs et
Territoriaux (Edited)
MONDIALISATION ET CITOYENNETÉ (Edited with J.- P. Michels)
and the Future of
Economics
Edited by
Blandine Laperche
and
Dimitri Uzunidis
Selection and editorial matter © Blandine Laperche and Dimitri Uzunidis 2005
Individual chapters © Contributors 2005
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Library of Congress Cataloging-in-Publication Data
John Kenneth Galbraith and the future of economics / edited by Blandine
Laperche and Dimitri Uzunidis.
p. cm.
“Papers from the International Symposium honoring John Kenneth Galbraith
held in Paris in September 2004”—Pref.
Includes bibliographical references and index.
ISBN 1–4039–9616–4 (cloth)
1. Galbraith, John Kenneth, 1908– 2. Economists – United States.
3. Economics. I. Galbraith, John Kenneth, 1908– II. Laperche, Blandine.
III. Uzunidis, Dimitri.
HB119.G33J64 2005
330.092—dc22 2005048689
10 9 8 7 6 5 4 3 2 1
14 13 12 11 10 09 08 07 06 05
Printed and bound in Great Britain by
Antony Rowe Ltd, Chippenham and Eastbourne
Contents
List of Figures vii
List of Tables viii
Acknowledgements ix
List of Contributors x
Preface by James K. Galbraith xi
Introduction 1
Part I Back to John Kenneth Galbraith

1. Galbraith: a Partisan Appraisal 15
James K. Galbraith
2. Where Do Galbraith’s Ideas Come From? 25
Richard Parker
3. Galbraith and the Post Keynesians 34
Paul Davidson
4. J.K. Galbraith: Economist of the Peace 40
Jacques Fontanel and Fanny Coulomb
5. John Kenneth Galbraith and the Uncompleted Task of Progress 52
Norman Birnbaum
Part II The Trouble with Economists and Policies

6. The Bias in Academic Economics: the Economics Salon 65
Jeff Madrick
7. Reframing Capitalism 77
James E. Sawyer
8. Power and Institutions in Macroeconomic Theory 87
John Cornwall and Wendy Cornwall
9. Reinventing Fiscal Policy 105
Philip Arestis and Malcolm Sawyer
10. Alternatives for the Policy Framework of the Euro 126
11. Promoting Growth and Welfare in a Changing Europe:
Economic Analysis and Policy 142
Jean-Luc Gaffard
v
vi Contents
Part III Economies in a Global Context: a Programme

of Action
12. The Future of the International Financial System 165
Paul Davidson
13. John Kenneth Galbraith and the Anatomy of Russian Capitalism 180
Stanislav Menshikov
14. Escaping the Squeeze: Lessons from East Asia on how
Middle-income Countries can Grow Faster 196
Robert Hunter Wade
15. The Third World’s Debt Problem 214
Kunibert Raffer
16. Global Organization and Developing Countries: Current Aspects
of Neo-mercantilism and the Global Framework of Accumulation 230
Dimitri Uzunidis
Index 241
List of Figures
8.1 Optimizing political preferences 96

8.2 Alternative political preferences 97
vii
List of Tables
8.1 Annual average standardized unemployment rates and

rates of consumer price inflation for 18 OECD countries 89
8.2 Average days lost to strikes, per thousand workers, 1960–89 94
8.3 Definitions of the variables used in the unemployment
equation 99
8.4 Regression results for the reduced form unemployment
equation 100
10.1 Recent macroeconomic data for the eurozone 127
13.1 Dynamic proportions of Russian and US economies 188
13.2 Macroeconomic proportions in the US, 1929–99 193
14.1 Trade regimes, incentives to sell on domestic market or
to sell abroad, developing countries around 1969 201
16.1 Share of manufacturing production in GDP per region,
1960–2000 237
16.2 Patterns of development 239
viii
Acknowledgements
There are many people and institutions we would like to thank for their
input into making this book possible. The IGS Group (Institut de Gestion
Sociale) in Paris was the co-organizer with the Industry and Innovation
Research Unit, University of Littoral Côte d’Opale (Lab.RII), of the first
Forum The Spirit of Innovation, International Symposium John Kenneth
Galbraith, in September 2004. The papers included in this volume were
all presented at the conference. Our first thanks go to Roger Serre, head of
the IGS Group and all the staff who took part in the organization of this
conference. We are most particularly grateful to Yves Enrègle, Claude Treyer,
Christine Lancesseur, Michèle Crost, François Diquero and Claire Jeuffrain.
We extend our thanks to Jarlath Dillon, head of the IGS international MBA
and his students for the compilation of the debates during the International
Symposium John Kenneth Galbraith.
Many institutions supported the organization of this event and the publi-
cation of this volume. We would like especially to thank the French Ministry
of Education and Research, the National Centre for Scientific Research
(CNRS), The Embassy of the United States in Paris, the French Senate, the
French National Institute on Industrial Property (INPI), the French Region
Nord/Pas-de-Calais Council and the University of Littoral Côte d’Opale.
We offer our deep appreciation to all the members of the scientific com-
mittee of this symposium, for their help in the selection of papers, in the
construction and in the publication of this book. We especially thank Philip
Arestis (University of Cambridge) for his help with the publication of this
book. We also express our thanks to James K. Galbraith who, from the very
beginning of this project offered time, advice and help to make this event
and this book possible. We also thank our colleagues of Lab.RII–ULCO, for
their precious help, especially Sophie Boutillier and Clotaire Moulougui who
gave us advice on the structure of the book and Jean-Claude Raibaut, who
read and made important corrections on the manuscript.
And finally, we warmly thank John Kenneth Galbraith who, all along the
preparation of this book, gave us his moral and intellectual support.
ix
List of Contributors
Philip Arestis is University Director of Research, Centre of Economic and

Public Policy, University of Cambridge, UK, and Professor of Economics,
Levy Economics Institute, USA.
Norman Birnbaum is University Professor Emeritus, Georgetown University
Law Center, USA.
John Cornwall is Emeritus Professor of Economics at Dalhousie University,
Canada.
Wendy Cornwall is Emeritus Professor of Economics at Mount Saint Vincent
University, Canada.
Fanny Coulomb is Assistant Professor (Maître de Conférences) of Economics,
University Pierre Mendès France, Grenoble, France.
Paul Davidson is Editor, Journal of Post Keynesian Economics, Bernard Schwartz
Center for Economic Policy Analysis, New School University, New York.
Jacques Fontanel is Professor of Economics, University Pierre Mendès France,
Grenoble.
Jean-Luc Gaffard is Professor of Economics, University of Nice Sophia
Antipolis, IUF and OFCE, France.
James K. Galbraith holds the Lloyd M. Bentsen Jr Chair in Government/
Business Relations at the Lyndon B. Johnson School of Public Affairs, the
University of Texas at Austin, USA.
Jeff Madrick is Editor, Challenge magazine and New York Times.
Stanislav Menshikov is Professor at the Central Mathematical Economics
Institute of the Russian Academy of Sciences.
Richard Parker is Professor in Public Policy, J.F. Kennedy School of
Government, Harvard University, USA.
Kunibert Raffer is Associate Professor at the Department of Economics,
University of Vienna, Austria.
James E. Sawyer holds the Louis B. Gaffney Chair of Arts and Sciences,
Seattle University, USA.
Malcolm Sawyer is Professor of Economics, University of Leeds, UK.
Dimitri Uzunidis is Director of the Research Group on Industry and
Innovation (Lab.RII), University of Littoral Côte d’Opale, France.
Robert Hunter Wade is Professor of Political Economy, Development
Studies Institute London School of Economics, UK.
x
Preface
James K. Galbraith
These papers from the International Symposium honouring John Kenneth

Galbraith held in Paris in September 2004 are individually a fine tribute to
my father, suffused in many cases with reminiscence and personal affection.
But taken together, they represent considerably more than that. One might
say – indeed I declare – that they signal the re-emergence of a repressed
current in modern economics, that of rigorous scholarship dealing with the
large social questions from an engaged point of view.
What are the largest social questions? Surely they include the use and
abuse of power by leaders of large countries and the executives of large
corporations. These issues especially feature on the pages that follow.
Surely the greatest conceits of orthodox economics lie in the implicit treat-
ment of the state as the dispassionate instrument for the pursuit of social
welfare, and of the corporation as a price-taking profit-maximizer with
control neither of its market nor of its technology, which is to say without
distinctive identity in the mind of the consumer. Such a view, needless to
say, renders many of the most important phenomena of modern life incom-
prehensible, and even invisible to the trained economist.
For Galbraithians, on the other hand, the purposes of any organization are
its own. They are to control resources, to stabilize present and future, to pro-
vide a comfortable style of life to members, to display and to exercise power.
To a degree, these purposes and the organizational structures that pursue
them are unavoidable, even necessary. Galbraith was never nostalgic for
the never-never-land of ahistorical models. The point was not to obliterate
large organizations and market power, still less the modern state, but to
make their behaviour tolerable and consonant with the larger objectives of a
good society. This goal, and the design of policies to achieve it, has become
the province of the truly modern economist.
These papers reach for modernity in that sense. Some deal with militarism,
the disease of state power. Others deal with the failure of states to pursue the
directed goals of full employment with reasonable price stability, and the
subordination of these goals to others – privatization, deregulation, sound
finance – advanced in some cases by economists in the subtle service of
vested interest. Others deal with the emerging crisis of the corporate form,
which flows from the decline of countervailing power, and that is the emer-
gence of fraud and criminality among those who control the corporation
itself. Still others address the wilful detachment of right-thinking economists
in today’s academy – a salon society, as Jeff Madrick styles it – truly the
microcosm of the culture of contentment.
xi
xii Preface
Galbraith’s economics centred on the American experience in the post-war

world. But he long ago recognized that the future of economics lay in a
global analysis, and he contributed to this in essays on development and
poverty, inspired especially by his Indian engagement. These papers advance
that recognition, with special emphasis on the failures of two decades of
neo-liberalism and the imperative of a new direction in world financial
structure and policy. The final papers here constitute – almost – a programme
of action, if not a manifesto, in this direction.
As Galbraith’s own ideas spring from multiple sources, his followers
are institutionalists, Keynesians, socialists, environmentalists, feminists and
free-thinkers of many other types. What unites us is a will to restore to eco-
nomics the purpose that it had under Marshall and Keynes but has since
largely lost among the puzzle-solvers, social apologists and forecasters of the
academic and business realms. We seek to revive the profession of the social
scientist as social critic; incorruptible, detached from power, and yet deter-
mined to point the way toward a better world.
The test of our success cannot lie in applause or access to the corridors of
power, still less in immediate or early accomplishment of policy objectives.
Though John Kenneth Galbraith had his measure of these, conditions have
changed, and they will not be forthcoming for us, at least not soon. What we
can seek is to form and to sustain an intellectual community: active, critical,
productive and self-improving. That is our goal. The international sympo-
sium in Paris and these papers represent a beginning. There will be more to
follow. And sooner or later, something will come of it, we believe.
Austin, Texas
12 March 2005
Introduction
J.K. Galbraith often refers in his writings to Alfred Marshall’s definition of

economics: the study of man in the ordinary business of life. Such an
approach to economics implies taking history into account to understand
current economic facts. The analysed phenomena are placed in their historical
and political perspectives, embracing political interests and class relations.
Moreover, macro and microeconomic levels are used to obtain a richer
analysis. And finally, economics tends to appear as a whole, including
many fields which are considered as being the conventional divisions and
subdivisions of the discipline.
Galbraith’s open-minded approach cannot be confined in a narrow school
of thought. Influences are of course important, and in the case of Galbraith,
the influence of Keynesian theory is the first that comes to mind. However,
many other influences must be emphasized, as stressed by the authors of this
book which ensues from the Forum The Spirit of Innovation, John Kenneth
Galbraith International Symposium (22–25 September 2004).1
Galbraith and the spirit of economics
Coming back to Galbraith’s works is useful to modern economists because

economic science and research are in the grip of contradictory forces. On the
one hand, is a certain self-regulated economics, disconnected from reality
and based on mathematical models and applications. On the other hand,
the social requirements for economic expert evaluation (economic analysis
and forecasting) in an uncertain context, every day invalidates the progress
of pure mathematical research applied to economics.
Coming back to Galbraith’s works enables us to consider more closely the
economic realities that modern economists have to face. For example, the
state plays a crucial role in all industrial societies, supporting the endoge-
nous creation of resources and markets (notably through military and
civilian research and innovation programmes) but it is also at the origin of
1
2 John Kenneth Galbraith and the Future of Economics
new forms of economic conflict between North and South (for example,
international treaties based on ideological considerations of ‘free trade’).
The first part of the book is devoted to Galbraith’s life and writings. The
authors especially focus on Galbraith’s questioning of pure competition
theory. They show the transition of Galbraith from a relatively mainstream
to a heterodox position, influenced by Keynesian and institutionalist
economists.
In the second part of the book, the authors study Galbraith’s contribution
to the development of strategies for overcoming the problems which
characterize the evaluation of economic policies and the solutions proposed
by conventional economists.
The third part of the book expands this Galbraithian spirit to the wider
world. The major issues faced by national economies in the developed and
the developing world are intimately linked to the creation of a global
capitalism in which international agreements often dominate autonomous
national regulation. Conflicting relations within and between developed
nations are propagated to the Third World in shock waves or in rebounds.
What are the economic and political consequences for developing countries?
This book proposes answers to such issues which could shape the future of
economics as well as of economies.
Back to J.K. Galbraith
In the first chapter, which transcribes the inaugural address of the conference,
James K. Galbraith presents a personal review of the core propositions of
J.K. Galbraith’s thought. The list he proposes is not exhaustive. However,
drawing on J.K. Galbraith’s major books, it captures three essential themes.
The first ensues from The Great Crash (1955), which demonstrates that finan-
cial panics affect the real economy and is, according to James K. Galbraith,
one of the first great works on the subtle economics of insider operations
and financial fraud. The second theme, found in The Affluent Society (1958),
is the logical demolition of the orthodox theory of consumer choice. The
third theme is the theory of economic organization in The New Industrial
State (1967). This book, explains James K. Galbraith, challenges us rigorously
to contemplate what happens when power passes irrevocably to the organi-
zation. Moreover, it helps us to understand the ‘Corporate Republic’ which
characterizes contemporary America. From these starting points, James K.
Galbraith develops elements of his own work that can apply the larger
Galbraithian spirit to a research programme. What are the principles which
could place Galbraith at the starting point of the future of economics? Ten of
them are analysed here, including the abolition of the micro/macro distinc-
tion, the importance given to empirical work and to the teaching of the great
thinkers and the good use of mathematics. According to James K. Galbraith,
pluralism is a necessity, but it needs to be combined with discipline and
Introduction 3
rigour. The task, he says, is not only to understand economics and the world
that economics attempts to describe, it is also to change it: a task which is
discussed in this book in many different ways.
For Richard Parker,2 J.K. Galbraith’s genius lies in his understanding of the
interconnection between economics, politics (including statecraft, economics
and political interests, class, corporation and so on) and society. In his
speech, transcribed in Chapter 2, Richard Parker asks the question: where do
Galbraith’s ideas come from? It is commonplace to assume that Galbraith’s
embrace of Keynesianism in the 1930s is sufficient answer. But Parker brings
to light the progressive political tradition of Galbraith’s family as a patrimo-
nial legacy underlying his thought. Parker also shows the importance of the
teaching of economics in the late 1920s and early 1930s. During these years,
Galbraith’s teachers (notably Leo Rogin) introduced him to early Keynesian
thought and to the progressive thinking of other non-Marshallians, espe-
cially the social-historical school, later known as the first institutionalists.
From these influences and his encounter with towering figures in American
agricultural academics and policy (such as Howard Tolley and John D. Black),
Galbraith had already assembled, according to Parker, the mental architec-
ture and the disposition to embrace Keynesianism when it arrived in the late
1930s. It is on elements of these pre-Keynesian influences that Galbraith
drew in placing his own distinct stamp on post-war Keynesian thought.
But how did the neoclassical Galbraith disappear and the Keynesian
Galbraith emerge? How did the Post Keynesian movement emerge? Was it in
reaction to Samuelson’s neoclassical synthesis of Keynesianism? How to
explain the birth of the Journal of Post Keynesian Economics? Did Galbraith
play a role in this birth? Would the world be different today if Galbraith had
been secretary of state during the early days of the Kennedy administration?
Why has Galbraith never been awarded the Nobel Prize in economics
(although he clearly deserves it)? In Chapter 3, Paul Davidson gives answers
to such questions. He recalls Galbraith’s life through professional, personal
and familial anecdotes, showing the importance of Galbraith’s support for
Post Keynesians in encouraging the development of a separate Post Keynesian
School of economics.
In Chapter 4 Jacques Fontanel and Fanny Coulomb raise the issue of the
place of military power in Galbraith’s work. Galbraith, as economist of
the peace, denounces excessive militarism. He sees the military sector as
particularly illustrative of the power of ‘technostructures’ which are partially
autonomous, evading democratic control. The authors explain that Galbraith
was led to develop a heterodox theory on military issues, which is profoundly
original even if its sources lie in Keynesian and Marxist theories. According
to Galbraith, war, or its threat, makes it possible to control the conflicting
tendencies of inegalitarian countries. Moreover, military power, in develop-
ing countries, but also in developed countries, is in opposition to democracy
and economic development. Even though military expenditure may exercise
a short-term positive influence, in the long run, it represents an economic

waste which limits economic development in the poorest zones, favours the
emergence of bloody conflicts and only benefits a few. This is why Galbraith
pleads for disarmament and for a decrease in military aid to developing
countries in favour of humanitarian and educational aid. Galbraith has inde-
fatigably exhorted economists to study the real problems of their time,
including the questions of war and military expenditure. In our attempt to
understand economics, the world that economics attempts to describe and
also change, this message is of the highest importance.
In his contribution, which is also the last chapter (Chapter 5) of the first part
of the book, Norman Birnbaum examines J.K. Galbraith’s contribution to the
discussion of industrial society (in its democratic variant) in the twentieth
century and asks what lessons we can draw for the next one. He recalls that
according to Galbraith, in order to contain the power of concentrated financial
and productive capital held in the hands of a managerial class with adminis-
trative, scientific and technical knowledge, state intervention, the intervention
of public interest groups and trade unions and the development of education
have major roles to play. In other words – an idea which was in high degree of
consonance with other thinkers all over the world – the goals of socialism
could be attained only if the managerial and scientific elite were directly con-
trolled by society. Democracy was necessary. However, what lessons can be
learned from the lack of resistance of state socialism and from the failures of the
European models of social democracy? For Birnbaum, they show that
Galbraith’s view of the permanence of the social democratic transformation of
the political economy in an industrial society requires rethinking.
The trouble with economists and policies
The contributions in Part I illustrate J.K. Galbraith’s critical thinking, which

still troubles the academy of economics. In Part II, the conventional –
sometimes absurd – ideas of the dominating economic paradigm are dissected
in minute detail through macroeconomic analysis and the study of problems
of our times.
In Chapter 6, Jeff Madrick considers tendencies in the practice of economics
that are the consequence of bias rather than empirical findings or theoretical
breakthrough. The author argues that the profession has become like the
French Salon of the nineteenth century, whose rules and edicts were designed
to maintain art standards but also served to restrict and control artists.
Members of the economics profession are characterized by the fact that they
do economics using statistics only and fail to see people behind their mod-
els. In this chapter Jeff Madrick studies several examples of this academic
bias; from Friedman’s monetarism to free trade, the problem of inflation, the
neglect of public investment and of the demand-side sources of growth, to
the blind faith in markets and its real application to the case of shock
Introduction 5
therapy in Russia or in the theory of corporate management in the 1990s.

This list of biases, which is a tour through some of the author’s own obser-
vations over time, has stifled debate in America and has led to damaging
policies. According to Madrick, it suggests a lack of courage in the professional
economic community, the sort of courage Professor Galbraith has always
epitomized.
In the same vein, in Chapter 7, James Sawyer relies upon a method drawn
from Galbraith, Gramsci and urban planners Schöm and Rein to deconstruct
conventional wisdom associated with neo-liberalism. The chapter explores
assumptions of order underlying the neoclassical paradigm and probes
discontinuities with the way in which the world actually works. According
to the author, general equilibrium obscures hoarding behaviours by rentiers
or ‘pseudo-capitalists’ (defined here as rentiers who hoard assets in uses that
are non-productive of the common good) who commit what Galbraith calls
‘innocent fraud’.3 According to James Sawyer, correcting egregious behav-
iours requires re-conceptualization of the role of the government at the
national and at the global level as well as rethinking the nature of capital.
For the author, in the post-industrial world, capital must be seen as a means
of moving from one set of outcomes to the future attainment of a more
desirable one. In a postscript written in the context of the 2004 US presi-
dential election, James Sawyer asks for more interdisciplinary and cross-
disciplinary strategies which may prove the best means within and without
the American academy for deconstructing the neoclassical conventional
wisdom, thereby promoting a healthy iconoclasm in the tradition of
J.K. Galbraith.
John Kenneth Galbraith has argued that economists have needlessly
reduced the depth and relevance of their theories by neglecting to include
power and institutions in their analysis as major determinants of economic
performance. One of the main tasks of John Cornwall and Wendy Cornwall
in Chapter 8 is to support this charge, using developments in macro-
economic theory over the past half century. They found this neglect to be
highly culpable in a decline in acceptance of the kind of macroeconomics
associated with Keynes’s General Theory. The second task of the chapter is to
outline an extension of the Keynesian model along Galbraithian lines. This
requires a reformulation of Keynes’s theory of aggregate demand to include
power and institutions as determinants of aggregate demand policies. This is
performed by testing the model with standard econometric techniques.
Their test results provide strong evidence that the distribution of political
power and the degree of trust and cooperation in labour relations are impor-
tant determinants of aggregate demand policies and therefore of unemploy-
ment rates. This holds true both across the OECD economies and over a
period covering the ‘Golden Age’ and the ‘Age of Decline’.
Recent developments in macroeconomic policy, both in terms of theory
and practice, have elevated monetary policy while fiscal policy has been
downgraded. Monetary policy has focused on the setting of interest rates as

the key policy instrument, along with the adoption of inflation targets and
the use of monetary policy to target inflation. According to Philip Arestis
and Malcolm Sawyer in Chapter 9 the effectiveness of monetary policy being
questionable, fiscal policy should be reinstated. This is the main focus of the
chapter. The authors consider at length fiscal policy within the current ‘new
consensus’ theoretical framework. They find the proposition of this thinking –
that fiscal policy provides at best a limited role – unconvincing. They exam-
ine the possibility of crowding-out and the Ricardian equivalence theorem
(RET). A short review of quantitative estimates of fiscal policy multipliers
gives credence to their theoretical conclusions. Philip Arestis and Malcolm
Sawyer’s overall conclusion is that, under specified conditions, fiscal policy
is a powerful tool for macroeconomic policy.
The implementation of a policy of growth requires institutions suited to the
choice of the main economic measures. The economic experience of the
eurozone in the first five or more years of the existence of the euro has raised
serious questions about the appropriateness of the institutional and policy
arrangements governing the European single currency and their ability to deal
with unemployment and recession (as well as inflation). This is the central
issue addressed in Chapter 10 by Philip Arestis and Malcolm Sawyer, who
argue that those arrangements must be changed. The institutional arrange-
ments are embedded in the Stability and Growth Pact (SGP) and in the mone-
tary policy operated by the European Central Bank (ECB). The authors begin
by briefly locating the key theoretical features and policy implications of the
system of European Monetary Union (EMU). Then they proceed with the dis-
cussion of the SGP and ECB arrangements and describe how they have been
operated since their creation in January 1999. From a criticism of the present
arrangements and the underlying theoretical perspective, they shift to sugges-
tions for fundamental changes in the institutional and policy arrangements.
Such suggestions are aimed at scrapping the Stability and Growth Pact and
replacing it with modes of macroeconomic coordination which do not impose
deflationary tendencies on the eurozone economies. Reform of the ECB with
changes in its objectives and in its mode of operation is also suggested.
What is the link between institutional change and economic growth? This
is the issue dealt with by Jean-Luc Gaffard in Chapter 11. The problems that are
common to all European countries are the maintenance of full employment,
social achievement and levels of welfare. The common solution is growth
and innovation, that is, access to the most advanced technologies as the way
to revamp the growth process. In order to achieve this, the prevailing con-
sensus, derived from unfavourable comparisons with the performance of the
US economy, consists in promoting the emergence of a new institutional
framework and enhancing potential growth rates. This consensus is built on
a theoretical framework which focuses on structural properties of the
economy. It considers macroeconomic intervention to assure stability and
Introduction 7
balanced public budgets as a preliminary step – once the economy is

stabilized – to structural reforms aimed at favouring innovation processes.
This macroeconomic stability is regarded as a set of rules or behaviours to
achieve monetary stability and fiscal discipline; given once and for all, they
are supposed to be efficient whatever the moment at which they are applied.
However, according to Jean-Luc Gaffard, most European countries were
exhibiting wild and recurrent changes in growth regimes during the last two
decades of the twentieth century. Such a degree of structural instability can
largely be explained by coordination failures that concern both individual
behaviours and economic policy. Some crucial episodes in the growth
process of the different countries presented in this chapter lend support to
such conjecture. In other words, the different productivity trends in Europe
and the US in the 1990s and the apparent disappearance of the productivity
paradox in those years in the US confirm the scenario that focuses on coor-
dination failures. On the one hand, the poor performance of productivity in
Western Europe is the result of a reduced process of accumulation, due to
tight monetary policy and more generally to a wrong policy management.
On the other hand a stable and substantial rate of investment is behind the
positive productivity trend in the US. Ex post, this is an obvious explanation
of the difference. But behind these various accumulation processes, different
coordination mechanisms have been at work, the one actually sustaining
this process, the other failing to do so. Different coordination mechanisms
that cannot be reduced to the properties of technology and the character of
the incentive systems but that involve the harmonization over time of all the
elements involved in the adjustment process. According to Gaffard, institu-
tions matter, but the real issue is the necessarily complex set of conditions
that make the process of accumulation of capital regular. This set of condi-
tions cannot be reduced to the choice of an institutional arrangement pre-
sumed optimal with respect to the need for catching up or forging ahead.
Thus, contrary to the current consensus, macroeconomic stability, far from
being regarded as a precondition of growth, will result from a process that
requires discretionary interventions. The rationale of such interventions is,
for Jean-Luc Gaffard, quite the opposite of that presiding over the measures
making up the policy consensus previously expounded.
Economies in a global context: a programme of action
Is it possible to correlate the entropy which exists in economics with the

great change that faces national economies in a world becoming more and
more interdependent? Economic activity cannot be dissociated from the
global context. Commerce, finance, information and communication
technology, the weight of international organizations and war – all of which
have global repercussions even when local – shape the global context
in which all economic activity takes place.
In Part III, the authors show that the troubles of economists are not
unrelated to the trouble which characterizes international economic rela-
tions. The authors emphasize and open up pertinent ways of thinking and
acting for the future of economies.
Despite the continuing support for the ‘Washington Consensus’ within
the IMF, the World Bank and the US Treasury, most astute observers of the
international financial system recognize that there is something seriously
wrong with the existing system. According to Paul Davidson in Chapter 12,
although many recognize the symptoms of a severe malady in the system,
few realize what its fundamental flaws are. Accordingly, few can prescribe the
correct medicine to cure the illness or vaccine to protect the international
financial system from relapse. The global economy is at a crossroads. It can
try to muddle through with the existing defective international financial
system while hoping that some marginal actions can quarantine the devas-
tating depressionary forces unleashed by financial crises to developing
nations and avoid contagion spilling over to developed nations. Or we can
produce a new financial architecture that not only protects all nations from
the devastating effects of international financial crises similar to those the
world has experienced since the 1970s, but also eliminates the global depres-
sionary pressures of the current system and therefore makes possible the
potential of global full employment. This chapter is devoted to suggesting
how the latter can be achieved. Paul Davidson presents the foundational ele-
ments of his clearing system proposal. According to him, a global depression
should not happen again if our policymakers have sufficient vision to
develop this Post Keynesian approach. In other words, this is an example of
the type of courage, in the sense developed by Madrick in Chapter 6, that
thinkers, but also policymakers, should have.
In their book Capitalism, Communism and Coexistence (1988), J.K. Galbraith
and S. Menshikov assumed that the centrally-planned economy of Russia
would slowly transform into a mixed system combining competitive market
mechanisms, active state intervention and a well-developed social security
infrastructure. In reality, explains Stanislav Menshikov in Chapter 13, the
Russian economy today is a form of oligarchic capitalism with a high degree
of concentration and monopoly in most basic industries, an underdeveloped
banking system, weak government stimulation of the economy and a
shrinking social security infrastructure. Such a system tends to rely on exces-
sively high profit margins, hinders technological progress, promotes infla-
tionary pressures, creates high income inequality and mass poverty, and
prevents the rise of a numerous and stable middle class. The result is an
extremely narrow domestic market, excessive dependence on high-priced
exports of mineral resources, decay and stagnation in manufacturing and
high technology, and lop-sided and unstable growth of the economy in
general. A major reason for such developments is the neo-liberal model of
market reforms and running the economy that turned out to be perfectly
Introduction 9
suited to the vested interests of an extremely narrow group of oligarchic

capitalists focused on fast self-enrichment. Menshikov suggests a list of
reforms needed to improve the situation. They are based on institutional
and evolutionary economic theory. He presents a minimum programme of
measures which propose the greater role of the state to support the capital-
deficient sectors of the economy as well as sectors with a high potential for
competition in foreign markets. The government sector should also act as a
pioneer in breaking up monopoly behaviour in the Russian economy.
Another area of alternative economic policy is the consistent improvement
of macroeconomic proportion in order to attain the normal expansion of
the domestic market and adequate growth rates of the economy. And in the
Galbraithian spirit, the author suggests that practical considerations, and
not ideologically-motivated models, should be used as the basis for
economic policy decisions and long-term strategies.
Institutional problems also face countries which industrialized under
strong state intervention. Traditional institutions disintegrate under pressure
from the global context. Middle-income countries continue to be under
pressure to further open their economies to free trade and investment, to pri-
vatize state-owned assets, deregulate entry and exit to sectors, and give no
preference to domestic firms over foreign firms. The pressure comes from the
global economic multilaterals (especially the WTO, the IMF and the World
Bank) and from the US government and the EU. This consensus is justified
by the claim that these policy shifts will lead to faster rates of investment
and economic growth and thence to faster rises in average living standards
above the national poverty line. This can be viewed, according to Robert
Wade (Chapter 14), in terms of the ascendance of a rentier-oriented form of
finance capitalism, which subordinates the needs of industrial capitalism to
the extraction of financial returns to the holders of financial assets, seeking
the highest returns on money capital worldwide. It opens industrial capital-
ism’s ownership to takeover by financial groups through mergers and acqui-
sitions. Once they dominate industrial capitalism, mergers and acquisitions,
often ‘hostile’, become the central process of capital restructuring. Wade’s
premise in this chapter is that the governments of middle-income countries
should be cautious about embracing anything close to this kind of policy.
According to the author, policymakers and policy analysts in developing
countries have to reconsider the thrust towards free markets as the route to
catch-up development, and then engage in a more open-minded way with
the East Asian experience of the development state. Some of the roles of the
state in economic development in capitalist East Asia – first in the post-
Second World War decades, then in the last decade of the twentieth century –
are here presented. The author emphasizes that (a) a lot of the sectoral indus-
trial policies and programmes set in East Asia were of a rather modest kind,
yet in aggregate were probably very effective in accelerating the transformation
of the economy into higher value-added activities; (b) they did not require
sophisticated calculations and a highly skilled bureaucracy; and (c) other

developing countries can and should adopt the same norms of industrial
policy, even if with still more modest, blunter instruments. Moreover, there
is, according to the author, a body of theory, or theoretical insights, at hand
to support a strategy of governing the market in a developing country
context based on ideas of economies of scale, learning-by-doing, second-
mover advantages, stickiness in location decisions of transnational corpora-
tions (TNCs) and the arbitrariness of much of ‘comparative advantage’. And
there is also some relevant empirical evidence, even if its conclusions about
effectiveness are open to dispute – though no more so than the evidence
which purports to show the fallacies of governments’ efforts to change the
composition of economic activity.
John Kenneth Galbraith recognized the necessity of debt relief for the
Third World. Later, he criticized the delay in finding a quick and fair
solution, and the sacrifices imposed on people in the Third World that
would be unacceptable in industrialized countries. In Chapter 15, Kunibert
Raffer presents a solution to overindebtedness that would implement
Galbraith’s views quickly and easily. After sketching the evolution of debts
and showing why ‘debt management’ has not worked, this chapter contrasts
the proposals presently on the table. It advocates adapting the basic ele-
ments of US municipal insolvency (Chapter 9, Title 11 USC) to sovereign
states. Respecting the very foundation of the rule of law an independent
panel of arbitrators, not creditors, would have the authority to take decisions
on debt resolution. This fair and efficient procedure promotes human rights,
decent living standards, a fresh start for debtors and democratic structures,
and is also in the best interests of bona fide creditors. Extending basic legal
protection mechanisms beyond OECD borders it would do away with debtor
control by multilateral creditors and with the unjustified privileges presently
enjoyed by them. Treating sovereign debtors economically like any other
debtors would again allow market risk and market incentives to work in
sovereign lending, improving the allocative efficiency of international
capital markets.
According to J.K. Galbraith’s hypothesis of the unequal power of players,
the global legal framework of accumulation is drawn up by the most power-
ful states. The first consequence for developing countries is the questioning
of their own market organization mechanisms and socio-economic relations
in order to make them compatible with international rules. The national
legislation increasingly being a framework for the implementation of supra-
national laws, a large part of the national economy is more and more beyond
government control which, in normal conditions (which is less and less
possible) is democratically established in order to provide solutions to specif-
ically national issues. In Chapter 16, following a framework discerned in
J.K. Galbraith’s thinking, Dimitri Uzunidis presents the evolution of the legal
framework applied to global players in order to discuss the consequences of
Introduction 11
the introduction of supranational rules in developing economies. Then, the

author imagines, with Galbraith, another global organization in which insti-
tutional revival and market control are replacing liberalism, globalization
and development crises. He also explains that further to the setback suffered
by neo-liberal economies in the 1990s, as well as financial crises, a measured
return of regulation and institutionalism seems to be taking place inter-
nationally. Can this trend be a source of optimism? According to the author,
such an analysis is limited, notably in the context of the return of bilateral-
ism in the processing of economic issues and of the attitude of the govern-
ments of many developing or industrialized countries which accept the
unilateral US position. This position, inscribed in the attitude of the great
power is vital for the safeguard of US military and monetary power as well as
of its big firms. At the same time, it diminishes the negotiating capacity of
both developed and developing countries. Faced with such a huge economic
power nations will be led into the same deadlock as the implementation
of the measures of the Washington Consensus, revised by international
institutions.
Notes
1. The Forum The Spirit of Innovation, John Kenneth Galbraith International
Symposium, took place in Paris, 22–25, September 2004. The 68 participants, from
five continents, contributed to the understanding of John Kenneth Galbraith’s
writings on the themes of the large corporation, the role of states in economic
dynamism, the origins of innovation and growth, the link between money, finance
and the real economy, and the place of war in today’s capitalism. They also focused
on the specificity of John Kenneth Galbraith’s approach to economics.
2. Richard Parker has recently published John Kenneth Galbraith: His Life, His Politics,
His Economics (New York: Farrar, Straus and Giroux, 2005).
3. J.K. Galbraith, The Economics of Innocent Fraud (Boston and New York: Houghton
Mifflin Company, 2004).
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Part I
Back to John Kenneth Galbraith
1
Galbraith: a Partisan Appraisal
James K. Galbraith
Let me first read a message from my father:
To all attending: Age and medical restraint firmly prevent my attendance

at this the greatest tribute to my writing and my political and economic
history in all time. I am indeed sorry not to be with you on what I trust
will be a glowing occasion, at least to the extent that Economics and its
related subject matter permit.
It is my pleasure that my son James K. Galbraith will be with you and
will deliver his own comment. It is my further pleasure that he has
emerged as one of the more influential economists of his time. The
University of Texas has long been a center of the engaging, alert, and dis-
sident economic view. In my early academic years economic visitors from
Europe had at first on their schedule the diverse interests of New York,
then Harvard, and on to Austin, Texas and its different and distinguished
center of economic discussion. Now a part of this community, it is my
particular pleasure that the second J.K. Galbraith will be with you. Also,
I hasten to add, a full delegation of economic colleagues and one-time
students. Few economists have been accorded the pleasure and, indeed,
the esteem of a gathering such as this. I greet and thank you, one and all.
Paul M. Warburg Professor of Economics Emeritus, Harvard University
It is obvious, after such a greeting, that I am not going to be able to restrict

myself to comments on my father’s work; I will be obliged to say a little bit
on my own.
John Kenneth Galbraith always loved the many sessions of exegesis
devoted to his work by the Association for Evolutionary Economics, the
American Agricultural Economics Association, and even by the American
Economics Association on occasional better days. I’ve attended a fair num-
ber of such convocations. I could never bring myself to get quite as much
enjoyment out of them as he did.
15
For there is an element of the personal in such tributes that tends to be a

little overwhelming. My father is often compared to so fundamental an
intellect as Thorstein Veblen, as a brilliant mind, writer and social critic. At
one level, who would not be content with that? But I always thought that he
deserved more – that indeed Veblen also deserves more than he characteris-
tically gets from such comparison to Galbraith. The deficiency lies in the
way they tend to be treated as economists. There is something in the appreci-
ation of the luminous individual that speaks, also, to the dark side, that
evokes the loner, the evanescent flare, the cul de sac – the man whose
message came and perhaps went, while the economists moved on. It never
much bothered JKG but it bothers me.
For, like Veblen, Galbraith in my view deserves to be recorded as a trans-
forming figure. Like Veblen, he offers an approach, a manner of thought, a
structure – to an economics that manifestly still waits, and greatly needs, to
be transformed. Here I’ll sketch a case for that proposition – and then go on
to suggest how we may achieve it.
What are the core propositions of Galbraith’s thought? The following list
is emblematic rather than exclusive. Among other things, I do not deal here
with the topics of price control and the economics of strategic bombing
on which Galbraith long ago built his technical reputation. But this list,
drawn from his greatest books, captures three themes that are in my view
essential.
1. From The Great Crash, we have of course the conviction that financial
panics affect real activity. No one in the nineteenth century or with experi-
ence of agriculture ever seriously doubted that the economy runs on credit
or that real activity depends on banks. Only in the higher reaches of acade-
mic life could such a thing be denied. The denial, nevertheless, took power-
ful hold. The Great Crash is a wonderful corrective. It has remained
continuously in print for fifty years – outselling all of Galbraith’s other
books, or so I believe.
Still more important than the melody are the notes. Here we have not only
mass psychology and vulnerable technology – the panic that outruns the
ticker, as it did again in the market break of 1987. But The Great Crash also
gives us the subtle interplay of players: how National City bribed the son of
Peru’s president $450,000 for the privilege of marketing a $50 million dollar
loan. As Galbraith notes, ‘Juan’s services were of a rather negative sort. He
was paid for not blocking the deal.’ The debts so accrued forced Peru and
other countries similarly traduced to attempt export-led growth. This was
blocked by rising tariffs, which precipitated default and helped to set off the
panic against the banks.
The Great Crash is built on such stories. Taken together, they teach us that
economics, like history, is made at least in part by particular persons. This is
a message that the profession has stoutly resisted, preferring always the
Galbraith: a Partisan Appraisal 17
denatured maximizing abstraction homo economicus to the flesh-and-blood

of Ivar Krueger, the Match King.
Krueger deserves to be mentioned today because when he shot himself,
on 12 March 1932, he did so in his apartment in Paris. JKG notes that ‘with
the cooperation of the Paris police, the news was withheld until the
[New York] market closed … [however] the security system of the Paris police
was less than perfect. It is fairly certain that there was heavy selling that
morning – including heavy short selling – of Krueger and Toll by continental
interests.’
The Great Crash is one of the first great works on the subtle economics of
insider operations and financial fraud. But it’s not just stories. I can’t resist
giving you one example of the economic method it contains:
To the economist embezzlement is the most interesting of crimes. Alone

among the various forms of larceny it has a time parameter. Weeks,
months, or years may elapse between the commission of the crime and its
discovery. (This is a period, incidentally, when the embezzler has his gain
and the man who has been embezzled, oddly enough, feels no loss. There
is a net increase in psychic wealth.) At any given time there exists an
inventory of undiscovered embezzlement in – or more precisely not in –
the country’s businesses and banks. This inventory – perhaps it should be
called the bezzle … varies in size with the business cycle. In good times
people are relaxed, trusting, and money is plentiful. But even though
money is plentiful, there are always many people who need more. Under
these circumstances the rate of embezzlement grows, the rate of discovery
falls off, and the bezzle increases rapidly. In depression all this is
reversed … Audits are penetrating and meticulous. Commercial morality
is enormously improved. The bezzle shrinks. (pp. 132–3)
Though the essential precedent for this approach – generalization from

example – goes back to Adam Smith, there are not many passages in eco-
nomics since Smith that illuminate a new subject with such penetration.
Can anyone doubt that we could do with more?
2. The Affluent Society is best remembered for its endearing, enduring

phrases, above all the ‘concept of the conventional wisdom’, and for its
evocative passages on private opulence and public squalor, such as the one
about the ‘family which takes its mauve and cerise, air-conditioned, power-
steered and power-braked automobile out for a tour [and] passes through
cities that are badly paved, made hideous by litter, blighted buildings, and
posts for wires that should long since have been put underground’ before
going on to ‘picnic on exquisitely packaged food from a portable icebox by
a polluted stream [and spending] the night at a park which is a menace to
public health and morals’ (p. 253).
But it is much more than that. In The Affluent Society, we find a logical
demolition of the orthodox theory of consumer choice. It proceeds from the
unassailable observation that stable preferences cannot exist for goods that
do not exist. The process of innovation necessarily entails the creation of
markets. Thus the dependence effect: the dependence of consumption on
production and not the other way around. This is, in essence, a plain-English
version of the point about instability of preference fields that Philip
Mirowski drove home in More Heat than Light three decades later. Enormous
trouble could have been saved if the profession had taken the hint the
first time.
3. Then we have the theory of economic organization in The New Industrial

State. Here Galbraith built on the foundation of Berle and Means, on Joseph
Schumpeter and to some extent on Max Weber, on the behavioural for-
malisms of Herbert A. Simon, and on his own American Capitalism of 1952
and its concept of countervailing power. But the portrait in TNIS is alto-
gether richer, conveying understanding not only of the separation of owner-
ship from control but also the significance of the specific bureaucratic
processes that generate corporate decision-making and the interplay of
company and state. In The New Industrial State, Galbraith challenges us to
contemplate rigorously what happens when power passes irrevocably into
the organization. He forces us to recognize that the fundamental decision-
making process of modern economics – maximization subject to constraint –
is untenable in a world of asymmetric information (as Stiglitz has taught us
to call it) and negotiated decisions representing the compromised interests
of established players.
The New Industrial State did not anticipate later developments in many
respects. The incursion of the Japanese technostructure (especially in steel
and autos) into the American scene in the 1970s, eventually stabilized by
market sharing deals under President Reagan, wasn’t foreseen in the book.
Nor was the return to power of high finance in the 1980s, as the demolition
of Bretton Woods restored the role of the banks, and as high interest rates
first permitted them to rake in their gains and then, in a repeat of the early
1930s, nearly ruined them all. Galbraith also did not anticipate that part of
the technostructure would spin away from the large industrial corporations
in the 1990s, becoming a distinct and independently financed economic
force, susceptible (as we learned) to bubble and pop.
Nevertheless, The New Industrial State gives us something that nothing else
at that time did: a framework for analysing all of these phenomena in com-
plex organizational terms. This is missing from the class analysis of the
Marxists, different from the macro and sectoral analyses of the Keynesians,
and alien to the denatured firms and representative households of neoclassi-
cal equilibrium. And it is much closer than any of these to the actual
decision-making institutions of American capitalism.
One may argue that in the new millennium the large corporation has
regained its central position on the American political scene – that we live in
what I’ve called the ‘Corporate Republic’. Indeed one may argue for an
understanding of the present American government – the George W. Bush
administration – almost precisely in terms of corporate governance as The
New Industrial State teaches it to be.
● We have the essentially clientelist character of decision-making, unable to

deliberate in an extended, goal-seeking way, because of the overriding
necessity of deference to players who happen to occupy particular roles.
Thus we have the capture of strategic direction – in national security,
finance, regulation and other areas – by cliques who (like the techno-
structure) can lay claim to expertise not available to outsiders, who can
manufacture bogus expertise at will, claiming the privilege of dispensing
it without fear of substantial contradiction.
● We have the public relations apparatus with the unique characteristic of a
corporate propaganda machine, namely an inability to tell a truthful
story that is consistent from one day to the next. Yet like the press releases
of large corporations, this apparatus nevertheless expects and receives
deferential treatment from the press. Meanwhile challengers and critics
are treated as the financial papers handle unionists and tort lawyers.
● We have the rubber-stamping ‘board of directors’, which in the modern
United States we refer to by the deferential title of ‘Congress’.
● We have the shareholders, nominal owners and participants in occasional
elections, which the management is determined never under any circum-
stances to lose.
● Above all, we have the Chief Executive Officer as specialist in public
relations – the man who spends his time on the golf course (or at the ranch)
in order to show that he can, in order to advertise to the world that things
are under control. Or more precisely to obscure the fact that they are not.
All of these characteristics have analogues in the corporation of The New

Industrial State – or would have them, in any modest updating of that analysis.
And that, my friends, brings me to my principal message for the morning. If

we are weary, as Veblen (1972, p. 229) wrote, of a ‘monocotyledonous wage
doctrine’, and a ‘cryptogamic theory of interest, with involute, loculicidal,
tomentous and moniliform variants, what is the cytoplasm, centrosome, or
karyokinetic process to which we may turn, and, in which we may find
surcease from the metaphysics of normality and controlling principle?’
What are we doing? What are we doing here? Are we merely paying tribute
to a great thinker, a brilliant man, a political inspiration? Or are we here for
a more serious purpose? Are we part of the project – advanced with force
and verve under French student leadership by the Post Autistic Economics
movement in recent years – of changing the way economics conducts its

affairs? And if our purpose is, as I hope, the latter, then what must we do,
together, to bring this about?
The answer will not be found in wit, in literary genius or political celebrity.
It can only be found in research. And one thing my father did not do – one
thing that he never seriously attempted – was to build a research tradition
that would carry on the spirit of his work. Nor, in the struggles of his day
between Marxians, Keynesians and neoclassicals would economics have
permitted any such thing. But if the ideas are to survive, that task is before
us now.
Needless to say this is a project I’ve had in view for many years. Let me say
a few words about the elements in my work that, I believe, apply the larger
Galbraithian spirit to a research programme.
First, I and a growing group of students have shown that the study of
inequality has operated greatly below potential. The reasons lie in the
preference of economists for the analyses of individuals and their character-
istics, for the sample survey and the sample statistic. But inequality is every-
where and always a social characteristic. By its nature the study of inequality
relates individuals to each other. The essential task is therefore to discover
the predominant patterns of change in the structure of relative pay and
incomes. This can be done in fine detail, using data generated by social and
political processes. We have done it for the global economy, for Europe, for
Russia, China, India and the United States. The result is what Walt Rostow
would call ‘meso-economics’ – an economics of regions, sectors and industries.
With a rich portrait of the patterns of change, one can move far beyond
the brilliant insight of Galbraith’s pen, toward numerical propositions that
directly confront the conventional wisdom. I’ll offer just one example. Is it
the case, as so incessantly argued, that European unemployment is due to
the excessive equality, the socialist legacy, of European labour markets? The
answer, we have shown, is that this is not the case.1 Higher pay inequality in
Europe is systematically associated with higher, not lower, unemployment.
The details of the finding are for another time and place. The simple message
is that the quantitative arts are not the exclusive preserve of adherents to
textbook theory.
A second area to which I have been more midwife than parent concerns
the problems of corporate governance and what my colleague Bill Black – an
economist/lawyer/criminologist with a remarkable history as a whistle-
blower – calls ‘control fraud’. Control fraud is that type of fraud committed
by those in control. It constitutes an especially interesting problem for the
economics of crime and market failure, for it is a pattern of activity that
directly challenges the rubrics of ‘law and economics’ – the concepts for
instance of moral hazard and market discipline. The power of Black’s approach
is that it calls attention to specific characteristics of control frauds that cannot
be accounted for by these ideas. It opens the way to an understanding of
corporate behaviour which combines the institutional decision-analysis of

The New Industrial State – focusing in this case on the interaction of control
frauds and their lawyers and accountants – with the fine personal detail
reminiscent of the narrative in The Great Crash.
Third, let me mention the topic on which I cut my teeth as a practitioner:
the conduct of monetary policy. I’ve been working on monetary policy for
about thirty years now – my longest professional preoccupation. And it is
here that my approach is perhaps most directly influenced by my father,
even though he cares little for the topic. For while most economists treated
monetary policy analysis as substantially a matter of numerical models, I
pioneered the application of hermeneutics, of text-analysis, of explication de
texte as I learned it in high school in Rennes, to the topic. And I believe that
this approach – the deconstruction (if you like) of official statements – has
perhaps the greatest promise of transforming the conduct of policy itself. For
it turns out that to central bankers, numerical models are mainly matters of
rhetoric. They are not serious affairs of scientific conviction. Central bankers
care little for evidence, and are insensitive to test statistics however adverse.
But they are rather vulnerable to ridicule in public, which can be effected by
pointing to elementary illogic in their verbal expression. The spirit of this
critical approach is obviously eminently Galbraithian.
The shared characteristics in these three areas of my work are community
and method. These are the ingredients that are, frankly, missing in John
Kenneth Galbraith’s work. They are for lesser men and women to be concerned
with, to be sure. But they are also the steps we must take if we wish – as
I believe we should wish – to build an enduring intellectual tradition.
Let me close, then, by suggesting ten broad principles for that tradition.
First, the micro/macro distinction should be abolished. It exists in princi-
ple to separate irreconcilable doctrines. The new classicals have recognized
this, and have abolished macro. (As Evelyn Waugh said of Randolph
Churchill’s surgeons, it was a miracle, they found the only part that was not
malignant, and removed it.) We should take the opposite tack: toward a
theory of human behaviour based on principles of social interaction.
Second, empirical work should be privileged. Real science does not protect
bad theory by concentrating on unobservables. It is, rather, a process of
interaction between conjecture and evidence. Believe it or not, this could
happen in economics too.
Third, our economics should teach the great thinkers, notably Smith,
Marx, Keynes, Veblen and Schumpeter – and naturally Galbraith. We need
not reinvent the field; nor should we abandon it. The Affluent Society could
never have been written without Smith, Ricardo, Marx, Schumpeter, Veblen
and Keynes.
Fourth, pop constructs derived from neoclassical abstractions, such as social
capital, natural capital and so forth, play a useful but at best a limited role.
They are noteworthy as efforts to reconcile neoclassical ideas and policy

commitments to real social problems, and their exposition helps in the
formation of tactical alliances. But these constructs also extend, rather than
attempt to overcome, the logical flaws and empirical difficulties of the neo-
classical system. As such, they lack the essential radicalism of our approach.
Fifth, nor should we accept the reconstruction of economics as an
amalgam of interest-group politics, however progressive the groups may
themselves be. The fact that race, gender and the environment are important
social issues does not mean that economics requires a separate branch for the
economics of race, another for the economics of gender and another for
‘sustainable development’. It should mean, rather, that the core of our
approach should handle these questions (which relate to power, discrimina-
tion, entropy and so forth) in a way that is central to the discipline we
espouse.
Sixth, an economics of modern capitalism should study the actual, existing
features and behaviour of our system. Households, business enterprises of all
types (including some characterized by diminishing and others by increas-
ing returns, some with monopoly power and others without), money and
credit systems, governments and their budgets, and the international system
are all parts of a nested, hierarchical structure of rule- and convention-
setting institutions, of interacting and sometimes conflicting sources of
power. That’s our subject matter; let’s pursue it with full attention to the
complexities of its structure.
Seventh, mathematics should clarify the complex implications of simple
constructs, not obscure simple ideas behind complex formulae. Dynamical
systems, fractal geometries, cellular automata can help us to understand the
principles underlying evolutionary social dynamics. They are also fascinating.
They help students learn to think. We do not spurn mathematics – we object
only to its use as a bludgeon, to shut off debate.
Eighth, measurement matters. We should embrace the full spectrum of
information sources, not merely sample surveys (with their obsessive focus
on personal characteristics) and the national accounts, but also credit, trade,
industrial and financial data. And we should be both creative and aggressive
in linking economic measurements to other information: political events,
the environment, quality of life, demography, health.
Ninth, a focus on social structures and the data that record them requires
new empirical methods. The study of dispersions, of inequalities, is intrinsic
to the study of power. The study of power is relational, and cannot be done
properly with parametric techniques held hostage to the dogma of hypothe-
sis and test. There is no single formula for empirical learning. Numerical
taxonomy, discriminant analysis, multidimensional scaling, and many other
techniques are available for studying economic relations. We should use
them. There are large gains to be had here, for small investments of effort.
Tenth and finally, our economics is about problems that need to be solved.
There remain before us the pursuit of full employment, balanced growth,
price stability, development, a sustainable standard of life. That is why
students once were attracted to our field. That is why they abandon it now.
That is also why, if we develop a coherent research and teaching programme
that broadly respects the principles outlined above, we will prevail in the
long run.
I have no desire to dictate a specific course of action. Pluralism can and

indeed must be combined with discipline and rigour. Others these next few
days will, I hope, speak to their own innovations. I’m anxious to listen, and
to learn. But let’s be conscious of two fundamental tests. One of them is well
captured by a remark of Paul Samuelson’s, quoted by Richard Parker in his
stunning intellectual biography of John Kenneth Galbraith. Samuelson
writes: ‘In the history of ideas, the thinker who creates a new synthesis and
speaks in telling fashion to a new age is the one who plays the pivotal role in
history.’ Galbraith met that test and so should we.
And then there is a comment by Parker himself, capturing the essence of
my father’s world view. ‘The “truth”, he writes, of an economic theory ulti-
mately lay in its success or failure when applied to policy’ (p. 564). Let’s not
forget our political obligations. As Galbraithians, our task is not only to
understand economics and the world that economics attempts to describe. It
is also to change it. And to do so in a spirit of abiding liberalism, generosity
of spirit, openness and fair play, combined always with humour and a touch
of detachment. Those are my father’s enduring traits and they should also
be ours.
Thank you very much indeed.
Note
1. J. Galbraith and E. Garcilazo, ‘Unemployment, Inequality and the Policy of Europe,
1984–2000’, Banca Nazionale del Lavoro Quarterly Review, LVII, 228 (2004), 3–28.
References
John Kenneth Galbraith, American Capitalism: the Concept of Countervailing Power
(Boston: Houghton Mifflin Company, 1952).
John Kenneth Galbraith, The Affluent Society (Boston: Houghton Mifflin Company,
1958).
John Kenneth Galbraith, The New Industrial State (Boston: Houghton Mifflin
Company, 1967).
John Kenneth Galbraith, The Great Crash 1929 (Boston: Houghton Mifflin Company,
1988).
Philip Mirowski, More Heat than Light: Nature as Social Physics, Physics as Nature’s
Economics (New York: Cambridge University Press, 1989).
Richard Parker, John Kenneth Galbraith: His Life, His Politics, His Economics (New York:
Farrar, Straus and Giroux, 2005).
Thorstein Veblen, ‘Why is Economics Not an Evolutionary Science?’ in Max Lerner
(ed.), The Portable Veblen (New York: Viking, 1972).
2
Where Do Galbraith’s Ideas
Come From?
Richard Parker
Let me say how pleased I am to see so many Galbraith scholars from around
the world here today. If I may paraphrase John F. Kennedy’s famous remark
to a White House dinner honouring Nobel Laureates, ‘This is the most extra-
ordinary collection of talent, of human intelligence, gathered in one place,
with the possible exception of when John Kenneth Galbraith dined alone.’
I am deeply indebted to many of you in my own work, and I look forward to
continuing the conversations several of you have already begun with me
here. Finally, let me say how appropriate it is that we gather in Paris for
this meeting. I can imagine no place better than the City of Lights, with its
ancient heritage of intellectual rigour and engagement, style and rebellious –
indeed revolutionary – élan for us to celebrate the world’s most famous
living economist.
John Kenneth Galbraith is a towering figure in economics (perhaps the
only giant of his generation who has not yet received the Nobel Prize) – and
this conference, in taking his influence and legacy seriously, in seeking both
to analyse and resurrect attention to his thought, will, I believe, itself be
noted by future historians as a turning point in the West’s appreciation for
Galbraithian economics.
It moreover seems appropriate that we meet now at what is, of course, a
critical moment in more than this man’s career. In barely six weeks American
voters will choose a new President and Congress, a choice that will reverberate
across the world as powerfully as the choice the United States made on
8 December 1941, when – a day after Pearl Harbor – it entered World War II.
On that day 64 years ago, America chose not only to go to war, but to engage
the world as it never had before. Following Pearl Harbor, the world’s largest
economy transformed itself into the world’s greatest military power, and
projected its power across the planet, from the plains of Germany to the
deserts of North Africa and the jungles of Asia and the South Pacific.
What Americans did not know then – but all of us know today – is that
once that choice was made, America would never again turn back from its
new role of global superpower, or from using its immense military, economic,
25
political and diplomatic power to constantly reshape, for better or worse, the
lives of billions of human beings around the world.
Today, America believes it is once again at war, as the consequence of the
events of 11 September 2001, and is in many ways as full of righteous anger
in its mission as it was after Pearl Harbor, convinced that it has again been
attacked without cause by evil madmen bent on the destruction of its way of
life; an innocent actor in the world who has been called once again from
peaceful slumber to battle against darkness in the name of both good
and God.
But of course America is not so simply innocent, and the unwelcome role
of America as superpower to many who see the United States as a hated
world changer of the lives, values and cultures of others – without seeking
their opinion, assent or cooperation – is at the heart of the anger which
drives Washington’s ‘terrorist’ enemies today.
But why is war and global power relevant to a discussion of economics and
Galbraith the economist? Because, I believe, it is in his distinctive under-
standing of the deep interconnections between economics as a blackboard
theory of production and distribution – and the far larger world of politics
and nations, of statecraft, of economic and political interests, class, corpora-
tions, lobbyists, a concentrated media, and a global citizenry educated into
thinking that the particular values of a hegemonically-organized world, dri-
ven by the latest evolutionary state of capitalism, are simply normal and
inescapable – that his genius lies. But where do those ideas come from?
The commonplace explanation to many is that Galbraith’s embrace of
Keynesianism in the 1930s, along with many young economists of that gen-
eration, is sufficient. In the cauldron of the Depression, although he was an
early supporter of the New Deal, it was his reading of The General Theory in
1936, and the 1937–38 academic year he spent at Cambridge, that ever after
determined the broad outlines of his thought; even if from the 1950s
onward, Galbraithian economics took on distinctive characteristics that
often placed him at odds with his Keynesian colleagues in the neoclassical
synthesis.
Lest we forget, however, John Kenneth Galbraith in three weeks will
celebrate his ninety-sixth birthday, meaning that far more than any of us
here, he has lived the twentieth century first-hand – and that he didn’t read
The General Theory until his late twenties, which leaves open the question of
what influences shaped him before then.
At his birth in 1908, kings, sultans and emperors ruled most of the nations
of the earth, just as they had for thousands of years, and the number of
authentically democratic states could be counted on two hands – or perhaps
even one. Electricity was new, the automobile was new, motion pictures and
the telephone and the airplane and modern medicine were all new. The
majority of the world’s citizens were illiterate, and still lived by primitive
farming in many ways just as their ancestors had, not by industry. And yet
Where Do Galbraith’s Ideas Come From? 27
the seeds of today’s world – our world – were already present then: industry,
technology and science were creating a new mode of production; cities were
exploding in number and size, with uneasy mixtures of extreme wealth and
extreme poverty side by side; and migration, mass education and mass
entertainment together were giving birth to unprecedented new forms and
possibilities for individual identity and community.
It was a world, in short, in the throes of change – in many ways far greater
changes than those of the past twenty years, when talk of post-industrialism,
the new economy, and the revolutionary impact of computers, the internet,
and biotechnology have been all the rage. In Europe, socialists, communists,
social democrats and others were challenging unstable monarchic and half-
monarchic, half-democratic governments on the continent, while in North
America, populist and progressive forces were similarly challenging the
entrenched power of a new capitalist plutocracy built on unprecedented
concentration of wealth and its servile allies in politics. Yet the world also
then stood poised to give birth to the bloodiest, most destructive century in
human history, ten decades when more than 150 million would die in wars,
millions more would die in revolutions and their aftermaths, and more than
a billion would die of preventable disease or malnutrition generated in large
measure by the dislocations all this modern change entailed.
Galbraith has written sparingly of the influences those early years of his
life had on him, and yet as we understand from psychology, they inevitably
exercised a powerful effect on his later thinking. The start of World War I
came when Galbraith was just six years old, but by the time it ended, not
only the larger world, but the intimate world he knew in tiny Iona Station,
Ontario had been changed forever. Canada in 1914 had loyally sent off hun-
dreds of thousands of her sons to fight and die in Europe, and over the next
four years had suffered horrendous casualties in the process. In Ontario
alone, 70,000 men, nearly a third of those who served, were killed or
wounded during those four years.
The war’s political effects were no less gargantuan. The Liberal Party of
Sir Wilfrid Laurier – to which Galbraith’s parents had long been loyal – had
broken apart during the war over the issue of conscription, as more and more
Canadians came to see the insanity of ‘the war to end all wars’. In 1917, the
national election – ‘the bitterest campaign in Canadian history’, as historian
John English (1993, p. 194) described it – ended with one wing of the Liberals
narrowly winning power in an incongruous coalition with Conservatives.
For those rebellious Liberals whose candidates were defeated – including
Galbraith’s parents, Archie and Kate – it was a break point in their lives.
Archie joined the local draft board, not to support the war but in order to
exempt as many neighbouring farm boys as possible from the slaughter.
When the war ended, he then joined the new United Farmers of Ontario,
a remarkable (though today little remembered) insurgent party that won
control of the Ontario legislature in 1919, during one of the most rebellious
years in Canadian history, when strikes swept the country and insurrection
was in the air. Galbraith was eleven, and has often recalled going out with
his father to campaign for party candidates, most famously the time his
father spoke in a nearby farmer’s barnyard, and climbed atop a large pile of
manure, where he then began his speech by apologizing for speaking from
‘the Tory platform’.
Archie’s campaigning was, of course, a lesson in the power of wit – but also
indelibly about the importance of choosing sides, and in fighting for what
one believed. Over the next four years, the victorious United Farmers of
Ontario, in concert with their Labour Party allies, acted on their beliefs,
unleashing an extraordinary torrent of progressive legislation that, as his-
torian E.C. Drury (1966, p. 108) wrote, ‘Canada and North America had
never seen, or perhaps thought possible’. Minimum wage laws for women,
expanded welfare for widows and orphans, civil service pensions, workers’
compensation reforms, an overhaul of education, new taxes on corporations
and utilities, new public savings banks, new credits for farmers and coopera-
tives, rural road and rail construction, giant public hydroelectric projects, even
critical funding for medical research that led to the discovery of insulin – all
these now poured forth from the UFO/Labour government.
When after four years, the government fell, in a rift between its ‘dry’
farmers and ‘wet’ urban workers over the issue of Prohibition, a pall settled
over the Galbraith household, made far worse for the family because that
same year Kate Galbraith suddenly died. Here again, Galbraith has told us lit-
tle about the effects of events in 1923, when he was fifteen, but they are not
hard to imagine. His sister has said that the gloom that settled over the
house during the next several years was palpable, with their father so dis-
traught there was no Christmas tree, no Christmas presents, no celebration
of any kind for two years after. Galbraith soon found his grades plunging,
and eventually took five years to complete high school. Whatever the pain a
child feels losing his mother, it must have been equally terrible to experience
the ongoing pain of his father, who never remarried, and who only gradually
recovered over several years the warm and affectionate character he had
shown his children for so many years prior.
I am not a psychological historian, but the impact of those early years
must have been extraordinarily powerful on young Ken Galbraith’s character
and imagination. He had been born into a progressive, and in many ways
modern, family. His father, both in his farming practices and community
service, was considered what Galbraith later called, using the vernacular of
the Canadian Scots, ‘a man of standing’, someone widely respected for his
views and habits by the rest of the community, and sought out for his opin-
ion. And indeed, when Archie Galbraith died in 1938, it is testimony to that
community’s respect for Archie (and not just a son’s affectionate memory)
that more than 600 people turned out in the midst of a raging Canadian
snowstorm in the depths of winter for his funeral. One admirer of Archie’s
was so determined to pay his respects that when his car broke down, he
hired a farmer to carry him and his car on a horse-drawn sled more than six
miles to reach the funeral.
If Archie Galbraith and the progressive political tradition he embodied are
the patrimonial legacy present in Galbraith’s thought, the teaching of
economics in the late 1920s and early 1930s is the academic pre-Keynesian
element of no less importance. Galbraith was first exposed to this at
Berkeley, where he was first trained in academic economics. Galbraith in his
memoirs makes much of his introduction to Marshall and neoclassical
thought, in which he was drilled by Ewald Grether. But, because most of us
are not trained in the history of our profession, his classes with teachers such
as Leo Rogin and Howard Tolley are of critical importance in terms of their
impact.
Leo Rogin was a fairly young figure when Galbraith encountered him,
only a decade or so older than most of his students, and caught up in several
challenges to conventional neoclassical thought. It was he who introduced
Galbraith to Keynesian thought, albeit in its pre-General Theory outlines, as
well as to the generally progressive thinking of other non-Marshallians.
(Paul Sweezy (see Parker, 2005) later judged Rogin to have been a ‘Marxist-
influenced’ scholar, though from my own reading of Rogin’s few published
works, I think that is incorrect.)
Few today, however, fully understand the role of figures such as Rogin, or
realize that the history of early modern academic economics in America up
to the Great Depression and Keynes is not one continuous unbroken line
that ran from Smith, Ricardo and Mill through Marshall, Walras, the
Austrians and Pareto, but something quite different, akin to an ongoing
academic war that spanned the decades from the American Civil War up to
the Depression.
In this war, there were two camps, one basically Marshallian and neo-
classical, and one far more ‘Galbraithian’ if you will, in its earlier form known
as the social-historical school, and later, as the first institutionalists
(although neither of these terms is fully satisfactory). With the publication of
Marshall’s great Principles in 1890, teaching of economics in the powerful
private universities of the East – Harvard, Yale, Princeton and so on – quickly
found its master text. But in the public universities of the Midwest and West,
in states such as Wisconsin, Texas, Washington and California, it was
Richard Ely’s text that was dominant. (Indeed, as Joseph Dorfman’s history
of American economics reminds us, Ely’s Outline of Economics (1926) far out-
sold Marshall nationally, because of the greater size of the public universi-
ties, for more than forty years after the appearance of Marshall’s text.)
Ely, like most of the social-historical economists, had received his graduate
training in Wilhelmine Germany, in a moment when following unification
the new German state soared as an economic and political power, and not
only deeply involved the state in economic development, but pioneered
(under Bismarck, ironically) the creation of the first modern welfare state. To
figures like Ely, the ‘German model’ exercised magnetic attraction in con-
fronting the massive disruptions of America’s industrialization and the
Social Darwinist justifications that accompanied it. To Ely, economics was
foremost a moral science, and as a Christian Socialist, he founded the
American Economic Association in 1885 in the belief that economists must
direct state action ‘and say what will be the consequences of such action,
and whether it will be for good or evil’ (Ross, 1991, p. 408).
As Mary Furner, Dorothy Ross and other historians of American economics
have underscored, the split between the more conservative Marshallians and
the progressive Elyites defined the young profession for decades. There were
repeated purges of the progressives by university presidents and trustees,
who were alarmed at the supposedly ‘socialist’ direction of this sort of
economics; purges that cost hundreds, including Ely himself, their jobs –
and taught a lasting lesson about the values of caution to the profession that
remained. After leaving Johns Hopkins, Ely eventually found work at the
University of Wisconsin, where (after an attempted purge of him there) he
went on to create the so-called ‘Wisconsin School’ of economics that served
as a model for engaged progressive scholarship, using his research to draft a
vast array of reform-minded legislation for the progressive state governor
Robert Lafollette. As late as 1919, this rift in the profession was still so large
that the profession’s first great mathematical economist, Irving Fisher of Yale,
made it the subject of his AEA Presidential address. Fisher, in that address,
frankly described the profession as deeply riven between ‘conservatives’ and
‘radicals’, and called for a truce based on simultaneous adoption of a
Marshallian theoretical approach and a highly progressive legislative agenda
that included a sharply progressive income tax, a nearly one hundred per
cent inheritance tax to reduce wealth inequality, and transformation of large
corporations into cooperatively-owned institutions.
Through teachers in Berkeley’s Economics Department such as Leo Rogin,
young instructors such as Paul Taylor, and through progressive fellow
graduate students such as Gregory Silvermaster and Robert Merriman (who
died in the Spanish Civil War fighting for the Republic), Galbraith learned
as much about this second, competing, progressive ‘camp’ in American
economics as he did about Marshall at the hands of Ewald Grether.
No less important, in his agricultural training at Berkeley’s Giannini
Foundation, he was also introduced to the latest thinking in agricultural
policy by men such as Howard Tolley. Here again we, as modern city-dwellers,
know little about this germane history or the attempts of economists such as
Tolley to bring the power of the state to bear on the ongoing crisis of agri-
culture. Yet it is also crucial in tracing out the origins of Galbraithian ideas.
The Department of Agriculture in those years was the most advanced and
sophisticated cabinet department in Washington, with its own degree-granting
graduate school, more PhD economists than any other department, and a
robust sense of the ways in which the federal government could reinvent its
150-year-long history of engagement in land and agricultural policy to
remake the world in which half of all Americans still then lived. It was under
Tolley that Galbraith was introduced to issues such as the hotly-contested
McNary-Haugen bill, parity, domestic allotments, and the many other ways
government was capable of structurally intervening on behalf of farmers,
who – though the embodiment of Marshall’s ideal small producer in a com-
petitive world of millions of small buyers and sellers – were being driven to
ruin, not prosperity, by the unfettered ‘market’. Tolley had worked for many
years at the Department of Agriculture before coming to Berkeley to teach,
and would return there after Roosevelt became President, rising to become
head of the legendary Agricultural Adjustment Administration.
It was, in short, at the hands of men such as Rogin and Tolley that a young
Ken Galbraith moved beyond the powerful emotional foundations of his
father’s progressive world view, and the lessons of his father’s behaviour
during World War I and under the United Farmer/Labour government of the
early 1920s, to a disciplined and informed academic initiation into econ-
omics as far more than conventional Marshallian thought. (And it was of
course Tolley who first introduced Galbraith to public service, hiring him to
work for the ‘triple A’ the summer after he graduated from Berkeley.)
John D. Black is the final figure I wish to mention as seminal in shaping
Galbraith’s thought before he encountered the Keynes of The General Theory.
It was Tolley who recommended that Black hire Galbraith for a lowly -
one-year instructor’s position at Harvard that began what became Galbraith’s
forty-year-long career there. And it was Black who became Galbraith’s first
real mentor, a man who not only used Galbraith as an assistant, but meticu-
lously advanced his career at Harvard in the 1930s, helped advance his
career thereafter, and willingly and persistently engineered his return to
Harvard in 1948.
Black, like Tolley, was a towering figure in American agricultural academics
and policy, who singlehandedly made urbane Harvard for a time into the
second largest producer of agricultural economics PhDs in the country. His
unparalleled energies, his devotion to his students, his tireless service to
advancing progressive farm policies both in the 1920s and then, with far
greater success, during the New Deal, marks him as a giant, now all too sadly
barely known. He encouraged Galbraith not only in his farm-related
research, but in much broader concerns with structural questions about price
behaviour, competition, and concentration in the non-farm economy that
gave Galbraith the needed preparation for usefully ‘discovering’ Keynes.
(Black, it should be noted, although he had no particular interest in
Keynesianism, nonetheless was the hand behind the fellowship that allowed
Galbraith to go to England to study with Keynes’s key disciples in 1937–38.)
Black, it should be noted, in his own progressive attitudes was deeply
influenced by the training he’d received while earning his PhD at the
University of Wisconsin, where he’d studied under Richard Ely’s great ally,
John R. Commons. And it was to Alvin Hansen, Black’s Harvard colleague
and America’s leading academic Keynesian (and a fellow Wisconsin
graduate) that Black in many ways metaphorically ‘passed on’ Galbraith
after his time in England and during the war years; a period that laid the
grounds for Galbraith’s completion of his anointment as a full-fledged
‘Keynesian economist’.
In working through the myriad of issues associated with the Galbraithian
legacy, the influence of these early pre-Keynesian figures in the formation of
Galbraith’s thought should be kept in mind. Despite the pretensions of some
intellectual historians, influences on the imagination of a leading figure in
any field are never a matter of simple causation, of one scholar or scholarly
tradition ‘determining’ the thinking of a major new figure in that field.
Oftentimes, there are deeply-rooted sources for that thinking, many of them
non-academic or non-intellectual, and rooted in family, in youthful associa-
tions, in the very earliest academic training which may not easily offer lines
of connection to better-known later influences.
From all these early influences, I believe Galbraith had assembled the
mental architecture as well as the disposition to embrace Keynesianism
when it arrived in the late 1930s, and more importantly that it is from
elements of these pre-Keynesian influences that Galbraith drew in placing
his own distinct stamp on post-war Keynesian thought; the stamp that
makes his work so singular.
Galbraith in many ways was educated in the broadest sense to embrace
‘the Keynesian spirit’ of generosity, of humanity, and of the essentially
instrumental role of economics in achieving a post-capitalist world; in some
sense, a ‘Keynesian spirit’ that is inescapable when one reads Keynes in the
original but which has been obliterated by an attempt to turn the master
into a gigantic machine producing state-guided growth without end, and in
some more profoundly moral sense, without purpose.
We owe Ken Galbraith an enormous debt for keeping alive that ‘Keynesian
spirit’ by bringing to bear the full weight of his own talent – his distinct
intellectual adaptation of Keynes’s ideas, his humour and his determination –
in his own work. In a profession that today shows little of the confident
unity of purpose that the neoclassical synthesis had fifty years ago, convinced
that government could, with the aid of economists, mathematical models
and computers, swiftly guide the world to a prosperous material equivalent
of Fukayama’s infamous ‘End of History’, the work of the Paris conference is
of manifest importance.
We would do well to remind ourselves that there are great economists
today who understand afresh what Galbraith has given us. Amartya Sen,
asked recently to appraise Galbraithian thought (Steele, 2002, p. 6), singled
out The Affluent Society as an example of the greatness of Ken’s work. The
book represents, he says Galbraith’s ‘great insight’ which ‘has become so
much a part of our understanding of contemporary capitalism that we forget

where it began. It’s like reading Hamlet and deciding it’s full of quotations.
You realize where they come from.’
Note
Let me thank Blandine Laperche, James Galbraith and the other organizers of this con-
ference for what has already been accomplished – and what still lies ahead in the next
day or two. Second, let me note what a pleasure it is to have Catherine Galbraith here.
Behind every great man there is a great woman, and for those who don’t know Kitty
Galbraith, let me say that her diminutive stature is deceiving; this is a woman who in
character and courage stands at least six feet, nine inches tall.
References
John English, The Decline of Politics: the Conservatives and the Party System, 1901–20
(Toronto: University of Toronto Press, 1993).
E.C. Drury, Farmer Premier (Toronto: McClelland & Stewart, 1996).
Richard Parker, John Kenneth Galbraith: His Life, His Politics, His Economics (New York:
Farrar, Straus and Giroux, 2005).
Richard Ely, Outlines of Economics, 4th edn (New York: Macmillan, 1926).
Dorothy Ross, The Origins of American Social Science (New York: Cambridge University
Press, 1991).
Jonathan Steele, ‘The Guardian Profile: John Kenneth Galbraith’, Guardian, 6 April
2002, 6.
3
Galbraith and the Post Keynesians
Paul Davidson
Shortly after he published his wonderfully interesting memoir A Life in our

Times, Ken Galbraith sent me a copy of this book. In this copy he wrote: ‘For
the Davidsons from the pre Keynesian world (and after too).’ In this book,
Galbraith discusses an interesting exchange of ideas on the cause of
unemployment that took place between himself and Henry Dennison in
1936. According to Galbraith, Dennison was, at the time, ‘the most interesting
businessman in the United States’ (Galbraith, 1981, p. 61).
Dennison believed that income from production moved into two streams.
One went to people of modest income (primarily wage earners) who were
likely to spend all they earned. The other stream went to the affluent and to
business enterprises (profit recipients) and was likely to be saved. This view
was similar to that of Kalecki.
According to Galbraith, Dennison believed that the cause of the depression
‘was the nonspending of the income in the savings stream … [Dennison’s]
remedy or partial remedy was to shift taxation from income that was being
spent … to income on its way to being saved – from a sales tax, as one
example, to the corporate or personal income tax’ (Galbraith, 1981, p. 64).
(This view is in direct opposition to economists in the current Bush admin-
istration who would favour eliminating the income tax in favour of
a national sales tax.)
Galbraith tried to convince Dennison that unemployment was the result
not of oversaving but was rather due to the fact that ‘free competition had
given way to oligopoly and monopolistic competition … The shortfall in
production from these defects caused the depression … The remedy was
more competition.’
Galbraith wrote a lengthy paper explaining all of this to Dennison.
Obviously, at this early stage of his career, Galbraith was a good neoclassical
economist trapped by the teaching of his professors at Berkeley.
Galbraith writes, however, that ‘In the very same weeks that I was writing
my brief for my views on competition and thus refuting the errors of
Dennison, I was reading The General Theory. As I did I discovered that Keynes
34
Galbraith and the Post Keynesians 35
was with Dennison and not with me’ (Galbraith, 1981, p. 65). Galbraith rec-
ognized that ‘the explanation of oversaving was much more sophisticated
than Dennison’s, but in practical consequences precisely the same’
(Galbraith, 1981, p. 65). Galbraith tells the reader ‘I was shaken’ by Keynes
argument. Consequently, Galbraith told Dennison that Keynes was support-
ive of the Dennison position rather than Galbraith’s competition versus
monopoly argument. Dennison’s response to this information was simply
that he was not surprised since ‘Keynes has made more sense than most
economists’ (Galbraith, 1981, p. 66).
Yet, Galbraith’s talent as a wordsmith extraordinaire, had made such a
persuasive argument in the paper that he had given Dennison that the latter
thought there might be something in the Galbraith position. Consequently,
Dennison forwarded the Galbraith paper to Felix Frankfurter (then still a law
professor at Harvard). Frankfurter, believing that Dennison had given him
the Galbraith paper as a proposal for a book, forwarded the paper to an
Oxford University Press editor. The latter accepted this ‘proposal’ and offered
Galbraith a book contract.
Galbraith tells us that ‘Dennison was delighted and I did not resist’ the
book contract. Dennison and Galbraith collaborated on a book entitled
Modern Competition and Business Policy (1938). Only an honest author like
Galbraith would later write about this book ‘It is a bad book that should
never been printed … But being an expression in slightly novel form of a
superbly orthodox position, it attracted favorable attention’ (Galbraith,
1938, p. 66).
From this anecdote about his life, what can we conclude about Ken
Galbraith?
First and foremost, Ken Galbraith is one of those rare specimens – an honest
economist rather than an ideologue. Only such an economist can have a
mind that is receptive to new ideas, theories and policy prescription as
economic events unfold and as the economic system evolves.
Following his recognition of Keynes’s insightful analysis, Galbraith decided
to go to Cambridge to get, so to speak, infused in Keynes’s General Theory at
its well-spring origin rather than from the Harvard seminars on Keynes that
‘were frequent and intense’, with a difference of views on Keynes between the
younger and elder faculty members. So in September 1937, Galbraith and his
new wife, Kitty, departed for England to spend the year at Cambridge
University. Unfortunately, Keynes was still recovering from his heart attack
and so Galbraith’s exposure to Keynesianism was left to informal discussions
with Richard Kahn, Joan Robinson, Piero Sraffa, and even Michael Kalecki.
Galbraith notes that the formal Cambridge lectures on money and banking
by D.H. Robertson ‘were not memorable although spiced on occasion with a
certain innovative meanness. Robertson, a gentle man, was deeply pained by
the errors of Keynes and also possibly by his notoriety’ (Galbraith, 1981,
p. 76). From this background, Galbraith indicates he ‘penetrated the thicket
of technical controversy surrounding Keynes’s work and became one of the

acknowledged oracles’ (Galbraith, 1981, p. 77). So we can date the academic
year 1937–38 as the point in time when the neoclassical Galbraith
disappeared and the Keynesian Galbraith emerged.
Galbraith returned to Harvard in September 1938. From 1935–37, a young
Canadian, Robert Bryce, who had attended Keynes’s lectures at Cambridge
between 1933 and 1935 was believed to be the authority on what Keynes
really meant. But as Colander and Landreth pointed out in their book The
Coming of Keynesianism to America (1996), Bryce’s seminars on Keynes were
developed in 1935 before he had read The General Theory – for Bryce had con-
sidered Keynes’s book very difficult to understand. When Galbraith returned
in 1938, he inherited Bryce’s mantle. Galbraith had at least read The General
Theory – something very few American economists have ever done.
At the same time as Galbraith returned to Harvard, Alvin Hansen, a recent
convert to Keynesianism after being a severe critic of Keynes, joined the
faculty and began giving lectures on Keynesian economics. Attending these
lectures was Paul Samuelson. Hansen’s version of Keynes filtered through
the ‘simple mathematics of income determination’ of Samuelson’s 45-degree
cross became, as Galbraith puts it, ‘the foundation of American economic
thought, policy and instruction’ (Galbraith, 1981, p. 91).
As early as the 1950s, my mentor and co-founder of the Journal of
Post Keynesian Economics, Sidney Weintraub was arguing that the Hansen-
Samuelson US version as well as the Hicksian ISLM (interest-savings,
liquidity preference and money supply) version of Keynes was a perversion
of Keynes’s analysis. It is in fact the reaction to Samuelson’s neoclassical
synthesis Keynesianism, which attempted to stitch together classical micro-
economics with Keynes’s macroeconomics, that gave birth to the Post
Keynesian movement. Accordingly it is interesting to speculate whether if
Galbraith had remained the most esteemed Keynesian at Harvard in the
1930s, there would have been any need for a separate Post Keynesian
reaction to the old Keynesianism of Samuelson, Solow, Tobin and so on.
I first saw Galbraith when I was a graduate student at the University of
Pennsylvania and Ken came to give a seminar on The Affluent Society. I was
thoroughly enthralled with the Galbraith thesis and therefore especially
amazed and dismayed at some of the hostile reaction of the older faculty
members.
I did not meet Ken Galbraith again until I spent the academic year of
1970–71 at Cambridge University while working on my manuscript Money
and the Real World (1972). It was my good luck to find that Ken Galbraith
would be spending the first two terms of the same academic year at
Cambridge giving lectures on what was to become Economics and the Public
Purpose (1973). Louise and I diligently attended all his lectures. By early
October, I was having ‘elevenses’ and ‘tea’ with Ken, Austin Robinson and
Richard Kahn on almost a weekly basis.
One incident stands out in my mind. On 27 November 1970, Kitty

Galbraith came up from London. Ken invited Louise and me to have lunch
with Kitty and himself. We discussed many things, even Vietnam. I remem-
ber Ken saying he would have liked to be Secretary of State during the early
days of the Kennedy administration. Galbraith’s opposition to military force
in Vietnam is of course well known. But it was Dean Rusk, a strong hawk on
Vietnam, who was Secretary of State. An interesting exercise is to try to think
how the world would be different today if Galbraith rather than Rusk had
been Secretary of State during these fateful days.
One final anecdote from my Cambridge period with Ken Galbraith. One
day, Ken informed Louise and myself that the American Economic
Association nominating committee had proposed him for the next AEA pres-
ident. Since the only alternative on the ballot was for a write-in candidate,
nomination is equivalent to election. Nevertheless Ken had heard that
Milton Friedman was so opposed to the Galbraith nomination that people at
the University of Chicago were trying to organize a write-in campaign to
defeat Galbraith. Of course, Galbraith won, but this tells how fearful con-
servative free-market economists were of having a liberal Keynesian like
Galbraith in this office. No such campaign has ever been launched against
the more traditional neoclassical synthesis Keynesians. Perhaps this fear of
Galbraith and his economics might help explain why he has never been
awarded the Nobel Prize in Economics, although he clearly deserves it.
By the early 1970s, monetarism had begun to dominate the old neoclassi-
cal synthesis Keynesianism of Samuelson and the like in the economics
profession; Keynes was becoming a dirty word. Sidney Weintraub argued
that the effect would be that Keynesian theory would no longer be accept-
able material for publication in professional economic journals – especially
those published in the United States. Accordingly, Sidney approached me
regarding the start of a journal that would be open to research and debate
based on Keynes’s analytical framework. Since I was, at the time, the area-wide
chairperson of the economics discipline at Rutgers University, Sidney felt
that I could mobilize some of the secretarial and typing resources necessary
to get such a journal off the ground.
What would we name this journal? Sidney thought the obvious title would
be the Journal of Keynesian Economics, but when I pointed out that the
acronym for this title would be JOKE, the name was quickly discarded.
Accordingly we chose the name Journal of Post Keynesian Economics – the JPKE.
We quickly discovered however, that the resources that I could muster at
Rutgers University would not be sufficient to produce a journal that had a
high-quality publishing appearance. I suggested that perhaps we merely
mimeograph each issue of the JPKE and mail it off to subscribers that way.
But Sidney would have none of this. He decided that we should make a list
of people who we would offer to make members of the Board of Editors of
the JPKE. Then we would write to these people indicating why we thought
there was a professional need for this new journal. We would ask them not
only to let us use their names as members of the Board of Editors but also for
a donation of at least $50 as seed money to get the journal off the ground.
Our original list of potential contributors consisted of some 75 names. We
hoped to get positive answers (and money) from about 25 people on the list.
To our amazement 67 of the 75 names accepted our invitation and sent us
cheques. Ken Galbraith contacted us and indicated that he would match
dollar for dollar whatever we received from the other contributors. He only
asked that we had an editorial policy where we did not wait for manuscripts
to, as he put it ‘come over the transit’. Instead we should also organize
symposiums on important policy matters for publication in the JPKE.
We immediately accepted this idea and have tried faithfully to follow
it. With the Galbraith matching grant we were almost certain we could
launch the JPKE.
But Galbraith ended up making another generous contribution. One late
autumn day, the president of the economics graduate student association
came to me with a problem he was having. The association had received a
grant of $2000 from Rutgers University to pay a big-name economist to
come to the university to give a public lecture. He told me that they had
originally invited Milton Friedman (who had been an undergraduate at
Rutgers). After some time, Friedman declined the invitation. Then he had
invited Arthur F. Burns (who had been Friedman’s professor at Rutgers in the
1930s). Burns also declined. If the students did not get a big-name economist
to come within the next three weeks, they would have to return the $2000
grant. The students had heard that I knew Galbraith and so they asked me to
invite him. I suggested that three weeks is not a big window of opportunity
for someone as well known as Galbraith. Nevertheless I would try.
I phoned Ken and invited him. He indicated that his calendar was very full
and he did not think he could make it. I then said to him ‘Ken if you come,
I will let you donate the $2000 honorarium in addition to the matching
money you had promised to start up the JPKE.’ Without a moment’s hesita-
tion, Ken replied ‘Great! Contact my secretary and if she can possibly work
out a time period in my calendar within your time constraint, I will be
there.’ Within a few hours, the details had been worked out and Galbraith
came within the week. He even paid his own travel expenses so that the
entire $2000 could go to help launch the JPKE.
With these Galbraith-augmented resources, Sidney Weintraub and I no
longer had to worry about financing the JPKE and could concentrate on
providing the reader with the best possible manuscripts we could get.
The first issue of the JPKE contained a symposium discussing what is Post
Keynesian economics. In his contribution, Galbraith wrote: ‘Post Keynesian
economics, like the great Keynesian revolution of forty years ago is amenda-
tory and not revolutionary. It holds that industrial society is in a process of
continuous and organic change, that public policy must accommodate to
such change, and that by such public action performance can, in fact, be
improved. Its commitment is to reformist change, not revolution, but it does
not consider this commitment a slight passive thing’ (Galbraith, 1978, p. 8).
In this expression, Galbraith held the torch so that Post Keynesians the
world over could see their way forward. We Post Keynesians owe a consider-
able debt to John Kenneth Galbraith. I am proud to say he is my friend and
my hero.
Note
This chapter also forthcoming as P. Davidson, ‘Galbraith and the Post Keynesians’,
Journal of Post Keynesian Economics, Fall 2005, vol. 28.
References
D.C. Colander and H. Landreth, The Coming of Keynesianism to America (Cheltenham:
Edward Elgar, 1996).
P. Davidson, Money and the Real World (London: Macmillan, 1972).
J. Dennison and J.K. Galbraith, Modern Competition and Business Policy (Oxford: Oxford
University Press, 1938).
J.K. Galbraith, Economics and the Public Purpose (Boston: Houghton Mifflin, 1973).
J.K. Galbraith, ‘On Post Keynesian Economics’, Journal of Post Keynesian Economics, 1
(1978).
J.K. Galbraith, A Life in our Times (Boston: Houghton Mifflin, 1981).
4
J.K. Galbraith: Economist of
the Peace
Jacques Fontanel and Fanny Coulomb
John Kenneth Galbraith is among the most famous economists, not only
known by specialists, but also by all those who wonder about the interactions
between social evolution and economic factors. He has rejected the narrow
hypotheses, axioms and postulates of the dominant economic science, criti-
cizing the too-simplifying analyses based on a supposed ideal world generat-
ing economic development and peace. Robert Eisner, former President of the
American Economic Association, asked why John Kenneth Galbraith had
not obtained the Nobel prize yet, answered with a smile: ‘Because he is too
intelligent’.1 He then added: ‘Maybe also because he is a free, really free
spirit …’
Fukayama announced the end of history at the beginning of the 1990s, but
today war remains a significant presence. It has taken the shape of colonialist/
civilizing operations in Iraq, civil and ethnic conflicts in former Yugoslavia,
in Rwanda and in Sudan, and of terrorist wars in developed countries.
During the last two decades, a number of economists have wondered about
the narrow connections between war and economy. They have notably been
influenced by the pioneer analyses of J.K. Galbraith, who is a founder mem-
ber of the association ECAAR (Economists Allied for Arms Reduction), which
is being further developed by his son, James K. Galbraith, with a new name,
EPS (Economics, Peace and Security). The association promotes peace and
the struggle against poverty. It has several Nobel Laureates among its
members – such as Kenneth Arrow, Douglas North, Lawrence Klein and
Franco Modigliani – and other famous members include economists such as
Michael Intriligator and Jeffrey Sachs.
The subject of military power has an important place in Galbraith’s work.
The military sector is particularly illustrative of the power of technostructures,
which are partially autonomous, evading democratic control. Showing the
irrationality of the arms race (and after 1991 of the maintaining of high mil-
itary expenditures in industrial nations), Galbraith (1993b) pleads for
disarmament and for a reduction in military aid to developing countries in
favour of other kinds of aid. His analysis remains nevertheless characterized
40
J.K. Galbraith: Economist of the Peace 41
by some pessimism as to the capacity of Western systems, and particularly of

America, for reform.
The denunciation of an excessive militarism
Galbraith’s analysis of the technostructure within the capitalist economic

system, pursued over more than thirty years, has always integrated the ques-
tion of the military sector. He has repeatedly denounced the autonomization
of military power and has analysed the specific economic role of defence
spending. In his analysis, the excesses of militarism notably ensue from a
bureaucratic shift of the economic system.
Militarism, technostructure and policy of contentment

In The New Industrial State (Galbraith, 1967), Galbraith explains that the
large corporation depends on state support to develop the research necessary
for technological innovation. Its will to control the market favours the
development of a ‘technostructure’, consisting of administrators and wage-
earning technicians, to the detriment of the entrepreneurs’ power. The
technostructure seeks the continuation of economic growth as well as the
satisfaction of shareholders, in order to ensure its perpetuity. Numerous
problems follow from its increasing dominance, including the progressive
autonomization of military power. Galbraith develops this idea in following
works, in particular in Economics and the Public Purpose (Galbraith, 1974). He
explains in this book that it is the power of the technostructure (more than
that of the bourgeoisie) which is reflected in the structures of the modern
state. He denounces the influence of the ‘military establishment’ – the
armed forces, military bureaucracy and private suppliers, in particular arms
firms – in the determination of the level of military expenditure and of
foreign policy. Two types of bureaucracies are concerned: one private
(the technostructures of arms industries) and the other public (in the US, the
Pentagon). They pursue common objectives of growth and technical inno-
vation in a ‘bureaucratic symbiosis’. Within the military sector, the citizen
has no initiative, the power is in the hands of manufacturers and armed
forces (Galbraith, 1974, p. 181).
In The Culture of Contentment (Galbraith, 1993a), Galbraith devotes two
chapters to the issue of the ‘collusion with the military power’ of the
‘content community’.2 He denounces the propensity of American capitalism
to self-destruction because of the general commitment to laissez-faire and to
market freedom. The privileged act to promote their comfort and immediate
interests, and without long-term objectives. Consequently they consider
state intervention to be a burden and they generally defend tax reduction;
regardless of any potential negative impact on industrial productivity
because of an increase in the budget deficit or of short-term interest rates.
Moreover, within the large corporation, the power given to shareholders
leads to dogmatic emphasis on profit maximization and to the neglect of the

production side. American society suffers from a ‘bureaucratic syndrome’, in
particular within large organizations, which results from the search for
contentment, with the will to fight against resistances, to avoid individual
mental effort and to favour a harmonious social climate.
Galbraith traces the origin of the ‘culture of contentment’ back to the
American victory in World War II. The superpower status of the United States
then required that the country undertook large military expenditures. The
consequent excessive militarism, according to Galbraith, is the partial cause of
the problems affecting contemporary American society. In contrast, Germany
and Japan’s post-war development focused – with a typical ambition of the
defeated, developing a culture of ‘economic war’ – on economic power rather
than military power. The latter is not necessary to become an important coun-
try in the hierarchy of nations. It is, on the contrary, the countries which first
pursued the ‘economic war’ issue that are now among the first in international
competition. So at the beginning of the 1990s, Galbraith claimed the superi-
ority of German and Japanese capitalism,3 which gave priority to production
rather than consumption. Barring important domestic upheavals, the
American economy risked slow decline into grave recession.
This analysis can be placed in a broader stream of economics in the 1980s
(see, among others Thuröw, 1992, or Väyrynen, 1992), which demonstrated
the superiority of Rhenish capitalism over Anglo-Saxon capitalism. All these
works built on ideas previously developed by Veblen, although he did not
present militarism as an essential characteristic of Anglo-Saxon capitalism.
In Imperial Germany and the Industrial Revolution (Veblen, 1964; first
published in 1915), Veblen pointed out the tendency of ‘modern’ capitalist
societies of the Anglo-Saxon type to become more and more peaceful,
because ‘commercial interests’ overcome ‘dynastic interests’. On the other
hand, dynastic societies (as in Japan and Germany) remain characterized by
specific mental habits inherited from the feudal period, during which
military conflicts and mercantilist policies were essential for these systems’
survival. In the long run, the dynastic model should normally disappear and
be replaced by that of modern societies.4
Galbraith’s analysis is then inserted in the institutionalist current, where it
distinguishes itself by its insistence on the importance of the military sector
in capitalist economic development, especially in the United States.
The use of the foreign threat by the military establishment

According to Galbraith, the position of the military establishment in the cul-
ture of contentment was consolidated during the Cold War by its image as a
bulwark against communism, which was presented as a direct threat to this
culture (Galbraith, 1993a). Underlining the excessive and unfounded
character (sometimes approaching ‘paranoia’, as in the time of McCarthyism)
of the fear of the USSR in the United States and in other Western industrial
nations, Galbraith explains that its manipulation by the members of the
military establishment allowed the maintenance of a high level of military

expenditures. Such a situation served the interests of many members of the
‘content community’, such as directors and workers in the arms industry,
defence lobbies, scholars and engineers (Galbraith, 1993a, p. 125). From
1973, in Economics and the Public Purpose (Galbraith, 1974, p. 192), Galbraith
warned against the idea developed by the military and the Pentagon’s ana-
lysts of insufficient military preparation; an idea with the sole aim of serving
their own interests to the detriment of national economic development, and
one which Galbraith further developed elsewhere, notably in The Culture of
Contentment (Galbraith, 1993a, p. 124). Here, he describes the impossibility
of any American politician standing up for a position apparently ‘soft on
communism’, considered at this time equivalent to being ‘soft on defence’,
and how this has favoured the development of defence expenditures. The
military establishment was therefore able to increase its power during the
Cold War and it has become autonomous, escaping democratic control.
During the Cold War, Galbraith also often denounced the role of ideology
in American foreign policy. The numerous American military expeditions,
whose declared objective was to contain Soviet expansionism, were mainly
intended to increase the power of the military establishment. Thus, during
the Vietnam war, Galbraith criticized the transformation of a civil war into a
conflict with a strong ideological content, whose outcome was presented as
decisive for the future social structure of all humanity (Reisman, 2001, p. 62).
The many military operations outside the United States during the 1980s
(Lebanon, Libya, Grenada, Afghanistan or Angola) were first and foremost
used to justify the importance and the power of the military establishment.
Also, the increase of military expenditure in the 1980s, during the Reagan
administration, answered no rational motive, such as the emergence of new
military threats, but rather responded to the fears of the ‘content electorate’
(Reisman, 2001, p. 125), which served the interests of the military establish-
ment (Galbraith, 1993a, p. 137). This renewed arms race has led to the
collapse of the Soviet Union, but its objective at that time was to satisfy the
needs of the military sector rather than to achieve this unexpected victory.
Thus, according to Galbraith, foreign policy is an instrument in the service
of bureaucracy, in particular of careers within ministries. The abolition of
obligatory military service in 1973 in the United States was a spectacular
result of the increasing reluctance of the middle class, marked by the culture
of contentment, to accept human losses in fighting, as had been the case
during the Vietnam war (Galbraith, 1993a, p. 127). However, it has not hin-
dered the interests of the military establishment, which now recruits from
more underprivileged classes.
The autonomy of military power and the lack of

democratic control
Galbraith has criticized the autonomous power of the arms industry lobby
and the fact that military power is not subject to any democratic control.
While traditional economic theory teaches that firms serve the consumer
(largely ignoring monopoly situations with huge profits or bureaucratic inef-
ficiency within organizations), Galbraith considers that it is in fact the con-
sumer who serves firms. Through marketing and advertising, consumer
needs are shaped so as to serve the objectives and financial interests of the
industrialists (Galbraith, 1993a, p. 132). The study of the firm has to take
into account the fact that the organization’s members may privilege stability
and bureaucratic comfort and not the objective of profit maximization. In
the military sector, the internal power of the establishment is particularly
important (Galbraith, 1993a, p. 133). Indeed, this sector avoids the con-
straint of multiple consumers’ choice and of effective demand, because it is
the military establishment itself which decides on what to maintain and to
produce in the field of military forces, installations and production. Military
industries are both the decision-makers and the producers. This idea has
notably been developed in Economics and the Public Purpose (Galbraith, 1974,
p. 179)5 and in The Culture of Contentment (Galbraith, 1993a, p. 134). In the
latter, Galbraith explains the close relations between the military sector and
the political establishment, in particular between members of parliaments
and the arms firms. These firms play an important role in the financing of
election campaigns; in certain regions they also have a key role in employ-
ment. The constant search for technological innovation, justified during the
Cold War by the claimed necessity to remain ahead in the arms race with the
Soviet Union, has led to a culture of ceaseless renewal in the arms industries.
According to Galbraith, innovation in military equipment is a stratagem by
which the military-industrial technostructures create the demand which
meets their production (Galbraith, 1974, p. 193).
The fact that the end of the Cold War has not led to a significant disarma-
ment is testimony to the autonomy of military power. Arms exports and the
development of military technologies continue to be widely financed
(Galbraith, 1993a, p. 139).
The stabilizing effect of military expenditures in

the capitalist system
Galbraith’s theory on the role of military expenditures in the capitalist mode
of production is profoundly original, even if it has its source in Keynesian
and Marxist theories.
Keynes himself had shown that military expenditure could serve as an instru-
ment of economic reflation, like any public spending (Coulomb, 2004, p. 166);
this idea was subsequently criticized by Robinson (1973) on the grounds that
the relative utility of different public spending should be considered. Following
Keynes, Galbraith recognized that the defence budget of the Reagan adminis-
tration had been a factor in economic growth and had offset the recessive
effects of tax reduction (Galbraith, 1995). His originality with regard to the
Keynesian analysis is to show that defence expenditures are very specific,
exercising an inertia effect in capitalist economies: less flexible downwards

than other public expenditures in times of budget cuts, they are also less flexi-
ble upwards in times of growth and of overheating, when they increase more
slowly than other public or private spending. On the other hand, in a reces-
sion, because of the inertia effects inherent in the defence sector (programmes
covering several years, inflexible and substantial personnel expenditures), mil-
itary expenditures exercise a stabilizing effect. They are thus presented as an
important element for the stability of capitalist economic systems, and partic-
ularly of the American economy. This analysis has been confirmed by the
results of several econometric analyses (Fontanel, 1995, p. 58).
Galbraith’s theory may also be compared to the Marxist theory of military
expenditures, notably explored by Baran and Sweezy in the 1960s. According
to these American economists, in a famous analysis of ‘monopoly capital’
(Baran and Sweezy, 1966), defence spending serves to absorb the economic
surplus fostered by capitalism; the arms race is then consistent with the logic
of capitalism which aims, through unproductive expenditures, at maintain-
ing a constant ratio between production and solvent demand. The surplus
can be absorbed through consumption or through civilian public expendi-
tures, but military expenditures are more effective in this role. Indeed, they
do not redistribute incomes to those whose productivity is weak, but they do
stimulate collective values. Disarmament is not compatible with capitalism,
which favours international tensions leading to armed conflicts or increased
military expenditures.
Galbraith offers an alternative to the Marxist theory of military expenditures,
by emphasizing the role of institutions and the autonomy of the military
bureaucracy (public and private), which answers its members’ own interests.
The ‘superstructures’ are autonomous with regard to the class war.
The economic and political implications

of disarmament
A founder member of the ECAAR, Galbraith has warned in numerous works

against the economic and political risks of excessive militarization at the
world level. Judge of his time, he has underlined the central role of war and
of its threat in the American system, but also the wastefulness of military
expenditures, which limit economic development in the poorest zones,
while favouring the emergence of bloody conflicts.
The impossible peace?

Galbraith (1989, p. 49) has traced the central place of the military sector in
the United States back to the origins of the American state, founded by mer-
chants who applied a mercantilist policy to foreign markets (according to
rules defined by Hamilton), in spite of their support for Jefferson’s liberal
philosophy. The military sector’s development has allowed them to
maintain their economic and political power at the domestic level. This
system, based on war and on power, has proved its efficiency since then.
This thought may be linked to a study (Anonymous, 1984; first published
1967) on the utility of wars and the possibility of a demilitarization of
American society. It was a secret, anonymous report that was supposed to
have been drafted by a special study group. J.K. Galbraith was for a time con-
sidered to be the director of the whole report. But it is now known that he
had only written a review of the report under the pseudonym, ‘Herschel
McLandress’, published in the Washington Post and the Chicago Tribune. In
1972 Leonard C. Lewin revealed in the New York Times that he had written
the entire report. The ostensible project was to determine the implications of
a lasting international peace for American society, which was organized
around preparation for imminent war. The hypothesis is made that the
world is not ready to face the economic, political, sociological, cultural or
ecological consequences of large-scale disarmament. What then are the real
functions of war (or of its preparation) in modern societies (Anonymous,
1984)? Is the end of war compatible with social stability?
According to the report, the economic effects of disarmament are difficult
to evaluate and there are no viable tests of such a scenario; they do not take
into account the non-military functions of war in modern societies. The fun-
damental misunderstanding lies in the idea that war is the continuation of
diplomacy, that it is subordinated to the social system which it is supposed to
defend. However, the economy’s transition towards peace is not as simple as
the establishment of new procedures and organizations. War has several non-
military functions (Anonymous, 1984, p. 104): economic (it slows down eco-
nomic progress and stabilizes stocks in surplus), political (international
relations serve to divert public attention from domestic social problems, so
reducing the tendency to social disintegration), sociological (war and military
institutions serve to channel antisocial elements, they prevent movements of
social contestation), cultural and scientific (the military sector imposes ideals
and gives science the power to solve all problems) and so on.
What institutions (or types of expenditures) could be substituted for the
military sector? According to the report, the present system cannot disap-
pear without causing irreparable damage unless substitutes for war are
found. These should meet four main criteria. They should:
● Lead to resources waste

● Be exerted through the normal system of supply and demand
(Anonymous, 1984, p. 151)
● Represent an instrument of regulation of cyclic recessions
● Convince citizens of their legitimacy, so that objections remain slight
Social programmes (health, education, housing or transport) are only imper-

fect substitutes for war, as is space research, as they do not propose substitute
enemies. The proposal of a conversion of war production to civilian public

works demonstrates a misunderstanding of the current economic system.
The report’s methodology and arguments are linked with both Keynesian
and Marxist theories. Between economics, politics and sociology, it presents
military expenditures as a pillar of the capitalist system. It also shares
arguments with the ‘neo-mercantilist’ current.
The thesis developed in this report may be applied, at least partially, to the
current military overspending of the United States, at a time when foreign
threats are not very evident. We can even consider that the American
government creates the conditions of conflict by increasing military
expenditures in an international climate more inclined to market economic
development.
The wastefulness of military expenditures

During the Cold War, Galbraith repeatedly stressed the wastefulness which
represented the arms race between the USSR and the United States. In a
speech in The Hague in 1992,6 he underlined once again the exponential
growth of military expenditures since the end of the Cold War, in particular
the fact that between 1960 and 1990, military expenditures had quintupled
in constant dollars, while the GNP had less than doubled. Galbraith often
regretted that the question of resources’ allocation for military objectives
remained too little studied by economists, particularly in the United States.
The argument for the superior requirements of defence was used to justify a
high level of military expenditures during the Cold War, to the detriment of
the struggle against poverty.7 The allocation between military and civil needs
shows a failure of the democratic process in the United States (Galbraith,
1995, p. 113).
The collapse of the USSR in 1991 generated great hopes for world disarma-
ment, while some foresaw a transition towards a multipolar interdependent
world. The idea that security should from now on be ensured with a mini-
mum of weapons, on the basis of the balance of threat, no longer seemed
subversive. The complete elimination of nuclear forces appeared as an
essential objective of humanity. In 1999, Galbraith asserted that the exis-
tence of nuclear weapons reduced the risk of open warfare, and that the
United States was particularly vulnerable, because of the high concentration
of economic and financial activities in certain zones, as in New York
(Galbraith, 1999). The disarmament process initiated by the major powers
partially met economic considerations, the American economy being weak-
ened by competition from the European Economic Community and
Southeast Asia – its strategic allies but also trade rivals – and the countries of
the former USSR being confronted with an unprecedented political,
economic and social crisis. From the start, Galbraith criticized the political
orientation of the reforms in these countries, which according to him were
not based on a serious reflection on the development of demand or on real
liberties (Galbraith, 1993, p. 28). And yet the risk is that democracy is
identified with scarcity and economic difficulties; besides, it does not represent
a solution by itself. Galbraith repeated this idea several years later (Galbraith,
1999). According to him, democracy is not the necessary and sufficient con-
dition for economic development, which will occur only if the political
teams are competent, honest and concerned about the general interest.
In 1993, Galbraith remained sceptical about the possibility of rapid world
disarmament (Galbraith, 1993a, p. 25). But six years later, he seemed more
optimistic about the possibility of limiting war, thanks to economic global-
ization. The situation appeared very different from that prevailing in Europe
on the eve of World War I, when heavy industries were the military allies of
governments and favoured nationalism (Galbraith, 1999). This reflection was
prior to the attacks of 11 September 2001 and to the conflicts in Afghanistan
and Iraq. It developed the arguments of French physiocrats and of British
classical economists for the pacification of international relations through
the development of trade interdependences (Galbraith, 1995, p. 125).
Thus, Galbraith has always defended the idea of worldwide disarmament.
While he underlined in his writings of the 1960s and 1970s that the military
sector had contradictory economic effects, by representing both a waste and
stabilizing factor, he did not consider the possibility of the positive effects of
military technologies on the civil sector. Today the United States is ahead of
the rest of the world in research and development and in technological
potential. It is the only superpower, combining military power without rival,
very advanced technological development, diplomatic and cultural force,
control of international organizations and a will to domination and prose-
lytism. If the US still appears as defender of an impartial economic free trade,
its economic policy is more than ever characterized by geo-economic
considerations. The level of American military expenditures shows the
importance given to support of the ‘society of contentment’ in a world still
stricken by the ancestral plagues of misery, lack of freedom and violence.
Military power against economic development

J.K. Galbraith has consistently criticized the wastefulness represented by mil-
itary expenditures in developing countries. The capitalist system facilitates
the emergence of an independent military power in industrial nations, but
its costs in human terms are only limited compared with that of the military
power in poorest countries. According to Galbraith, this diverts the correct
use of scarce resources and prevents the implementation of efficient govern-
ment (Galbraith, 1993a, p. 27). It inevitably leads to deprivation and
economic curbs. The resource requirements of the military sector represent
‘the greatest scandal and the greatest tragedy of our time’ (Galbraith, 1993a,
p. 25). If some countries partially escape this fate, elsewhere in Asia, in
Africa, in Latin America, the military power has excessive influence on the
government, when it is not itself the government. Besides, the question of
the arms trade has remained widely ignored by economists, as if this issue,
though essential, did not exist. Arms purchases by developing countries lead
to a transfer of resources towards developed exporting countries and away
from the satisfaction of essential needs and they favour murderous conflicts.
Galbraith has also criticized the military aid to developing countries, which
has always widely exceeded the civil aid in health or education (Galbraith,
1995, p. 269); the role of free education in the process of economic develop-
ment has not been enough emphasized (Galbraith, 1993a, p. 27) although
there is a direct link between the education level of a population and its
welfare. Galbraith has moreover observed that the strategies of indirect con-
flicts embarked upon by industrial nations during the Cold War aimed to
minimize human losses in these countries, while generating millions of civil
and military victims in developing countries, as in Vietnam or in Afghanistan
(Galbraith, 1993a, pp. 26–7). By destroying the potential for economic devel-
opment, conflicts also generate humanitarian disasters that result in millions
more deaths. Concerning contemporary conflicts, Galbraith declared himself
in 1994 in favour of the duty to interfere in case of domestic massacres, as in
Somalia or in the Balkans, under the auspices of the United Nations
(Galbraith, 1995, p. 270). He has on the other hand called into question the
efficiency of economic weapons, in particular the international economic
sanctions, which only generate a transfer of resources within the target econ-
omy and a greater sacrifice by the civil population, without achieving their
political or military objectives (Galbraith, 1995, p. 155).
Conclusion
J.K. Galbraith has often regretted that economic analysis was limited to the
study of production and demand in very rich economies, where fundamental
needs were already satisfied, without considering the recurrent problems in
less wealthy nations of misery, poverty and inequalities, resulting in vio-
lence. In 1953, Eisenhower underlined the wastefulness represented by mili-
tary expenditure. From the same perspective, J.K. Galbraith has indefatigably
exhorted economists to study the real problems of their time, and it has led
him to develop a heterodox theory on military issues. To Galbraith, war or
its threat allows control of the conflicting tendencies of inegalitarian
societies. Moreover, military power, in developing countries but also in
developed countries, is in opposition to democracy and economic develop-
ment. Its autonomous character results from the increasing power of the
technostructure within industrial nations, in particular in the United States.
Finally, even though military expenditures may exercise a short-term
positive influence on economic growth in developed countries, in the long
run, they represent an economic waste, only benefiting a few.
Galbraith’s analysis of peace has remained homogeneous in all its expres-
sions. If he recognizes the interest of a dominant power in using military
force to deter enemies, to provide a social cement that the values of

individualism do still not supply, and to maintain the ‘society of content-
ment’, he has also condemned the non-optimal character at the world level
of military expenditures and the incapacity of modern societies to give up
barbaric forms of conflict, wars or the domestic oppression of citizens by
armies, which may be both instruments of power and the power itself.
Notes
1. Told by Jacques Fontanel.
2. The content community is the one which takes advantage of the system and
defends it.
3. Which is based on a different economic organization, at the level of production
and productive methods and management.
4. However, Galbraith’s analysis is not determinist.
5. Galbraith explains that arms production decisions are made by the producing firms
and the armed services, and that the President, who ratifies the measures, is a pris-
oner of the military bureaucracy, which is represented in Congress by the
Commissions of Armed Forces.
6. International Conference of the Dutch Flemisch Economists for Peace, The Hague,
Holland, May 1992. Speech translated and published by Jacques Fontanel:
Galbraith, J.K. (1993), ‘Le pouvoir économique autonome’, in J. Fontanel (ed.),
Economistes de la paix (with J. Tinbergen, L. Klein, J.K. Galbraith, W. Isard,
S. Menshikov, K. Hartley, R. Schwartz, M. Chatterji, R. Smith) (Grenoble: Presses
Universitaires de Grenoble).
7. And notably during the Vietnam war (Galbraith, 1995, p. 212).
References
Anonymous, La paix indésirable, rapport sur l’utilité des guerres, préface de J.K. Galbraith
(Paris: Calmann Levy, 1984) (Original title: Report from the Iron Mountain on the
Possibility and Desirability of Peace, 1967).
P. Baran and P. Sweezy, Monopoly Capital (New York: Monthly Review Press, 1966).
F. Coulomb, Economic Theories of Peace and War (London: Routledge, 2004).
J. Fontanel, Les dépenses militaires et le désarmement (Paris: Publisud, 1995).
J.K. Galbraith, The New Industrial State (Harmondsworth: Penguin Books, 1967).
J.K. Galbraith, La science économique et l’intérêt général (Paris: Gallimard, 1974) (Original
title: Economics and the Public Purpose, 1973).
J.K. Galbraith, L’économie en perspective, une histoire critique (Paris: Seuil, 1989) (Original
title: A History of Economics, 1987).
J.K. Galbraith, La république des satisfaits (Paris: Seuil, 1993a) (Original title: The Culture
of Contentment, 1992).
J.K. Galbraith, ‘Le pouvoir économique autonome’, in J. Fontanel (ed.), Economistes de
la paix (Grenoble: Presses Universitaires de Grenoble, 1993b), pp. 23–8.
J.K. Galbraith, Voyage dans le temps économique (Paris: Seuil, 1995) (Original title:
A Journey through Economic Time. A Firsthand View, 1994).
J.K. Galbraith, Pour une société meilleure. Un programme pour l’humanité (Paris: Seuil,
1995) (Original title: The Good Society: the Humane Agenda, 1996).
J.K. Galbraith, ‘Challenges of the new millenium. Talks with Asimina Caminis’,
Finance and Development, WMF, December 1999.
D.A. Reisman, ‘Social Capital and Political Economy: Galbraith on States and Groups’,
in M. Keaney (ed.), Economist with a Public Purpose: Essays in Honour of J.K. Galbraith
(London: Routledge, 2001), pp. 51–66.
J. Robinson, An Introduction to Modern Economics (London: McGraw-Hill, 1973).
L. Thuröw, Head to Head: the Coming Economic Battle between Japan, Europe and America
(New York: Wm Morrow and Co, 1992).
R. Väyrynen, Military Industrialization and Economic Development: Theory and Historical
Case Studies (Geneva: UNIDIR; Aldershot: Dartmouth, 1992).
T. Veblen, Imperial Germany and the Industrial Revolution (New York: Augustus M. Kelley,
1964) (First edition: 1915).
5
John Kenneth Galbraith and the
Uncompleted Task of Progress
Norman Birnbaum
Academic, ambassador, author, adviser to governments and presidents, an

iconic figure of American ‘liberalism’ (our own and quite authentic version
of social democracy), great witness to the century, and not least, a loyal
counsellor and friend to so many – John Kenneth Galbraith can look back on
a marvellous life. I propose to examine his contribution to the discussion of
industrial society (in its democratic variant) in the twentieth century, and to
ask what lessons we can draw for the next one – in which, not entirely to our
delight, we now find ourselves.
Of course, Galbraith’s view of industrial society, its culture and politics, is
inseparable from his Keynesian view of economics, his youth in Ontario, his
experience as deputy price administrator in the Roosevelt wartime govern-
ment, and his subsequent role in the Democratic Party and as Kennedy’s
Ambassador to India. He grew up on a farm, and began his academic work as
an agricultural economist, so he knew at first hand of the great transforma-
tion by which industrial society has assumed its current state. He was a
New Dealer, which no doubt accounts in part for the fact that Kennedy
thought it wiser in the end to send him across the world to New Delhi rather
than invite him to the White House: Kennedy valued his judgement greatly,
but often managed not to follow it. He did have the idea, originally, of
appointing Galbraith as Chair of the Council of Economic Advisers, but
Galbraith himself considered that his public profile (the Republicans
thought of him as an enemy of the existing order) would distract from his
ability to advance through Washington’s political jungle. Moreover, the
responsibility for executing economic policy fell largely to the Treasury.
Kennedy’s Secretary of the Treasury was a Wall Street banker who had served
in Eisenhower’s cabinet as Secretary of Commerce and who repeated every
banal cliché of the business and financial elite with great conviction:
nothing else occurred to him.
It was, surely, Galbraith’s experience of government – as well as a superior
intelligence – which never led him to confuse models of reality with reality
itself. He knew that economic analysis was (and is) political economy in
52
J.K. Galbraith and the Uncompleted Task of Progress 53
every sense. Much has been written of Galbraith’s increasing estrangement

from the discipline of economics. As economics became ever more a matter
of refined quantitative analysis, it grew remote from the substance and tex-
ture of actual social life, in which the economy was embedded. In so far as
the instruments over which the quantitative economists disposed were in
fact capable of describing reality, most economists put them at the service of
the institutions of power. The reality they described was not economic and
social order in general, but a very specific one, with privileges for some,
barriers confronting others.
Ideas of objectivity were illusory – even or above all when drawn from the
natural sciences, the methods of which were in any case often absurdly
simplified or misconstrued by the economists loudest in their claims to be
following these. Many economists of the present generation believe that
social expenditure ought to be cut, adhere to vulgar notions of economic
motivation (in which the prosperous can only be moved by the prospect of
increasing, and the bulk of the working population by decreasing income),
and believe despite ample evidence of its corruption, fraud and incompe-
tence that the private sector is invariably more productive than the public
one. Perhaps it was Galbraith’s early exposure to the Calvinism of his Scots
ancestors, family and neighbours that made it possible for him to recognize
unshakable religious convictions when he met them.
Further, he was, with increasing outspokenness, an adversary of the
catastrophic assumptions of American imperialism that led his Harvard col-
leagues and the Democratic Party’s leaders to urge Lyndon Johnson into the
swamps of Vietnam – where they abandoned him. Galbraith had worked at
the end of World War II on an inquiry into the efficacy of strategic bombing
of German industrial targets and had concluded that it was not responsible
for winning the war by inflicting catastrophic damage upon the German war
effort. Scepticism about the foresight, knowledge and intelligence of the
professional leadership of American diplomacy and our armed forces was
another of his traits. He was for a brief unhappy period attached to the
US State Department and assigned to work on the post-war reconstruction of
Germany, Italy and Japan. He was appalled when notions of international
politics utterly remote from the economic and social situations of the
defeated nations counted for more than historical reasoning. The temporary
mastery of the world occasioned by the end of the war, he observed, had
gone to the heads of diplomats and politicians who could not think ahead.
When foreign policy became the preserve of bankers and lawyers who
alternated between government and service to capital, his scepticism
increased. To their economic cupidity they added arrogant refusal to deal
with the complexity and resistance of the rest of the world. That was a seem-
ingly inexorable derivative of their position at the top of a society whose
most ordinary citizens thought of themselves as privileged to belong to ‘the
greatest nation on earth’. Galbraith grew up as a Canadian in the Great
Depression, and his father was a local leader of agrarian social protest. That,
and his direct experience of capitalism’s catastrophic failures gave him
critical perspectives he never abandoned.
One of his many virtues is that before the absurdly over-used term, globalism,
was in common use he understood that the world was round. That accounted
for his interest in going to India as Ambassador. As a Canadian, a subject
however distant of an empire that had exhausted itself by its conquests, he
was immune to the familiar argument that the US was the natural heir of
Britain’s (and Europe’s) imperial responsibilities. These were responsibilities
the subjected populations had not entrusted us with, and our attempt to
exercise them invariably brought conflicts which our elites were unprepared
to meet with anything but force. Galbraith very early sensed a contradiction
painfully evident in the policies of George W. Bush.
The supposedly universal appeal of an American model of society legiti-
mated the use of force to bring recalcitrant nations to reason. If the model
was so compelling, however, why was so much force required? The pathetic
refrain ‘Why do they hate us?’ (much repeated in the orgy of national self-pity
that followed the attack on New York on 11 September of 2001) refracted a
difficulty. Public opinion could not grasp the reality of our world since opinion
is formed by imperial ideologues either unable or unwilling to acknowledge
that the world refuses subjugation to American power.
Galbraith was dismayed when Kennedy allowed his government to push him
into the humiliation that was the Bay of Pigs – despite Senator Fulbright’s
impassioned warning (he was Chair of the Senate Foreign Relations Committee)
that the project was disproportionate to the threat entailed in the Cuban
Revolution, contravened our national ideals and would be as devastating to
our prestige if it succeeded as if it failed. Galbraith, throughout his career as
political counsellor and publicist, declared that military expenditures took
an undue share of the American budget. He thought the Soviet military
threat, and the ideological danger of Soviet Communism, grossly exagger-
ated by an American party, bi-partisan, which lived not for service in the
Cold War apparatus but from it. Urging Kennedy and then Johnson not to be
pushed into the Vietnam debacle, he appealed to a sense of proportion: the
manifold foreign policy disasters predicted by Bundy, MacNamara, Rusk and
others should the Communists win did not in fact occur. Re-education
camps in unified Vietnam, and the struggles of the boat people to escape,
were indeed horrific. Another regime, in a nation unified by negotiation,
might well have been more humane – but it was precisely negotiation
between the Vietnamese parties that the US blocked.
The Soviet triumph in launching the first satellite to circle the globe in
outer space (the Sputnik) was a shock to American national consciousness.
Galbraith used the event as a cautionary tale: national strength resided in
matters like an educated labour force. His adversaries, however, used it to
argue for still more military competition. Galbraith was enthusiastic, however,
when in his address at American University on 10 June 1963 Kennedy

proposed a truce in which to negotiate an end to the Cold War. The
speech was received by American opinion with some hostility and much indif-
ference. Whether it was a factor in inciting a group or groups as yet unidenti-
fied to murder the President six months later remains an unanswered
question.
That speech, and with it the entire set of arguments for coexistence
advanced by critics of national mobilization for confrontation with China
and the USSR and ‘Communism’, are strikingly contemporary. The new Cold
War is termed ‘the war on terror’ and frequently uses the imagery of the pre-
ceding campaign to instil anxiety and obedience in the American public.
‘Experts’ on the Soviet Union (mostly devoid of knowledge of the history of
Russia or anything else) have been replaced by ‘experts’ on ‘rogue states’,
‘terror’ or ‘Islamic totalitarianism’, few of whom actually have read the
Koran in Arabic. The career of our Secretary of State, Dr Rice, is in this respect
exemplary: a scrutiny of her writings will show no cliché left unused – and
no position ever taken uncongenial to those in power.
About all of these matters, Galbraith was right. His persistent criticism of
‘military Keynesianism’ showed how aware he has been of the economic
impact of the American imperial commitment. Could he have integrated his
analysis of the political economy of the nation more closely with his relentless
scepticism about the working of the imperial state? To a large extent, that scep-
ticism suffuses much of his writing. The United States was not a society which,
incidentally, conquered a continent and then found itself constrained to exer-
cise world power. At the beginning of the twentieth century the historian
Frederick Jackson Turner declared that the closing of the frontier would result
in the end of the possibility of escape for surplus labour (to untilled lands).
Now the US would be unable to escape the weight of its own inequalities and
social conflicts. Those conflicts did increase, and some of Turner’s contempo-
raries and successors (the historians Charles Beard in the older generation and
William Appleman Williams in a more recent one) argued that it was precisely
to deal with class conflict that a new American empire was imagined – and
then achieved. The recent shorthand for the relationship of empire to class
society is the term, ‘the warfare-welfare state’. When we consider the large sup-
port for the most aggressive and unremitting of Cold War policies given by
presidents of the central trade union organization, the American Federation of
Labor–Congress of Industrial Organizations, the phrase is compelling. True,
two of the recent presidents, George Meany and Lane Kirkland, were suc-
ceeded by the present incumbent, John Sweeney, who has more open doubts
about the integration of the working class (and the trade unions, whose
numerical and political decline continues) in the imperial system. The union
movement, however, has not as such opposed the Bush foreign policy and as
the 2004 election made clear, has been unable to convince those workers not
in trade unions that it is in their interest to oppose that policy.
The American economy is part of an imperial polity and an imperial

structure. The Bretton Woods agreements for the control of the international
economy legitimated and provided mechanisms for the American economic
predominance made possible by the nation’s huge accumulation of produc-
tive resources and wealth during the war. Predominance was reinforced by
military power and by political power in the form of covert and overt inter-
ventions in the politics of other nations, including allied ones. Great Britain
exhausted its holdings of overseas capital during the war and was reduced to
debtor status vis-à-vis the United States. The American capitalist elite recog-
nized the indispensability of Great Britain as a military ally in Europe and
elsewhere, but was distinctly unforthcoming as regards support for two
post-war governments (the Labour governments of 1945–50 and 1950–51)
struggling with penury. In Germany, the US blocked the nationalization of
parts of the economy in the western zones and had to tolerate the (slow)
extension of the Bismarckian welfare state by the Christian parties to obtain
German agreement to rearmament. In some sense, the American ‘warfare-
welfare’ state was exported to its major European satellite state, the early
Federal German Republic.
Galbraith’s view of industrial society was presented in three books,
American Capitalism: the Concept of Countervailing Power (1952), The Affluent
Society (1958) and The New Industrial State (1967). There are differences
of emphasis in the texts, but a coherent view unites the three. Galbraith
argues that the power of concentrated financial and productive capital can
be contained, because organized capital requires an indispensable set of state
functions if it is to endure. These include regulatory intervention to organize
markets, the centralization of ultimate decision-making in regard to interest
rates and monetary aggregates and the provision of public goods (cultural,
educational, and scientific facilities, infrastructure in housing and transport,
and the protection of the biosphere through health care and environmental
policy). Political democracy cannot function without the extension of citi-
zenship to the economic sphere, the ideological precondition for the activity
of political leaders and civil servants resistant to ever present opportunities
to go on capital’s payroll.
A complication is presented by the notion of technostructure introduced
in The New Industrial State. Following a half century of familiar argument on
the bureaucratization of control of the means of production, Galbraith
sketched the consolidation of power in industrial societies by a managerial
class equipped with administrative, scientific and technical knowledge.
Rising levels of education, he declared, and the intervention of public inter-
est groups and trade unions – borrowing from the first of the books – would
enable democratic publics to avoid losing their sovereignty to the ostensible
masters of the technostructure. The whole, then, presupposed a very high
level, qualitatively and quantitatively, of participation in civic life. That is
what Galbraith saw as the task of the Democratic Party, and he recognized
that its international allies were to be found in much of the social Christian
spectrum, as well as in the parties of the Third International – and in the
developmental projects of Congress in India and similar movements and
parties elsewhere in the Third World.
There was a high degree of consonance between Galbraith’s views and the
depictions of industrial society by Raymond Aron, Georges Friedmann, and
the younger thinkers like Jacques Delors and Alain Touraine (and Michel
Rocard) in France. Similar views were expressed in the United Kingdom by
Anthony Crosland, T.H. Marshall and (revising his earlier views) John
Strachey. In Germany, Ralf Dahrendorf, Theodor Eschenburg and Helmut
Schelsky (as well as lawyers in politics like Fritz Erler and Horst Ehmke) spoke
in the same idiom. Alessandro Pizzorno and Paolo Silvos-Labini (and the
political philosopher Norberto Bobbio) came to the same conclusions in
Italy, as a Communist Party led by intellectuals secularized Marxism. Alva
and Gunnar Myrdal presented the same general view in Sweden. Behind the
Iron Curtain, the research group of the Czech Academy of Sciences which
under Radovan Richta produced a report on science, technology and society,
Julian Hochfeld, Jan Szecpanski and any number of Polish sociologists and
Andrei Sakharov and a cautious but decidedly undogmatic group at the
Soviet Academy of Sciences and in various Soviet institutes drew upon their
anti-Stalinism to make a circuitous journey to the same conclusions. They
argued that the technostructure inevitably transferred power from the ruling
party, which could not control it, to the managerial and scientific elite: it
followed that the goals of socialism could be attained only if that elite were
directly controlled by the society – in other words, democracy was necessary.
Galbraith was so convinced that an advanced moral and political equilib-
rium had been achieved in western societies, at least, that he did not object
to the remarkable complacency of Kennedy’s declaration in his Yale speech
of 1962 that our economic and social problems were now mainly technical.
It followed that publics would be wise to listen to those who mastered tech-
nical argument, that is, to the sorts of persons who constituted the Kennedy
government. I’m reminded of the remark by Christopher Lasch to the effect
that the Kennedy White House was a fusion of café society and Route 128
(the highway around Boston favoured by technological entrpreneurs and
their professorial partners from the Massachusetts Institute of Technology as
a site for their firms).
What has happened? Unregulated capitalism has for the time being
returned, if anything in a more brutal form since the three twentieth-
century alternatives to it (state socialism, western social democracy, and
Third World fusions of indigenous cultural ethos with Marxism) have been
so unresistant.
Let us begin with state socialism. The reformers in the Soviet bloc did
think that their historical turn had arrived with Gorbachev. There was an
appreciable amount of activity by civil society in the USSR in the years
following Stalin’s death, some of it repressed, some of it in the form of inner

party debate around the work of the research institutes, some of it reaching
the public. Whatever chance the enlightened Soviet technocrats had of ini-
tiating a democratic reform of their society, we can now say, was destroyed
by the very pathology they sought to overcome: the absence of participatory
institutions and an active public sphere. It was fear that these would develop
that led the party conspirators and the military to attempt to overthrow
Gorbachev. Into the vacuum not filled by Yeltsin’s ambiguous attempt to
construct a new legitimacy, two forces rushed. One was nationalism, not
only the nationalism of the separate republics but Great Russian nationalism
in a virulent form. The other was the unrestrained acquisitiveness of a seg-
ment of the Soviet managerial elite, joined to the piratical talents of homines
novi collaborating with international capitalism. The thousands of Gorbachev
supporters in the old Soviet technostructure had very little political capacity
of their own and in the end their resistance was feeble or null. The US in par-
ticular is now loud in its injunctions to the Russian government to limit its
obvious authoritarianism – but that authoritarianism is a political response
to the limitless rapacity encouraged by the American official sponsors of the
new Russian capitalism.
The society in the Soviet bloc in which the transition to a post-Communist
order has been accompanied by the retention of a considerable amount of
social decency is Poland. It, however, since 1956 was ruled by a Catholic-
Communist alliance. In Solidarnosc, the working class was allied to the cre-
ative and technical intelligentsia. Poland in terms of cultural and economic
exchange, opportunities to travel, and a semi-independent foreign policy
was in any case far more open to the rest of the world than was the USSR
before Gorbachev. The contrast between Poland and Russia suggests that not
only the general political culture of a society but the specific social alliances of
the managers and workers of the technostructure are important determinants
of their political choices.
The case of China confirms our sense of the limits and specificity of the
autonomy of the technostructure. The creative and technical intelligentsia
in China were traditionally champions of the rights of peasants and workers.
That is why so many of them considered the Communist state the legitimate
successor to Sun Yat-Sen’s republic.
The leadership of the Chinese Communist Party can claim to have made
an original contribution to social history, by encouraging (and indeed
participating in) an unprecedented extraction of surplus value from the
population while using Communist rhetoric. The rhetoric has appreciably
diminished in recent decades, and the Communist state justifies its
existence, its powers, its repressiveness, by describing itself as the guardian of
the national interest as against the conflict and fragmentation intrinsic to
capitalist development. The millions working in the technostructure have
been corrupted or cowed. It is not much consolation for those who expected
better of the Chinese Revolution to say that contemporary China is a

conspicuous refutation of the absurd assertion of a necessary connection
between capitalism and democracy.
What of the resistance to a renewed unleashing of capital in the western
social democracies? Unless and until the United States abandons universal
health insurance for those over sixty-five years of age (Medicare) and uni-
versal old-age pensions, disability payments to those unable to work and
support for the survivors of those who die during employment (Social
Security) it can claim to be residually social democratic. That is what troubles
the present President, but his offensive against Social Security (in the guise of
a project to privatize it in part) has incurred a good deal of resistance. That
much of the rest of the New Deal legacy, and that of the New Dealer Lyndon
Johnson’s great successor project, the Great Society, has been either destroyed
or is marked for liquidation by the party of the market, to which the Democrats
seem incapable of consistent and vigorous resistance, is hardly a recent phe-
nomenon. The critical American phenomenon (and seen as such by
Galbraith in his subsequent works, Economics and the Public Purpose, 1973,
and The Culture of Contentment, 1992) is the systematic decomposition of the
idea and practice of solidarity. The development of this amoral sentiment
has been accompanied by the increasing inability of American citizens to
imagine that the world being the way it is, it could be otherwise. To evoke
that possibility, for millions of Americans, is to remind them that they count
for very little in the eyes of the elite – a perception usually strenuously
denied. During the Great Depression, those in the not inconsiderable tech-
nostructure of the time were either themselves economically exploited or
threatened or moved to participate on moral grounds in the adventures of
social reform. If, however, the very existence of alternatives is denied, the
morality of solidarity appears frivolous and in any case politically irrelevant.
That the counter-offensive of capital has altered the doctrines and practical
engagements of a majority of economists is for Galbraith an obvious source
of regret – no, sorrow. Here, what we can say is that the availability of the
economists for service to American capital suggests that whatever the tech-
nostructure may generate, it does not by itself produce disinterested citizens
and professionals committed to the public good.
It is not only in the old Soviet Union or in the US that these negative
developments have disappointed the hopes expressed by Galbraith. That the
US has a political culture consisting primarily of individualism is an untruth,
compounding historical error and market ideology. Ever since the American
Revolution, the nation has been marked by eruptions of large and powerful
social movements. The Revolution itself entailed several – and a civil war
fought against the third of the population of the thirteen original colonies
loyal to the Crown. That much said, the Europeans are the heirs of 1641,
1789 and 1917. The European welfare states are results of the struggles of
liberals, social Christians and socialists (of all kinds) to extend the scope of
citizenship and limit the sovereignty of the market. Moreover (even in the
United Kingdom with its Civil Service tradition) the European intelligentsia
has a tradition of state service, of commitment to the public realm, far older
than the twentieth-century approximation of it achieved in the US. In the
circumstances, present developments in Western Europe, especially, are
striking. A considerable segment of the intelligentsia, working in the tech-
nostructure of their societies, has resigned itself to a substantial reduction in
the European welfare state. This is not taking place without argument, and
indeed severe resistance, as the conflict over the structure and substance of
the European Union and its proposed Constitution shows. The struggle is
joined, in pervasive if complex ways, to the European effort to resist the
claims of the US to global leadership. Those who think like Galbraith in the
US, advocates of an American version of social democracy, can no longer be
sure that whatever happens to us, the European social model will persist in
its distinctive form. There are in Europe much higher rates of political par-
ticipation than in the US, and immense amounts of unease in many sectors
of European society over the consequences of the re-institutionalization of
the market, the renewed commodification of entire areas of culture. Still, the
party of global capitalism has cause to congratulate itself, not least on an
achievement Orwell might well have recognized: measures reducing or
terminating social protection and the regulation of the economy are termed
‘reform’.
Galbraith’s instinct, in 1961, to go to India as Ambassador may have been
prophetic. Many of the nations once thought of as underdeveloped (especially
in Asia) have experienced large increments in national wealth – distributed,
usually, in ways which resemble the savage inequalities of the beginnings of
industrial capitalism in Europe and the US in the nineteenth century.
Meanwhile, economies then held to be irremediably stagnant in Latin
America have had similar transformations. A major source of irregularity in
growth and domestic social crisis in these nations has been the ebb and flow
of capital from Europe and the US, and the interventions of the IMF. No gen-
eral characterization of what was once the capitalist periphery is possible:
cultures and histories are too diverse. It remains to be seen if, for instance,
the bloc being formed by Brazil, Chile, Argentinia, Uruguay and Venezuela
will constitute a different version of social democracy. For the moment, as
alternative sites of production with cheap labour – and not, as previously,
only suppliers of cheap commodities and purchasers of manufactured goods –
the nations once on the periphery are now central to the fate of capitalism
and democracy.
It may be possible that critical contemporaries of Galbraith (Paul Baran
and Paul Sweezy, C. Wright Mills and Herbert Marcuse) were right on two
counts. (1) The institutions constructed by the Atlantic social democrats and
social Christians to control and domesticate class conflict had insufficient
powers of resistance when capital launched an offensive to destroy them.
(2) The control by capital of culture (the media in its assiduous and more or
less successful attempts to cretinize large segments of the western publics,
and the academic systems in their production of a generation or two of duti-
ful conformists) has attenuated and deformed the consolidation of democ-
racy. A public sovereign and able to think for itself is wanting. Galbraith, like
Adam Smith and Keynes before him, had philosophical presuppositions – an
idea of progress, incarnated in an educated citizenry capable of assuming
command, by instructing politicians and public servants of their duty to the
larger public good, of the destiny of their nations.
The new internationalization of capital, its capacity to escape the restraints
once imposed by the social consensus in the advanced industrial democra-
cies, has ended that consensus. Galbraith’s view of the permanence of the
social democratic transformation of political economy in industrial society
requires rethinking. That Galbraith is still doing a considerable amount of
that is what we should expect. The earlier achievement, meanwhile, set for
us all standards of intellectual probity and political independence we would
do well to emulate.
Bibliography
Ad Hoc Committee on the Triple Revolution, The Triple Revolution (Washington: The
Committee, 1964).
R. Aron, Eighteen Lectures on Industrial Society (London: Weidenfeld and Nicolson,
1967).
P. Baran and P. Sweezy, Monopoly Capital (New York: Monthly Review Press, 1966).
D. Bell, The Coming of Post-Industrial Society (New York: Basic Books, 1973).
N. Birnbaum, After Progress (New York: Oxford University Press, 2001).
W. Brandt and the Independent Commission on International Development Issues,
North-South, a Program for Survival (Cambridge, Massachusetts: MIT Press, 1980).
A. Crosland, The Future of Socialism (London: Jonathan Cape, 1956).
A. Gorz, Strategy for Labor (Boston: Beacon Press, 1968).
M. Lewin, The Gorbachev Phenomenon (Berkeley: University of California Press, 1988).
S. Mallet, The New Working Class (Nottingham: Bertrand Russell Peace Foundation for
Spokesman Books, 1975).
H. Marcuse, One Dimensional Man (Boston: Beacon Press, 1964).
C.W. Mills, White Collar (New York: Oxford University Press, 1951).
G. Myrdal, Beyond the Welfare State (New Haven: Yale University Press, 1960).
R. Richta, La Civilisation au Carrefour (Paris: Editions Anthropos, 1969).
A. Sakharov, Progress, Coexistence, and Intellectual Freedom (New York: Norton, 1968).
Alain Touraine, Post-Industrial Society (New York: Random House, 1971).
I. Wallerstein, The End of the World as we Know it (Minneapolis: University of
Minnesota Press, 1999).
Part II
The Trouble with Economists
and Policies
6
The Bias in Academic
Economics: the Economics Salon
Jeff Madrick
What has always impressed me most about John Kenneth Galbraith has
been his intellectual courage. Even when government was more or less in
fashion in the 1960s, Professor Galbraith stood apart. His iconoclastic advice
to John Kennedy on Vietnam is well known. His refusal to endorse the
famed Kennedy/Johnson tax cut was probably shared by some of his col-
leagues, but few on the inside, as he was, said it out loud. Galbraith correctly
wanted more spending on public goods. The nation chose to reorient the
debate towards something abstract, technical, and more palatable. Economic
growth through fiscal stimulus would solve the nation’s problems. Galbraith
knew that growth was imperative, but it was not enough.
When government became unfashionable, Professor Galbraith did not
change. The profession bent with the times; Galbraith did not. He has been
fearless in standing apart from his colleagues, as well as against wealthy
financial and powerful political interests, in the pursuit and propagation of
his economic views. The history of Galbraith’s iconoclasm should be a lesson
in the sociology of knowledge for all of us. As Americans have turned more
conservative politically in recent decades, Galbraith has remained a stalwart
believer in the importance of public goods, the undue influence of Wall
Street interests, the limits of markets, and the peculiar and growing insularity
of much of the economics profession.
In this spirit, I wanted to present briefly from an American economic
writer’s point of view tendencies in the practice of economics that I believe
are largely the consequence of bias rather than empirical findings or theo-
retical breakthroughs. I think the profession has become all too comfortable
with powerful interests. Money is more important even at the university
these days. This may be the principal explanation for what I perceive as
blatant bias in the profession. Business supplies grants and research monies;
they supply consultancies and outright jobs. Or maybe, and more kindly,
economists are going with the fashion of the moment. But the sociology of
economics goes beyond this, and I have a hard time understanding this fully.
For me the profession has become, to choose a Parisian analogy, something
65
like the artist’s Salon of the nineteenth century. Rules were established
allegedly to maintain art standards, but arguably and perhaps more impor-
tantly also to keep this fraternity of chosen French artists restricted and
controlled. You had to be talented to get into the Salon, yes, but you also had to
paint by the rules – and that often precluded the best and over-represented
those who either were comfortable with rules or were so ambitious they
did not care. To some critics, the art produced, with exceptions, eventually
became something like painting by numbers. Those who could see anew –
Manet, Monet, Cezanne and so on – refused to paint by these rules. Critics
eventually realized these revolutionaries and iconoclasts saw far more clearly
and painted more beautifully than most of their Salon brethren. Too much
of the most prestigious of economics academia today is like the French Salon
of the nineteenth century. They paint by numbers and no longer can see.
That is, they do economics by statistics only and fail to see the people
behind their models.
But this is not universally true and the barriers have been falling for a
while. Many economists participate in breaking down the economics Salon;
but the issue will be considered later. First, I will trace a few areas briefly and
impressionistically in which I think bias has been palpable, and an alleged
scientific method, rather than exalted, has been bent to a less than worthy
purpose.
1. For me, the most important of the turning points in public policy eco-
nomics were the debates between advocates of American Keynesianism and
those of Friedmanite monetarism during the 1970s. The story of Milton
Friedman’s ascent is fascinating. It began more or less in 1953, when he pub-
lished his first essays on positive economics. The most important of them
held that an economic model’s assumptions need not be realistic. No matter
that consumers in interviews, for example, might suggest a certain amount
of irrationality in their purchasing decisions. What matters is that the out-
comes of the economic model conform to what actually happened in the
real world. Ultimately, we may not know exactly how changes in the supply
of money affect nominal GDP, for example, but empirical evidence,
Friedman argued, shows that they do.
Friedman’s best work is probably not his monetarism, which argued that the
Federal Reserve should only maintain a stable rate of growth of money. Rather,
many agree, it was his work on the long-term nature of the consumption func-
tion, which had a strong and fairly objective empirical underpinning. But his
greater fame depended on his 1968 talk to the American Economic Association
about what became known as the natural rate of unemployment. He summarizes
his views articulately, as usual, in his Nobel lecture.
What I am concerned with here is why the views that had less empirical
substantiation – the monetary rules and the natural rate – nevertheless
caught on.
The Bias in Academic Economics: the Economics Salon 67
Let us return first to his monetarism by rule. The great irony is that
Friedman’s version of monetarism caught on as a policy tool in the 1970s. At
that very point, the empirical relationship with money and GDP, as dubious
as I think it always was, broke down. A piece by Goldfield et al. in the
Brookings Papers as early as 1976 clearly showed that money failed to predict
nominal GDP as Friedman and Schwartz (1963) suggested it would – and
failed by a wide margin. Later in the 1970s, Alan Blinder showed convincingly
in the book called Economic Policy and the Great Stagflation that measures of
money supply growth missed the forecasting mark time and again.
There were many possible reasons for this. Not least was that the regularity
of the relationship was never all that stable. Money can be endogenously cre-
ated; velocity is not stable. All the while, innovations in the 1970s in com-
mercial banking made money measures still harder to decipher. Demand
deposits and savings deposits were now increasingly mixed together, money
market funds exploded; Regulation Q was gradually being whittled away. The
money definition had to change, new measures were created. Due to such
institutional changes, and the strong economy (endogeneity), the monetary
aggregates kept rising even when interest rates were raised significantly.
Velocity based on M1 (cash and demand deposits) also rose sharply in
1976 and then bounced all over the place. Again, a strong economy and high
inflation probably affected velocity. Yet strict monetarists like Alan Meltzer
and Michael Mussa would write later how delinquent Arthur Burns and
William Miller were in holding the monetary aggregates in check. They and
others scoffed at loose money in 1977 under Burns and in 1978 under Miller,
as if these were simple matters.
In fact, interest rates were raised significantly in those years, and for some
of the reasons cited above, it was very difficult to get a true sense of where the
nation’s money supply stood, or even what it was. Charles Schultze, Carter’s
CEA chairman, for example, was concerned early in 1978 that money veloc-
ity would suddenly slow and that monetary policy was therefore too tight.
Still more financial innovations in 1978, such as money market certificates,
confounded the authorities further. High mortgage rates, for example, failed
to stifle housing demand as they had in the past because institutions could
still raise new funds from depositors even as rates soared. In the past, because
they could not raise interest rates to market levels, depositors withdrew
funds rapidly, which was known then as disintermediation.
By late 1978, Schultze and Treasury Secretary Blumenthal thought money
was too loose. But that was an easy call, if you were so disposed. OPEC dou-
bled oil prices again in late 1978 and early 1979, after having quadrupled
them in 1973 and 1974, and inflation was inevitably soaring as a result.
The CPI reached 9 per cent in 1973 and 12 per cent in 1974. But a loose
money policy could not account for that, according to any of the predictive
models. Loose money could not account for inflation of 12 and then 13 per
cent in 1979 and 1980, either. Money growth might have been able to
explain 6 per cent inflation in the mid-1970s and 7 or 8 per cent or so in the
early 1980s. Yet at that point, and especially later, mainstream economists
were determined to treat the money supply aggregates as the determinative
factor of inflation.
In fact, only the food shocks and the two OPEC oil crises, along with a
mistaken consumer price methodology that included mortgage rates, could
cause the CPI to reach double digits. Without these, inflation would have
been far lower, and perhaps even manageable. I do not mean to trivialize the
effects or even the tenacity of inflation. Even temporary shocks could find
their way into inflation for a longer period of time by raising expectations.
And I believe the inflation had to be subdued. But what panicked the nation
were the double digit rates, not rates of 7 or 8 per cent that rapid money
growth may arguably have induced.
It seems clear that many economists were simply determined to claim that
the 1970s’ inflation was a monetary phenomenon, and therefore they had to
minimize the impact of the price shocks. But loose money policies were the
subsidiary causes of the double digit inflation, the price shocks the main
ones. Blinder’s evidence is pretty telling. The loosening regulations, which
once rationed credit and now no longer did, may also have had a serious
causal affect. I don’t know of any studies that tried to measure this, although
notable Wall Street economist Albert Wojnilower did treat it to some degree
in a Brookings paper.
So we are left with this question. The empirical justification of public
policy monetarism – that is, all one must do is hold the growth of the money
supply stable – was falling apart in the 1970s. The relationship between
nominal GDP and money growth was far from stable. But monetarism was
widely adopted, especially among Wall Street economists and forecasters.
Why? Because monetarism could serve as a theoretical and therefore scientific
(and intellectually neutral?) justification of a new recession. And recession
was the old-fashioned way to fight inflation. You didn’t need a new theory
for that. Paul Volcker, claiming for a few years he was a monetarist, was the
man to implement such a strategy. Few believed that Volcker had full faith
in the monetary rules, though he still says he did to some extent. Rather,
many argue that he used it for the cover story that it turned out to be.
Volcker could more or less tell Congress it was not he who was raising interest
rates; rather, they were going up on their own because all he was trying to do
was stabilize the money supply.
So, we needed monetarism, not because it was empirically justified or
theoretically sound, but because it provided good cover for a harsh eco-
nomic remedy. Even Wall Street wanted a deep recession to stop inflation
once and for all. Under inflation, stock prices had stagnated for a decade,
and bondholders saw their wealth rapidly depleted. The American people,
standing in line for gas and seeing food prices soar, also now believed infla-
tion was their principal worry, according to surveys. Inflation did indeed
harm them, but would temporary inflation harm them as much as long-term
employment weakness? In particular, they blamed government deficits for
their ills. Keynesian spending became an easy mark.
This is not to say the economists did not urge too much stimulus in this
period. It is to say that they over-reacted to inflationary fears in the opposite
direction based on a theory that was losing any empirical credibility.
The natural rate theory stood on firmer ground at that time. Friedman’s
monetarist rules were undermined by empirical facts, but Friedman’s natural
rate theory was seemingly confirmed in those years. The Phillips curve did
indeed seem to be vertical, and it was soon widely held that Friedman had
explained stagflation. You could have high unemployment and high inflation
simultaneously, and it could indeed get worse. I do not mean to belittle the
idea of a non-accelerating inflation rate of unemployment (NAIRU), perhaps
at high rates of inflation it has validity. What I doubt is whether there is any
permanent NAIRU, or that it is necessarily high. But unlike basic Friedmanite
monetarism, empirical observation did support the NAIRU in the 1970s.
Therefore, it was arguable that expansive monetary policies, including low
interest rates, would not stimulate the real economy, only stoke the fires of
inflation.
But at the same time, you didn’t need a rather implausible theory (which
assumed that wages adjusted rapidly) of the natural rate to explain stagflation.
The price shocks offered a much simpler explanation. The sudden spurt in
prices acted simultaneously as a tax that dampened consumption and invest-
ment and as a cost that pushed up inflation. Isn’t there some scientific
principle that one always abides by the simpler theory if it is equally valid
empirically? Add to this the mysterious slowdown in the growth of produc-
tivity in the 1970s and one has a compelling, simple and traditional
explanation for stagflation.
Economists, even at old Keynesian institutions, climbed aboard the
NAIRU consensus. Only a few years ago, Brad DeLong wrote that you cannot
explain the inflation of the 1970s by way of the price shocks. Due to monetary
expansion based on the assumption that NAIRU was lower than it really was,
he estimates that the underlying inflation rate rose to 7 per cent. If annual
inflation only reached 7 per cent in the 1970s, American history would be
remarkably different. The people would not have been nearly this upset.
Arguably, inflation would not have gotten as high as the price shocks pushed
them without a higher underlying rate. But they got to 12 per cent in 1974
with a lower underlying rate than in 1978.
It turned out that the empirical evidence did not continue to support
Friedman’s claims about a NAIRU in the 1980s and 1990s. This did not stop
the mainstream profession from adopting a simplistic version of it, however.
A paper by William Brainard and George Perry, called ‘Making Policy in a
Changing World’, in a book of 2000 called Economic Events, Ideas and Policies,
edited by Perry and the late James Tobin and published by Brookings makes
a persuasive empirical case that the Friedman assertion held empirically only
in the 1970s.
Why did the high and unchanging NAIRU attract so many followers? Was
it the power of the theory? Was it the strong empirical support? It is hard to
escape the conclusion that it fit the politics of the time. It was a fine
theoretical way to justify tight money and slow growth over this period.
Professor Galbraith once said the NAIRU was apparently the unemployment
rate at any given time. He put his finger on it again.
Just a few final words about this period. Friedman’s view of the natural rate
was soon supplanted by the rational expectationists. Friedman at least said it
took a while for workers to figure out that their real wages weren’t rising. The
rational expectationists felt the workers could figure it out as fast or faster
than anyone else. Hence, no policy but stable money could possibly have
any effect on real outcomes in the economy. In other words, you could not
truly improve the condition of the economy except to avoid instability.
Moreover, the response to the high interest rates of Volcker’s Fed would be so
swift and so rational that their dampening effects on the economy would
not be all that bad. Sargent in particular proposed historical examples to
demonstrate this. The 1982 recession was not in the sights of this Chicago-
led school. The severity of that recession almost immediately cast strong
doubt on the theory.
But without serious empirics, why did rational expectations catch on? And
it has been widely influentional on most macroeconomic theory, even if it
has now largely been discarded. But remember what was going on at the end
of the 1970s. Herbert Stein said there was no widely accepted consensus
about fiscal and monetary policies as early as the mid-1970s. Charles
Schultze has told me in conversation only God could have created policies
for the late 1970s. It was a time of confusion and a deepening sense of futility.
And the nation was readily willing to accept a theory that said policy was
always and everywhere ineffective. Lucas and Sargent offered up their policy
ineffective proposition.
We should turn our attention on ourselves, of course. Some intelligent
reader might say that Keynesianism was just an excuse for government
spending. Well, Keynesianism has made something of a theoretical comeback.
People are not only talking about liquidity traps again but even sticky wages.
It could well be, contrary to Friedman, that the quality of assumptions
matter. At the least, I think of Keynesianism as appropriate in some if not all
circumstances. But there remains a strong argument for investing public
goods as well, with or without Keynes. Here, Professor Galbraith will always
be the leading light.
2. Let me turn briefly to other areas of palpable bias. Few areas of economics
attract as much academic support as does free trade. I lean towards being a
free trader myself. But it is pretty remarkable to me how rarely it is pointed
out that the standard theory depends on a key assumption being fulfilled.
The economy must be operating at full employment. We rarely hear about
such a constraint.
In studying free trade, I always believed that what gave it its grit was its
empirical justification. Is the gain in consumer and business surplus so much
greater than losses due to unemployment and bankruptcy?
I looked again at some of the historical studies. In retrospect, they are
models of ineptitude. A fine little book published by the Upjohn Institute
helped me with this enormously. It is called Job Creation, Job Destruction and
International Competition by Michael W. Klein, Scott Schuh and Robert K.
Triest. The earlier work of the 1970s and 1980s was based on net flows of jobs
and work. A net change in the unemployment rate of 2 per cent in
manufacturing masks a gross job creation of 10 per cent and a gross job loss
of similar magnitude. The dislocation effects are much larger than any com-
putation based on net changes could arrive at. Many of those who find jobs
take them at lower wages. There are other costs for job-seekers as well as for
companies to find and train new workers. One of the more influential early
studies was undertaken by Stephen Magee and published in 1972, and it was
based on net changes in industries, not gross changes. It is not surprising
that he found overwhelmingly in favour of free trade. He estimated that
eliminating all trade restrictions in the US would add 1 per cent to GDP. But
the costs of dislocation, measured on that net basis, were only 0.01 per cent
of GDP. The gains from trade exceeded the costs by 100 to one. Who could
argue with this?
But, it should be asked, who could imagine doing a study based on net
changes in employment unless one were determined to minimize the costs
of job dislocations? Gradually, the studies became more realistic. By making
necessary and obvious adjustments, Baldwin and others in 1980 found only
a 20 to one advantage to free trade. Still pretty overwhelming but far less
than Magee’s findings. Further appropriate adjustments of these studies,
Klein, Schuh and Triest argue, could reduce the multiple of gains from trade
to costs to a mere two to one.
Well, two to one is still pretty solid empirical evidence for free trade. But it
is no longer overwhelming. At the least, it should make policymakers think
twice before reflexively choosing free trade without supplementing it with
other policies. In America, the safety net must be improved to support a free
trade policy, in my view. But the nature of professional bias concerning free
trade is strongly suggested by the evolution of these studies.
3. Let me take another area that is especially close to my heart. In the US
there is a very strong consensus among academic economists that inflation
is habitually overstated. Some mathematical issues, involving using geometric
means, have been clarified, though even here there is controversy. I am not
fluent enough in them at this time to discuss them. But the main area of
contention is that improved quality of products is not satisfactorily

accounted for in the data.
Much of this has changed at America’s Bureau of Labor Statistics in recent
years, largely due to the work of the so-called Boskin Commission. The
commission of distinguished economists, headed by the first Bush’s former
CEA chairman, Michael Boskin, was appointed by the Senate Finance
Committee. The committee made few bones about it. It believed inflation
was too high, and if this blue-ribbon panel could show the BLS was wrong,
the committee could reduce the annual increases to Social Security recipients
that were indexed to the consumer price index. What a fine upstanding way
to circumvent the legislative process.
The Boskin Commissioners set about doing their more or less pre-ordained
work, and what sloppy work it was. The commission noted that the great
variety of fruit increased quality and reduced inflation. It noted that VCRs
made it far cheaper to go to the movies, assuming poor people who now
could at last see movies used to take their three kids in the car on weekends,
buy four-dollar popcorn, and blow fifty bucks. Now they need only spend
three dollars. Thus, given such quality increases, inflation was lower than
reported.
What was most telling about the quality of the Boskin Commission report
was that the economists uncovered no instances of reduced quality that
might suggest some inflationary input was too high. And they eliminated
the discussion of public goods altogether. An automatic key lock for a car
made cars more valuable, and therefore reduced inflation. But increasing
traffic, according to the illustrious commission, had no bearing on the value
of cars, and should not affect inflation.
Many criticized the superficiality of the report including myself in the
NY Review of Books. But what stunned me, at least in my own anecdotal expe-
rience, was how the academic community readily accepted it. Since then, a
commission headed by Charles Schultze has cast needed doubt on many of
its findings. But the economics profession was terribly willing to please. The
new findings also made it appear that real GDP and productivity growth
were also higher than reported. This must have been heartening to econo-
mists who believed America was following the right policies in this period.
4. I would like to say one thing more about public investment. The evidence
is strong that public investment has had a substantial pay-off in America.
Why is there no strong united front among most economists on the benefits
of public investment? I understand the Chicago School’s claims about the
inherent inefficiencies of government. But there is so much strong empirical
work in its favour. And fundamental theory suggests that the case for public
goods is strong. One NBER economist, Ishaq Nadiri of NYU, for example, has
done especially intriguing work with sophisticated production functions
measuring the consequences of transportation investment. It shows that
public and private investment returns are about equal on average, and may
at times favour public goods. Robert Eisner has long discussed such issues.
William Nordhaus has taken up the quest for the grail. Professor Galbraith is
now the godfather of this vein of work. But in my informal observation of
academic economics, little attention is devoted to it. Is this simply a bias
stimulated by the wealthy private donor to universities?
Despite the attempts by Feldstein, Barro and their disciples to show the inef-
ficiencies of high taxes and government spending, Joel Slemrod has done
exemplary work demonstrating that neither high taxes nor high levels of gov-
ernment spending have any correlation to economic growth. William Easterly
has climbed aboard, showing clearly how empirical studies that claim other-
wise have been untenable and unstable. Peter Lindert has a strong new book on
why government spending does not on balance detract from growth. Yet I
don’t find these catching fire. To the contrary, here in Europe, the economics
establishment almost only talks about reducing labour costs and payroll taxes.
There may be room for restructuring, of course. But economists do not under-
stand that America has been running on a tank of public goods it has not
refilled in years. It will not be running on empty soon, but the cost of replen-
ishing that tank is not fully accounted for.
5. I also have another pet gripe. Growth theory as practised by mainstream
economists has been, I think, especially frustrating. The adoption of Solow
model type thinking has focused mainstream theory about the sources of
growth almost entirely on supply-side variables. New growth theory, which
makes some allowance for rising economies of scale and endogenous growth,
does not seriously alter this point of view. Thus, to support growth, we must
save more, invest more, educate more. But what about stronger domestic mar-
kets as a source of growth? What can historical analysis add to the theory?
Surely, one of America’s major advantages is the size and efficiency of its mar-
ket. Wal-Mart exists because of that market. I think the size of the American
market created the fertile ground that gave rise to the scale economies of the
internet. Surely, as historians like Gavin Wright, Richard Nelson and Alfred
Chandler have shown, market size and efficiency, including a single language
and a single currency, were key advantages – perhaps the key advantage – for
America. For that reason, I believe in the value of the EU and think that China
and India will become enormously powerful. If demand-side sources of
growth were fully acknowledged among mainstream economists, there would
be more concern about stagnating wages, income inequality and lost incomes
due to trade. The result is that growth theory in the US has a bias in favour of
policies that support savings and capital over labour. And perhaps the popu-
larity of such policies in the current environment creates an incentive to keep
growth theory as narrowly focused as it is.
6. A quick point about shock therapy in Russia. Ironically, some of the
empirical justification for shock therapy was just the argument I make
above. A large market will promote economies of scale. But empirics said
nothing about the overnight creation of a market. What truly drove some
mainstream economists, notably from Harvard, towards shock therapy was
blind faith in markets. Milton Friedman lingered lovingly in their minds.
Capitalism assured liberty. The simplistic idea was carried forward ideologi-
cally. Neither theory nor practice, as far as I can tell, justified it. Only high
fashion.
7. Finally, consider the theoretical work involving the management of the
firm that turned out to be the foundation of some of the excesses on Wall
Street in the late 1990s. The new theory of the management of the firm was
derived from efficient markets theory (as was rational expectations),
introduced in the early 1960s by John Muth of Carnegie Mellon and carried
forward by estimable economists such as Eugene Fama, Franco Modigliani
and William Sharpe. The theory argued that financial markets so efficiently
incorporated new information that it was difficult for any individual to
outperform the market as a whole. The empirical evidence was basically that,
adjusted for risk, you couldn’t find anyone who beat the market. The
adjustment for risk may have involved some tautological assumptions, and
eventually it became clear that some investors did indeed beat the market
over time. Such performance was sometimes attributed to other factors, such
as inside information. At best, the weak case for efficient markets holds.
But the strong case for efficient markets is that, not only does the market
rapidly incorporate new information into stock prices, it is usually ‘right’
about the future earnings of corporations. It is a small jump from assuming
that the stock price is a correct estimate of future earnings to making it the
arbiter of managerial performance. If the stock price goes up, managers must
be doing something right. So reward them with stock options and they will
serve shareholders best.
The issuance of stock options distorted corporate behaviour in the 1990s,
and was a major source of scandal. The higher your reported earnings, the
better your stock did; the better your stock did, the wealthier your managers
were. The principal advocate of this view, Michael Jensen of Harvard
Business School (formerly Rochester), has since backed off the strong form of
efficient markets theory. In fact, he has claimed he never held it. But such
market faith had damaging effects and was simply not supported by empirical
work. Stocks went up with the fashions and excesses of the time, not with the
quality of management. Stock prices could be efficient without being rational
in the everyday sense of the word. Economics adopted a bias, I believe, that
was rarely defied among academics until the crash and the scandals made it
untenable. Why? Again, there is the Salon effect. But it was also awfully nice
to be on the side of the bull market and huge consulting fees.
This is fairly random list of examples of bias that I believe can be substanti-
ated. It is partly a tour through some of my own observations over time.
Such bias has stifled debate in America and has led to damaging policy. It
suggests a lack of intellectual courage in the professional economics
community and our best universities, the sort of courage Professor Galbraith
always epitomized.
But I should note that I think there is a healthy resurgence of good sense
among economists. Akerlof, Dickens and Perry intelligently took on the nat-
ural rate hypothesis in 1996. Stiglitz has been tireless in showing where
imbalances in information can distort markets. There is a growing body of
criticism of efficient markets theory, epitomized by Shiller’s book, Irrational
Exuberance. The large body of work in behavioural economics and finance is
encouraging, and to some degree is headquartered, ironically enough, at
Chicago. I think the work of the new structuralists such as Lance Taylor may
be catching on again. Some of the trade work of Dani Rodrik and others has
been impressive. Amartya Sen remains an institution unto himself. And on.
I am sure I leave many out. Many of these people I mention disagree with
some of John Kenneth Galbraith’s work. But few do not admire his icono-
clasm, courage, wit and contributions. A half century ago, Milton Friedman
found a home for his iconoclastic views at the prestigious University of
Chicago, where the spirit of laissez-faire economics was already alive and
well. There is no similarly prestigious home in the US for alternatives to sim-
ple laissez-faire economics today. But perhaps that is changing. Harvard was
once Professor Galbraith’s house. It is no longer. But maybe even it will make
a comeback.
Partial bibliography
G.A. Akerlof, W.T. Dickens and G.L. Perry, ‘Near-Rational Wage and Price Setting and
the Long Run Phillips Curve’, Brookings Papers on Economic Activity, 1 (2000), 1–60.
A. Blinder, Economic Policy and the Great Stagflation (New York: Academic Press, 1979).
Boskin Commission Report, ‘Toward a More Accurate Measure of the Cost of Living’,
US Senate Finance Committee, 1996.
W. Brainard and G.L. Perry, ‘Making Policy in a Changing World’, in Economic Events,
Ideas and Policies: the 1960s and After (Washington DC: Brookings Institution, 2000),
pp. 43–82.
A.D. Chandler, Scale and Scope (New York: Belknap, 1990).
DeLong, J. Bradford, The Inflation of the 1970s, www.j-bradford-delong.net.
M. Friedman, Essays in Positive Economics (Chicago: University of Chicago Press, 1953).
M. Friedman, A Theory of the Consumption Function (Princeton: Princeton University
Press, 1957).
M. Friedman, ‘The 1977 Nobel Lecture’, The Nobel Foundation.
M. Friedman and A. Schwartz, A Monetary History of the United States, 1867–1960
(Princeton, NJ: Princeton University Press, 1963).
S. Goldfield, D.I. Fand and W.C. Brainard, ‘The Case of Missing Money’, Brookings
Paper on Economic Activity, 3 (1976), 683–730.
M.C. Jensen and W.H. Meckling, ‘Theory of the Firm: Managerial Behavior, Agency
Costs and Ownership Structure’, Journal of Financial Economics, 3 (1976), 305–60.
M. Klein, S. Schuh and R.K. Triest, Job Creation, Job Destruction and International
Competition (Kalamazoo: Upjohn Institute, 2003).
P. Lindert, Growing Public (Cambridge: Cambridge University Press, 2004).
K. Murphy, A. Schleiffer and R. Vishny, ‘Industrialization and the Big Push’, Journal of
Political Economy, 97(5) (1989), 1003–26.
M. Mussa, ‘Monetary Policy’, in M. Feldstein (ed.), American Economic Policy in the
1980s (Chicago: University of Chicago Press, 1994), pp. 81–145.
I.J. Nadiri and T. Manunueas, Contributions of Highway Capital to Industry and National
Productivity Growth, Department of Transportation, 1996.
R.R. Nelson and G. Wright, ‘The Rise and Fall of American Technological Leadership:
the Postwar Era in Historical Perspective’, Journal of Economic Literature, 30 (4)
(1992), 1931–64.
T.J. Sargent, ‘The Ends of Four Big Inflations’, in R.E. Hall (ed.), Inflation: Causes and
Effects (Chicago: University of Chicago Press, 1982), pp. 41–97. Reprinted in
T.J. Sargent (ed.), Rational Expectations and Inflation (New York: Harper and Row,
1986), pp. 40–109.
R.J. Shiller, Irrational Exuberance (Princeton: Princeton University Press, 2000).
J.B. Slemrod, ‘What do Cross-Country Studies Teach about Government Involvement,
Prosperity, and Economic Growth?’, Brookings Papers on Economic Activity, 2 (1995),
373–431.
H. Stein, Presidential Economics, American Enterprise Institute, 1994.
L. Taylor, Reconstructing Macroeconomics (New York: Harvard University Press, 2004).
A.M. Wojnilower, ‘The Central Role of Credit Crunches in Recent Financial History’,
Brookings Papers on Economic Activity, 2 (1980), 277–339.
7
Reframing Capitalism
James E. Sawyer
Over the past quarter century advocates of the conventional capitalist

paradigm have engineered a resurgence of laissez-faire style public policies,
particularly in the United States. Challengers to this ‘religion’ have been
beaten back or otherwise marginalized by advocates of so-called free-market
economic policies as they clamour for a form of societal auto-regulation
through market-based institutions.
Eventually, if challengers are to prevail against this laissez-faire resurgence,
popularly described as neo-liberalism – according to the perspective of
Antonio Gramsci1 – either they must demonstrate the prevailing paradigm is
without foundation, or alternatively, they must pose philosophical syntheses
of greater importance and significance. Many of neo-liberalism’s challengers
become exhausted in pursuit of the former, when the paradigm’s primary
vulnerability is with the latter. The method here derives from Gramsci’s
perspective about posing competing philosophical syntheses.
MIT urban planners Donald Schön and Martin Rein2 offer a perspective
that articulates with Gramsci’s. Their work addresses policy-related conflicts
in which the parties observe the same facts but attach different interpreta-
tions, meanings and emphases in order to dismiss antagonists. They define a
metacultural frame as pertaining to the broadly shared beliefs, values and
perspectives through which a particular culture gives meaning to its thought
and action.
Informed by Karl Popper3 on the nature of scientific propositions, and by
Thomas Kuhn4 on the nature of scientific revolutions, through the lens
provided by Schön and Rein it may be impossible empirically to falsify the
metacultural frame of an opponent. This may be particularly true in what
Harvard’s Michael Porter5 calls wealth-driven societies characterized more by
wealth preservation than wealth creation. Arguably the United States is
becoming such a society.
In the sense of Gramsci, then, the particular opportunity for challenging
neo-liberalism is to demonstrate that its metacultural frame is inconsistent
with the resolution of the most intractable contemporary problems.
77
Of course, a popularly held metacultural frame is none other than what

John Kenneth Galbraith calls the conventional wisdom. Indeed, the chal-
lenge of deconstructing the conventional neo-liberal wisdom begins with
sorting out the difference between how the world is perceived to work by
neo-liberals, from the way in which the world actually works. One thinks of
the Galbraithian dictum that ideology should never trump reality.
The way in which the world works changes – sometimes gradually, some-
times precipitously – while too often the way in which the world is perceived
to work does not keep pace. As Keynes reminds us, all too often dysfunc-
tional economic outcomes have their genesis with some defunct economist.
Indeed, so it is with the contemporary neo-liberal conventional wisdom. It is
a lens into how the world was perceived to work in the bygone neoclassical
age of industrial capitalism. In many ways this lens is becoming decreasingly
relevant to contemporary wealthy societies because it can be oblivious to
many negative externalities including environmental degradation, intransi-
gent poverty stubbornly coexisting alongside material plenty, and egregious
market-based behaviours – particularly in the United States – of the ilk of
Enron, WorldCom, ad nauseam.6
Keynes called for the euthanasia of rentiers, and his dictum would cer-
tainly extend to what Galbraith calls ‘innocent fraud’ perpetrated at Enron
and a host of other US corporations by pseudo-capitalists. A pseudo-capitalist
is defined here as a rentier who hoards assets in uses that are non-productive
of the common good. These are people or institutions who consciously
manipulate or ‘game’ the system for their own self-serving ends. Many
pseudo-capitalists have been able to stay below the radar of the neo-liberal
paradigm because its ideological adherents are predisposed to excuse or
minimize the significance of their behaviours. Why is this so?
Across two centuries, the conventional wisdom of doctrinal capitalism has
asserted that the pursuit of self-interested action articulates universally with
the attainment of the common good when executed through the institutions
of private property and minimally regulated markets. For pre-industrial or
classical societies, the central problem within this frame pertained (and
continues to pertain) to wealth creation, and for industrial or neoclassical
societies, the central problem pertained (and continues to pertain) to the
explanation of cost or value. However wealth or cost-driven perspectives
neither describe nor adequately address the pre-eminent problem of post-
industrial societies, which is how to publicly choose among alternative
futures; that is, how to determine what the future shall be, how access
to future outcomes shall be distributed, and the rewards that will flow to
entrepreneurs who facilitate such outcomes.
A crucial related problem is how to police non-productive behaviours in
which self-interested action does not articulate with the attainment of the
common good. Such action can occur when pseudo-capitalists and other
rentiers enable themselves to be compensated as capitalists, but without
Reframing Capitalism 79
proffering the requisite industry, skill and risk-taking anticipated by society

in exchange for the preferred treatment it confers upon entrepreneurs.
Of course, the prevailing paradigm is silent – in any practical way – about
what the rate of profit on capital should be.
Capital is about the cultivation of future capability. For classical economist
David Ricardo, the central problem was wealth creation and the nature of
capital was agricultural, or seed corn. For neoclassical economist Alfred
Marshall, the central problem was the determination of value and the
nature of capital was industrial; it was an aggregate, denominated in a
monetary unit.
Even now one may argue that the nature of capital is in transition.
Industrial outcomes are segueing into emerging post-industrial society.
These are characterized by satiation of basic goods and services accompanied
by technological acceleration, a widening dispersion between the ‘haves’
and the ‘have nots’, a deteriorating environment, and the qualitative pursuit
of lifestyle, among others. Fierce competition exists for scarce ‘lifestyle
goods’ such as strategically located real estate, fashionable cars and clothes,
exotic vacations, entertainment and sporting events.
In a qualitative sense capital in the post-industrial world becomes
whatever is necessary to move from one set of outcomes or potentialities to
the future attainment of some other set. Indeed, it exists relative to the out-
come that the electorate chooses to create. Since capital investment is about the
cultivation of capability, it is rooted in some vision or scenario of the future.
Rather than speaking of laissez-faire capitalism or mixed capitalism, then,
the contemporary milieu might better be characterized as relative capitalism.
That is, capital requires definition relative to some vision it is engaged in cre-
ating. Otherwise, it is argued, it becomes merely a rentier asset engaged in
extending the status quo.
For the hypothesis of relative capital to be sustained, Say’s tautology must
be rejected anew, and with it the presumption that Newtonian order prevails
in real economies modelled upon the received doctrine. With the admission
of disequilibrium in which planned saving may diverge from planned
investment,7 hoarding8 behaviours become admissible theoretically as well
as practically as pseudo-capitalists may seek equivalent rewards with capital-
ists, while withholding the full menu of entrepreneurial services expected by
society. Pseudo-capitalists, then, may save or control the saving of others,
but fail to expand social output to potential because they restrain the
attainment of equilibrium-level investment and may actually contribute to
disinvestment.
The roots of pseudo-capitalism are innocent enough; indeed, they are
staples of conventional instruction in management education and applied
policy analysis. Consider the so-called least cost rule of the marginal pro-
ductivity theory of resource demand. ‘A firm is producing a specific output
with the least-cost combination of resources when the last dollar spent on
each resource yields the same marginal product.’9 A corollary is that one
dollar’s worth of any asset should receive the same high rate of return as one
dollar’s worth of any other asset. Otherwise, the financial asset holder may
reduce opportunity cost and therefore increase portfolio yield by replacing
lower yielding assets with higher ones.
But this ostensibly rational dictum at the level of the individual or organiza-
tion too often becomes reified and dogmatized, and prescribed as a path of
rational action for entire societies. For instance, consider how pseudo-capitalist
behaviours may emerge within a contemporary economic environment in
which trillions of dollars are traded electronically each day in global finan-
cial markets and few factories are more than a day’s plane journey away from
the global markets they serve. In this environment a product may be
designed, financed, produced and marketed in entirely different countries.
Here, industrial capitalists who choose to do so may morph conveniently
into post-industrial pseudo-capitalists.
This transformation is described by beginning with the dictum that one
dollar’s worth of any asset P should receive the same rate of return as one
dollar’s worth of any other asset C, where P and C denote pseudo-capitalist
and capitalist assets, respectively. For instance, we begin with the capitalist
holding C and the pseudo-capitalist holding P. Soon the capitalist may be
motivated to morph into a pseudo-capitalist because he recognizes the
opportunity cost of holding C is the extra skill, industry and risk-taking that
s/he perceives to go uncompensated. The unmitigated pursuit of self-interest
may ultimately lead all capitalists to act as pseudo-capitalists. To the extent
this occurs, then societal outcomes are reduced by the value of the extra
contributions indicative of the difference in social product between the
capitalist class and the rentier class.
Pseudo-capitalist behaviours are not likely to raise opposition from the
ranks of either conventionally trained policymakers or the academic keepers
of the sacred paradigmatic flame who sustain them. Buried beneath the
surface of the prevailing paradigm, however, are embedded assumptions that
may have appeared benign in the industrial age but have profound ethical
implications in the post-industrial age. Among these is the assertion that the
pursuit of self-interested action universally articulates with the attainment
of the common good. While this may have been a reasonable generalization
of authors including P.H. Wicksteed10 and John Bates Clark,11 writing a cen-
tury ago about the Industrial Revolution, now, too often it describes merely
an ideological position rather than extant reality. In part this has transpired
because the way in which the world works has changed, while the way in
which we think about how the world works has remained remarkably static
in the face of a global revolution in the way business is conducted.
In this transformed environment, relative capitalism advocates that
wealthy societies act publicly to create social welfare functions through the
polity rather than solely privately, through the market, in the designation of
what constitutes capital. Since capital in post-industrial society becomes

the qualitative asset base necessary to move from the status quo toward some
other preferred scenario, it requires voters, today, to select among alternative
scenarios, in order for the one that is chosen to come to fruition some
number of years hence. Consequently, entrepreneurial acts that do not
conform to the democratically prevailing social welfare function12 become
non-productive or even counterproductive.
The prevailing neo-liberal paradigm that camouflages pseudo-capitalist
behaviours is rooted in a Newtonian methodological view in which time and
friction are banished, and in which equilibrium is assumed to prevail con-
tinuously. In the simple model, Say’s tautology mandates that all planned
household saving shall be identical to all planned business investment. No
leakages are allowed in the model that would otherwise be manifested as
unemployment or unsold inventories, for instance, within the standard
Keynesian system.
One serious problem is that the conventional method takes ‘snapshots’ of
an actual economy when equilibrium is presumed to prevail, rather than
continuous sampling in anticipation that extant disequilibrium may be
more the norm. This latter perspective, of course, led to Keynes’s rejection of
Say’s tautology. This allowed government policies based upon Keynesian
method to focus on, analyse, and correct for unemployment and unsold
inventories within an industrial framework. Seven decades following the
Great Depression, however, it is asserted that Say’s tautology has become
reimposed subtly as a consequence of the laissez-faire resurgence.
Because it denies disequilibrium, the methodological invocation of Say’s
tautology is also blind to hoarding13 behaviours in which capitalists invest
less than is transmitted to them in household saving in the simple two sector
formulation. This occurs because entrepreneurs may be motivated to hoard
or otherwise act as pseudo-capitalists, but the political–economic system is
blind to their manipulations and continues to reward them as legitimate
capitalists.14 Contemporary hoarding takes many non-productive forms
including accounting frauds and other egregious behaviours by some
US corporations. John Kenneth Galbraith reminds us that the corporation is
an essential feature of modern economic life. However, he also reminds us
that without public oversight the corporation can become a cover for devi-
ous actions that extend to outright theft on a massive scale. ‘Innocent
Fraud’15 may occur within or without the boundaries of law, precipitated
with no sense of guilt or responsibility, and may derive from conventional
economic teachings in business schools and elsewhere.
A new perspective is required that realigns conventional economic thinking
about the way in which the world works, including a dramatically revised
role for government to oversee the designation of capital, even as the
Keynesian paradigm asserted a new role for government – almost 70 years
ago – of provisioning economic security. Government’s pre-eminent new
role within contemporary relative capitalism becomes the coalescence of a

vision of the future with the attendant capital assets necessary to attain it,
then the creation of an incentive structure to bring that vision into being.16
It must set the rate of profit on capital in order to curb hoarding behaviours.
An example of a negative incentive directed at hoarding behaviours or
pseudo-capitalist behaviours, for instance, would be the Tobin tax, an excise
tax on cross-border currency transactions, one outcome of which would be
to reduce so-called financial churning by speculators.
Enormous challenges accompany government’s emerging role. Indeed,
the emerging commons of contemporary corporate capitalism is global and
is less amenable to control by nationalistic economic policies. However,
where are the global institutions to determine the character of capital, to set
the rate of profit, and to impose sanctions upon pseudo-capitalists across the
global marketplace?
A coordinated, multilateral oversight of global corporate capitalism is
required, even at a time when the United States in particular is becoming
dangerously unilateral.17 Within the conventional neo-liberal wisdom of the
United States, the paradigm of self-interest has been virtually reified, thus
rendering the coalescence of a widely shared public vision of the future
enormously challenging at best, and at worst, untenable.18 Also, because
capital relativity places great emphasis on vision, it leaves post-industrial
societies increasingly vulnerable to ideologically motivated manipulations
by charismatic and media-smart politicians who too often may attract
popular support without credible plans for shared sacrifice to implement the
common good.
A postscript on the US presidential election
Democrats flagellate themselves even as they direct anger at one another

following the November 2004 election victory of George W. Bush. The
challenger lost by over three million votes in an election portrayed by
The Economist19 as a contest between the incompetent Bush and the inco-
herent John F. Kerry. Editors of the pre-election edition preferred incoher-
ence as the lesser of two evils but, to the contrary, Republicans hung on
handily to retain the presidency and to extend their majorities by four each
in the House of Representatives and the Senate. Multiple conservative
appointments of seats on the nine-member Supreme Court are sure to follow
in Bush’s second term. The reality is that the United States has become a
centre-right global superpower. Indeed, the neo-liberal sweep may well usher
in the greatest structural re-engineering of the American institutional
landscape since the Great Depression, including delegalization of abortion
and sweeping social security and tax code overhauls.
Certainly the election was about the way in which the world is perceived
to work and the rules by which the game is perceived to be played.
Conservative columnist David Brooks20 of the New York Times describes the
campaign as having been a war of ideology, and surely it is a war in which
American liberals are losing. They remain unsuccessful at recasting them-
selves as a distinctive, coherent and credible political alternative to the
monolith of neo-liberalism. Their opponents have persevered shrewdly.
Beginning after right-leaning Barry Goldwater’s failed presidential bid in
1964, a veritable industry of think tanks and policy institutes has formed to
shape, refine and dispense the Republican conventional wisdom. This trans-
formation has been abetted indirectly by neoclassical scholars, although
some may be reluctant to acknowledge the direct links to their ideas.
Arguably, many economists function in dual roles as de facto social philoso-
phers, successfully camouflaged within a profession notorious for hiding its
value judgements behind a smokescreen of professed value neutrality.
Galbraith Symposium presenter and New York Times correspondent Jeff
Madrick21 argues that convergence of the profession around an accepted set
of views – characterized by insularity and comfort with powerful interests –
represents the very problem J.K. Galbraith has always fought against.
Madrick’s point is that a healthy iconoclasm – lacking in the American
academies – is essential to thorough debate of economic issues in the media.
Certainly the US media debate is becoming ever less robust.
It is argued here that the failure Madrick identifies – in the sense of
Antonio Gramsci – should be extended to encompass the American academy’s
failure to challenge the very metacultural frame undergirding the neo-liberal
conventional wisdom. In short, US liberals need to go on the offensive with
a more credible story that also deconstructs the story of their opponents. The
neo-liberal story, based in a Newtonian world view of order, presumes that
market-based institutions essentially auto-regulate societies crafted upon
laissez-faire principles. Social welfare functions created outside of the market
are eschewed and government-led planning is dismissed as congenitally
inefficient at satisfying citizens’ consumer preferences. Of course, disequilib-
rium hoarding behaviours by pseudo-capitalists are of little interest to
neoclassicals who undergird the neo-liberal story line with a portrayal of
general equilibrium as the norm rather than the exception.
Arguably, American liberals should break through iconoclasm to make a
new beginning, even as neo-liberals did four decades ago. In doing so they
must better explicate their own intellectual system from theoretical top to
applied political bottom, thereby dismissing antagonists, as Schön and Rein
describe, by using their analyses to cast doubt upon the competing metacul-
tural frame. To this end, esoteric research must be translated into practical
applications. An example is behavioural economics. Recently (2000),
Princeton psychologist Daniel Kahneman won the Nobel Prize for pioneer-
ing research in this emergent subfield. Behaviourists describe how individu-
als often act irrationally, thereby supporting the case that government may
need to play a role in guiding markets and individuals in areas where failure
is likely. Such findings constitute a promising new line of refutation of

efficient market theory, used by neo-liberals to sustain their case for a
world view of order in which government intervention in the market is
denigrated.22
American economists may also do well to consider other promising possi-
bilities for interdisciplinary and cross-disciplinary scholarship. Among these
are motivated social cognition from the field of psychology, and the appli-
cation of cognitive science to politics from the field of socio-linguistics.
Briefly regarding the former, Stanford’s John T. Jost23 and colleagues have
integrated several decades of research dealing with the psychological bases of
political conservatism into a seminal article integrating theories of personal-
ity, epistemic and existential needs, and ideological rationalization. They
regard political conservatism as an ideological belief system that is signifi-
cantly related to motivational concerns having to do with the psychological
management of uncertainty and fear.
Regarding the latter, Berkeley socio-linguist George Lakoff24 has pioneered
the cognitive study of how liberals and conservatives think. In his work on
so-called moral politics, Lakoff analyses the unconscious world views of
liberals and conservatives to explain why they are at odds over so many seem-
ingly unrelated issues, including taxes, regulation and social programmes.
The differences, according to Lakoff, arise from radically different concep-
tions of morality and ideal family life, meaning that family and morality are
at the core of American politics. In turn, these variables may be highly corre-
lated with the conservative penchant for certitude and order, with enormous
attendant implications for the role of equilibrium in economic thought.
In sum, interdisciplinary and cross-disciplinary strategies may be among
the most hopeful within and without the American academy, for decon-
structing the neo-liberal conventional wisdom, thereby promoting a healthy
iconoclasm in the tradition of John Kenneth Galbraith.
Notes
1. A. Gramsci, Quaderni del carcere. Cited in G.C. Harcourt, Controversies in Political
Economy (New York: NYU Press, 1986), p. 106. Passage on ‘The Intellectuals’ read at
the memorial service for Piero Sraffa, November 1983.
2. D.A. Schön and M. Rein, Frame Reflection: Toward the Resolution of Intractable Policy
Controversies (New York: Basic, 1994).
3. K.R. Popper, Logic of Scientific Discovery (New York: Basic Books, 1962).
4. T.S. Kuhn, The Structure of Scientific Revolutions (Chicago: University of Chicago
Press, 1970).
5. M.E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990).
6. Enron’s plan for manipulating wholesale electricity prices in the Californian
market during the winter power crisis of 2000–01 is described graphically in internal
memos handed over by company attorneys to the Federal Energy Regulatory
Commission (FERC). The Commission released the documents with an accompa-
nying observation that Enron traders were ‘creating and then relieving phantom
congestion’ on California’s electricity grid (www.nytimes.com/2002/05/07/

business/07ENRO.html). In one strategy called ‘megawatt laundering’, Enron
bought power in California, resold it out of the state, then bought it back and
resold it again into California – allowing the company to circumvent price caps.
This is a specific instance of gaming the regulatory functions of government.
Other pseudo-capitalist revelations abound. For instance, the CMS energy corpo-
ration acknowledged that $4.4 billion worth of its volume for 2000 and 2001
resulted from ‘round trips’ with no economic value. Round trips are ‘wash sales’
or ‘mirror-image’ swaps in which the same amount of power is exchanged at the
same price between two players. Revenue is booked on each of the operating
statements, even though there is no revenue. The Securities and Exchange
Commission is boosting its investigation into an array of such schemes. Swaps of
fibre-optic capacity have occurred in the telecom industry, for instance, appar-
ently for similar reasons. A lawyer familiar with these transactions claims that at
least in some cases no service has been provided (Wall Street Journal, 16 May 2002).
7. See literature on ex ante versus ex post equilibrium, for instance in: R. Clower,
‘Reflections on Science … and Economics’, Intermountain Economic Review, 5
(1974), 1–12; and A. Leijonhufvud, On Keynesian Economics and the Economics of
Keynes (New York: Oxford University Press, 1968).
8. An agricultural example of hoarding is illustrative within a classical system.
A farmer holds capital including in the form of a plough horse; the horse may be
‘enumerated’ or counted according to its use to verify that it is making a produc-
tive contribution to economic output. However, consider that after the farmer
uses the horse in his field to pull a plough, he tethers it permanently by the door
of his house for the pleasure of his children. Now, the horse no longer would be
enumerated as a capital asset because it has been removed from the stock of capi-
tal assets and hoarded by a ‘rentier’ into the stock of consumption producing
assets. It is no longer an instrument of growth because it has slipped from
productive to non-productive use. In the logic of the classical system it now
contributes only to private good rather than the common good. (We are reminded
again that Say’s tautology asserts this will not happen in a real economy.)
9. C.R. McConnell and S.R. Brue, Economics 16e (New York: McGraw-Hill Irwin,
2005), pp. 504–17.
10. P.H. Wicksteed, An Essay on the Coordination of the Laws of Distribution (London:
Macmillan, 1894), and The Common Sense of Political Economy (edited with an
Introduction by Lionel Robbins) (London: Lowe and Brydone, 1933).
11. J.B. Clark, The Distribution of Wealth (London: Macmillan, 1899). Clark declares in
the preface (p. v): ‘It is the purpose of this work to show that the distribution of
the income of society is controlled by a natural law, and that this law, if it worked
without friction, would give every agent of production the amount of wealth
which that agent creates.’
12. See, for instance, Bator’s seminal article. F. Bator, ‘The Simple Analytics of Welfare
Maximization’, American Economic Review (1957), 22–59.
13. Hoarding became a significant topic of the post-General Theory exchange
between Jacob Viner (J. Viner, ‘Mr. Keynes on the Causes of Unemployment’,
Quarterly Journal of Economics, 51:1 (1936), 27–33) and Keynes (J.M. Keynes, ‘The
General Theory of Employment’, Quarterly Journal of Economics, 51:2 (1937),
209–23). Keynes clarified that in disequilibrium, with household saving exceed-
ing business investment, production also exceeds consumption and hoarding is
the outcome, in the form of cash balances, otherwise known as the liquidity trap.
Risk-averse households demand greater money stocks, descending interest rates

notwithstanding. A substantial professional literature has developed in the ensu-
ing years regarding the role of the liquidity trap with various policy disputations
or solutions under highly specialized circumstances (see, for instance: D. Patinkin,
Money, Interest and Prices: an Integration of Monetary and Value Theory (Cambridge:
MIT Press, 1965, 1989).) However, unfortunately, except for the specialized liquid-
ity trap application, the concept of hoarding has largely disappeared from the
economic lexicon.
14. J.E. Sawyer, Why Reaganomics and Keynesian Economics Failed (London: Macmillan
and New York: St Martin’s Press, 1987).
15. J.K. Galbraith, The Economics of Innocent Fraud (Boston and New York: Houghton
Mifflin, 2004).
16. Indicative economic planning, as the term is used for instance in the economies
of Austria and Japan, is roughly proximate to the concept of a social welfare function
that includes setting the rate of profit on capital.
17. Global partnerships require a measure of shared sacrifice rather than the unmiti-
gated pursuit of unilateral self-interest. Whereas international cooperation on
issues such as SARS may be possible because failure to do so immediately invokes
a ‘common bad’ on all nations, atmospheric carbon reduction is more illusive. On
many such global issues the Bush administration has pursued a role equivalent to
neo-liberal ideological bully. This is possible, in part, because most outcomes,
such as environmental degradation, occur over the longer term, beyond the
immediate accountability of a single presidential term in which domestic voters
are likely to hold an administration responsible for negative outcomes. Also, a
large percentage of American voters appear uninterested in world opinion outside
of the United States.
18. Also required are public initiatives to curtail self-interested acts by individuals,
with large negative external effects. For instance, economist Michelle J. White
contends that drivers have been running an ‘arms race’ on American roads by
buying increasingly large vehicles, particularly sport utility vehicles (SUVs) and
light trucks. An important reason for driving them is that they provide their fam-
ilies extra protection in the event of a crash. But these vehicles pose an increased
danger to occupants of smaller vehicles as well as to pedestrians, cyclists and
motorcyclists. ‘For each one million drivers that shift from driving cars to driving
light trucks (SUVs included), between 34 and 93 additional car occupants, pedes-
trians, bicyclists or motorcyclists are killed per year and the value of the lives lost
is between $234 and $624 million per year.’ See M.J. White, ‘The “Arms Race” on
American Roads: the Effect of SUVs and Pickup Trucks on Traffic Safety’, Working
Paper 9302 (San Diego: Department of Economics, University of California at San
Diego and Cambridge, MA: National Bureau of Economic Research, 2003).
19. The Economist, 30 October 2004.
20. nytimes.com/2004/07/24/opinion/24brooks.html.
21. See Chapter 6.
22. Wall Street Journal, 18 October 2004.
23. J.T. Jost, J. Glaser, A.W. Kruglanski and F.J. Sulloway, ‘Political Conservatism as
Motivated Social Cognition’, Psychological Bulletin, 129(3), 339–75.
24. G. Lakoff, Moral Politics: What Conservatives Know That Liberals Don’t, 2nd edn
(Chicago: University of Chicago Press, 2002).
8
Power and Institutions in
Macroeconomic Theory
John Cornwall and Wendy Cornwall1
Introduction
While increasingly large segments of the economics profession cast

themselves adrift in a sea of representative agents governed by the invisible
hand, John Kenneth Galbraith has spent a lifetime studying and explaining
the realities of the advanced industrial state. These realities are dominated by
problems that stem from the accumulation and exercise of power by large
corporations, and the obligation of government to counter this power in the
public interest. This focus has made Galbraith a persistent critic of economic
theories that give power and institutions at best a very minor role, and more
usually none at all, in influencing economic performance. He finds this
neglect of power and institutions, typical of mainstream economic theories,
seriously diminishes their capacity to improve our understanding of the real
world and its problems. In this chapter we find that recent radical changes in
economic theory, initiated and propagated primarily by American econo-
mists, reaffirm Galbraith’s assessment. This shift has resulted in an entirely
new formulation of macro theory, profoundly different from that associated
with Keynes’s General Theory. We focus on how macroeconomic theories
explain unemployment, because the treatment of unemployment is at the
centre of this revolution in macroeconomic analysis and policy. By contrast-
ing the core features of the original Keynesian macroeconomics with the
new mainstream macroeconomics (hereafter referred to as Keynesian and
New Keynesian macroeconomics respectively), we can more easily identify
the shortcomings and misrepresentations that result when power and insti-
tutions are omitted from theory. These are essential determinants of macro-
economic outcomes, needed in order to understand why performance differs
over time and among countries, and to design effective policies to remedy
malfunction.
The second section contrasts macroeconomic developments in the two
episodes comprising the period since World War II, the ‘Golden Age’ and
what we designate the ‘Age of Decline’. The third section reviews the
87
changing mainstream schools of macroeconomics that prevailed over the

same historical period. The fourth section summarizes in non-technical
terms our extension of traditional Keynesian theory, in which power and
institutions are integral elements determining macroeconomic function. In
the fifth section these ideas are organized formally as a constrained
optimization problem. This model is tested in the sixth section, which
reports the results of an econometric model that includes measures of power
and institutional characteristics as possible influences on unemployment
performance in the OECD economies. The conclusions are contained in the
final section.
The stylized facts
Table 8.1 records unemployment and inflation data for 18 developed

capitalist economies from 1960 until the end of the century, the 1990s being
the last short-run period for which comparable data are available. The coun-
tries fall into three groups: those with low rates of unemployment through
the entire period (the low unemployment countries); those with relatively
high rates of unemployment throughout the period (the high unemploy-
ment countries) and a third group in which low unemployment until the
mid-1970s was followed by high unemployment thereafter (the low-high
unemployment countries). The data show there were two lengthy episodes
distinguished by their differing performance, the Golden Age of low unem-
ployment, moderate inflation and rapid growth (not shown), followed by
what we designate the Age of Decline, an episode of high unemployment,
high rates of inflation and slow growth. Each episode covers a series of short-
run business cycles, with turning points in GDP determined by the OECD
and cited at the top of the columns.
The customary definition of full employment emphasizes the absence of
involuntary unemployment after an adjustment for frictional or ‘job-search’
unemployment. Inspection of Table 8.1 shows an overall average unemploy-
ment rate of 2.3 per cent for the 18 developed capitalist economies during
the Golden Age. During this episode 3 per cent was commonly accepted
as the full employment rate of unemployment in the United States. We
follow this custom, although choosing an overall average rate as high as
4.5 per cent would not alter the nature of our conclusions. Table 8.1 brings
out clearly the exceptional unemployment and inflation records of all but
four of the economies in the first episode; these form the high unemploy-
ment group. This was a period of expansion of the welfare state, especially
outside of the United States, resulting in noticeable reductions in poverty
rates and in the inequality of income distribution. It was clearly a Golden
Age for most.
The period from the mid-1970s to the closing years of the century was one
of economic decline. Accelerating inflation rates in the late 1960s and early
Power and Institutions in Macroeconomic Theory 89
Table 8.1: Annual average standardized unemployment rates (U) and rates of consumer
.
price inflation (p) for 18 OECD countries (%)
1960–67 1968–73 1974–79 1980–89 1990–2000

. . . . .
U p U p U p U p U p
Low unemployment
Austria 2.0 3.6 1.8 5.2 1.8 6.2 3.3 3.8 3.9 2.4
Japan 1.4 5.7 1.2 7.1 1.9 9.9 2.5 2.5 3.2 1.0
Norway 2.0 3.9 1.7 6.9 1.8 8.7 2.8 8.3 4.8 2.5
Sweden 1.6 3.8 2.2 6.0 1.9 9.8 2.6 7.9 7.1 3.3
Switzerland 0.0 3.4 0.0 5.6 0.4 4.0 0.6 3.3 3.1 2.3
Unweighted average 1.4 4.1 1.4 6.2 1.6 7.7 2.4 5.2 4.4 2.3
High unemployment
Canada 4.8 2.4 5.4 4.6 7.2 9.2 9.4 6.5 9.3 2.2
Ireland 4.9 4.0 5.6 8.9 7.9 14.9 14.3 9.2 11.3 2.6
Italy 4.8 4.0 5.7 5.8 6.6 16.1 8.0 11.1 10.6 4.0
United States 4.9 2.0 4.6 5.0 6.8 8.5 7.3 5.5 5.6 3.0
Low-high unemployment
Australia 2.2 2.2 2.0 5.6 5.1 12.2 7.5 8.4 8.4 2.7
Belgium 2.0 2.8 2.5 4.9 7.1 8.4 9.8 4.9 8.5 2.2
Denmark 1.6 6.2 1.0 6.3 6.1 10.8 8.1 6.9 7.1 2.2
Finland 1.6 5.6 2.6 5.8 5.1 12.6 5.4 7.1 11.7 2.3
France 1.6 3.6 2.6 6.1 4.5 10.7 8.8 7.3 11.1 1.9
Germany 0.6 2.7 1.0 4.6 3.2 4.6 5.8 2.9 7.7 2.5
Netherlands 1.0 3.6 1.5 6.9 5.4 7.2 7.9 2.8 5.4 2.5
New Zealand 0.1 3.3 0.3 7.4 0.8 13.8 4.6 11.8 7.8 2.1
United Kingdom 2.7 3.6 3.3 7.5 4.7 15.6 9.8 7.4 8.0 3.6
Overall average 2.2 3.7 2.5 6.1 4.4 10.2 6.6 6.5 7.5 2.5
Sources
U: OECD Historical Statistics 1970–2000 and earlier issues, Table 2.19, Standardized Unemployment
Rates. For 1960–64, unemployment rates were obtained from the LSE data set. For Austria, Denmark
and Switzerland, and for New Zealand prior to 1974, standardized rates are not available; unemploy-
ment as a percentage of the total labour force is used instead.
.
p: OECD Historical Statistics 1970–2000 and earlier issues, Table 7.10.
1970s were followed by persistent inflation problems in spite of restrictive

aggregate demand policies and rising unemployment rates. Episodes of high
unemployment for most economies began in the mid-1970s and extended
over a period approximately twice the length of the Golden Age.2
The unweighted average unemployment rate rose from approximately one
and a half times its Golden Age average rate to triple this rate by the 1990s
short-run cycle. Within these average figures there were also exceptions,
as the five low unemployment countries continued to experience low
unemployment rates, except for Sweden in the 1990s.
The continued failure to achieve full employment raises a serious

challenge to the belief that capitalism is self-regulating. Although mild
fluctuations in output and unemployment within this episode might be
attributed to shocks, they cannot explain the persistence of the high and
rising unemployment that began in the mid-1970s; it has gone on too long
and has been experienced by too many economies. Instead, this episode
draws attention to a long and widely shared period of inadequate aggregate
demand. This requires explanation, as does capitalism’s success in the previ-
ous period. We return to the analysis of this deterioration in performance
following a discussion of the radical shift in mainstream macroeconomic
theory that accompanied the decline.
Paradigm shift
The Golden Age of capitalist development was also the golden age of
Keynesian macroeconomics. Mainstream macroeconomic models gave a
central role to aggregate demand in determining the equilibrium of the
system. Any failure of the private sector to achieve full employment levels of
aggregate demand would be short-lived, corrected when necessary by
stimulative fiscal policies. It was the high growth rates of aggregate demand
experienced during this episode that led to the economies’ achievement of
full employment levels of output and employment. With few exceptions,
inflation was at acceptable rates throughout the Golden Age. It was
modelled by an assumed stable, downward-sloping Phillips curve with a
politically acceptable menu of inflation/unemployment choices. Given the
commendable macroeconomic performance of the episode and economists’
wide acceptance of a Keynesian explanation of the stylized facts (‘we were all
Keynesians’), little effort was made by macro-economists to push the chain
of causation deeper to consider whether there were specific historical factors
underlying performance and delivering a Golden Age.
Bouts of rather severe inflation in the late 1960s and early 1970s marked
the beginning of the end of the Golden Age. Central bankers, business and
political leaders believed the underlying force generating unacceptable infla-
tionary pressures to be the growing exercise of labour power, to a large extent
caused by the rising affluence and sustained high employment of the
Golden Age. This led to an ‘overload’ of demands on the economy, especially
demands on governments made by labour, that could not all be satisfied.
The economy had become inflation-prone and needed a drastic anti-
inflationary response from government. Based on this appraisal, the recov-
ery programmes advocated by business and political leaders, especially in the
United States, Canada and the UK, increasingly involved reduction of the
welfare state and deregulation, to yield greater ‘flexibility’ in capital and
labour markets. Their adherence to this explanation of decline and its
remedy can be considered to large extent political, a resurrection of a latent
ideology of long-standing importance in these countries. According to this

world view, these kinds of market interventions are symptoms of undesirable
power shifts. Abolishing them redistributes power and restores the efficiency
of a private enterprise market economy.
The stagflation of the 1970s and 1980s was accompanied by the
emergence of New Keynesian macroeconomics, which was to replace
Keynesian theory as mainstream macroeconomics. This is a theoretical
framework with a causal structure and policy implications fundamentally
different from Keynesian macroeconomics. In New Keynesian macro-
economics the equilibrium rate of unemployment, a non-observable entity,
is uniquely determined by exogenous supply-side factors. Aggregate demand
plays only a passive role. Given some initial level or growth of aggregate
demand, built-in adjustment mechanisms bring aggregate demand into line
with the supply-determined equilibrium, that is the natural rate of
unemployment or NAIRU. Inflationary problems are then explained as the
consequence of the authorities’ efforts to reduce unemployment below its
equilibrium rate through overly stimulative aggregate demand policies. The
long-run Phillips curve was claimed to be vertical at the equilibrium rate of
unemployment, a ‘fact’ ignored by Keynesian policymakers at their peril.
Although actual unemployment was high and there was substantial
evidence that much of it was involuntary, this was nonetheless claimed to be
an equilibrium according to New Keynesian macroeconomics. The apparent
difficulty was resolved by alleging that the real wage was too high to employ
all workers willing to work; moreover, the wage was rigid downward, because
of excessive labour power, so that unemployment could not be decreased by
stimulative aggregate demand policies.
The failure of restrictive aggregate demand policies to quickly reduce
inflation to Golden Age rates, in spite of substantial and prolonged high
unemployment, reaffirmed the beliefs of economists who already subscribed
to a laissez-faire vision. The growing acceptance of vertical Phillips curve
analysis and its unique unemployment equilibrium reinforced this vision. It
can be said that a serious omission was a prime cause of the decline in sup-
port for Keynesian theory, and that it contributed to an even wider accep-
tance of New Keynesian principles. Keynesian theory provided the policy
solutions to economic problems, but could not explain why these policies
were not routinely used by all countries, or applied uniformly over time by
an individual country. Once economic theory enters the real world via a pre-
scription for interventionism, as Keynesian theory does, it must consider the
institutions and the distribution of power that might constrain policy
options. By including institutions and power and changes in their structures,
the analysis can identify the constraints at work and the appropriate policy
responses.
More exactly, beginning with the decline in macroeconomic performance
in the mid-1970s and continuing to the present, Keynesian economists had
failed to develop a general explanation of governments’ unwillingness to

supply the aggregate demand policies required to achieve full employment.
Without such a theory the best available explanation of stagflation, espe-
cially among the younger macro-economists, was seen to be the rising polit-
ical and economic demands upon the system by labour. The appropriate
‘remedial’ measures included reductions in labour power. Effectively, this
New Keynesian explanation of the difficulties and programme for recovery
coincided with the views of business and political leaders. With the notable
exception of work by the Post Keynesians, the macroeconomics that
emerged was embedded in the supply determined equilibrium framework, a
framework that denies the need for any theory of aggregate demand other
than its automatic adjustment to aggregate supply. Arguments for rejecting
New Keynesian macroeconomics as a method of analysis are a subject for
another paper. We will offer a critique of their policies below.
A political economy theory of aggregate demand
Extending the Keynesian model

The remainder of this chapter focuses on formulating a theory of aggregate
demand that can explain differences in unemployment rates both between
economies and through time. It builds upon a traditional Keynesian base,
and is intended to correct the omission in Keynesian macroeconomics
referred to in the previous section. While this chapter deals with differences
in aggregate demand and unemployment across countries, the model can
also be used to analyse the changes in aggregate demand and unemploy-
ment from the Golden Age to the Age of Decline.
In the extended model, aggregate demand policy is endogenously
determined. Its starting point is a central insight of the General Theory – high
unemployment rates and low levels of output are caused by deficient
aggregate demand and can be remedied by fiscal policy. Persistently high
unemployment can therefore be attributed to the authorities’ failure to sup-
ply the needed expansionary policies. We then push the analysis deeper
by asking why they might fail to provide this level of aggregate demand (or
why they have been willing to do so in the past). The answer lies in the
underlying power and institutional structures. Although these change rela-
tively slowly compared to movements of the usual economic variables, they
are nevertheless ‘historically specific’ having varied significantly from one
historic episode to the next.3
The demand for and supply of aggregate demand
Thus, we model the dominant macroeconomic policy response of the
authorities in any historical episode as the outcome of an interaction
between the supply of and demand for full employment policies. In this
framework, the strength of demand for full employment policies is determined
by the distribution of political and economic power among organized interest

groups. The policies supplied by the fiscal authorities depend upon whether
there are constraints limiting their policy options.4 For example, they may
be unwilling to supply full employment levels of aggregate demand because
to do so would generate unacceptable inflation or external imbalance, or
because there are laws that limit budget deficits. To focus on essentials, in
this section we assume that the only constraint limiting the authorities’ pol-
icy options is an unacceptably high inflation rate at full employment. In the
fifth section the central issues are analysed in a more formal manner, allow-
ing for the treatment of additional constraints on policy options, followed in
the sixth section by an econometric test of our political economy theory of
aggregate demand.
The party control theory of economic policy is the most prominent of the
models focusing on the demand side and is a useful point of reference. It
offers a political explanation of policy choice, explaining differences in
unemployment rates across countries in terms of the relative strength of
right-wing and left-wing political parties (for example, Kalecki, 1971; Hibbs,
1987; Alesina et al., 1997). It assumes that political parties represent the
society’s socio-economic divisions, and that labour is more willing than cap-
ital to trade price stability for lower unemployment, a preference registered
at the ballot box in its choice of political parties. However, this analysis is
incomplete. The distribution of political power accounts only for the
strength of demand for expansionary policies. Even the most ardently pro-
labour government must consider the costs of supplying a full employment
policy, the most obvious being the inflation cost. In this case, the key factor
underlying the costs and willingness to supply stimulative policies is the
position of the Phillips curve, with a poorly placed Phillips curve acting as a
constraint. For example, if the maximum politically acceptable rate of price
inflation intersects the Phillips curve to the right of the full employment rate
of unemployment, policy will target an unemployment rate greater than
the full employment rate. In such an economy, inflation costs constrain
expansionary policies.
The position of the Phillips curve is determined by particular labour
market institutions. In the period since World War II, the most important of
these has been the strategy adopted by labour, business and government to
institutionalize ‘fairness’ in labour markets. With some variations, there
were two types of strategy. One permitted full employment with politically
acceptable rates of inflation; the other failed to do so.5 The latter results from
using a ‘market power’ strategy in which wage settlements were reached
through unrestricted collective bargaining between labour and manage-
ment. There were no institutions that would routinely coordinate wage
settlements with national goals; governments had failed to exercise leader-
ship in establishing such institutions. The lack of coordinating institutions
resulted in a strong emphasis on the money wage as the target of bargaining.
Maximizing the money wage, with the cost of living and wage settlements in
other sectors as guides, was the means chosen to secure real wage gains. The
adoption of this labour market strategy reflected, and helped to perpetuate,
the conflict endemic to an adversarial industrial relations system, often
manifested as a high strike volume. Since labour’s market power rose when
unemployment rates fell, this strategy generated a negatively sloped long-
run Phillips curve. Further, this strategy produces a high strike volume,
which pushed the Phillips curve to the right, creating a menu of inflation–
unemployment choices that excluded simultaneous full employment and
acceptable inflation.
In other economies a ‘social bargain’ strategy was adopted by labour in co-
operation with capital and overseen by government. In this case labour
accepted the need for money wage restraint in order to achieve national
goals such as wage and price stability and international competitiveness. In
exchange, labour was promised full employment, the rising real wages that full
employment generated through higher productivity growth, and welfare
programmes as a safety net. Variations in the institutional forms of the social
bargain, including the generosity of welfare programmes and employment pro-
tection measures were largely the result of differences in the power of labour.
In the late 1960s, the breakdown of social bargains in many economies and
their replacement by a market power strategy was a contributing cause to the
end of the Golden Age. According to our analysis, increased strike activity
would be expected as a result of this institutional change, a consequence of
the industrial unrest inherent in an adversarial bargaining strategy. Table 8.2
records the average days lost per thousand workers as a consequence of strikes
for each of the three country groups of Table 8.1. For the groups with consis-
tently low or consistently high unemployment, we can see that strike activity
is also consistently low or high. But in the group of countries whose social
bargains collapsed in the late 1960s, strike activity increases to well over twice
its earlier level. This institutional change, from harmonious to adversarial
industrial relations, caused their Phillips curves to shift rightward, with the
earliest impact felt on wage inflation; the effect on unemployment was
delayed until the mid-1970s, as governments countered rising inflation with
restrictive policies, according to the New Keynesian prescription.
Table 8.2: Average days lost to strikes, per thousand workers, 1960–89
Country group 1960–67 1968–73 1974–79 1980–89
Low unemployment 43 32 32 57*

High unemployment 370 676 706 333
Low-high unemployment 97 257 248 207**
Notes
* This falls to 36 if Sweden is excluded.
** Excludes Belgium, because of missing data.
A formal model
Our contention is that power and institutions act together to determine

economic outcomes, unemployment in our example. Our example has so far
considered the chosen labour market strategy as a determinant of the position
of the Phillips curve, because this indicates the degree of trust and harmony in
industrial relations. While the level of industrial harmony is crucial, here we
allow for the existence of additional institutional constraints that determine
economic outcomes. The distribution of power decides the political party
whose preferences will be furthered, but the pursuit of these preferences is lim-
ited by what is possible.6 The model consists of a political preference function
which is to be optimized subject to the existing Phillips curve.7 The Phillips
curve is assumed to be downward sloping, so that there are trade-offs between
unemployment and inflation that governments can exploit. The formal
model clearly overstates the precision with which governments act; multiple
policy goals, lack of information, and policy mistakes make such precision
highly unlikely. Fortunately, all that is needed in practice is the assumption
that political preferences differ enough to produce consistent differences in
unemployment outcomes as governments attempt to optimize.8
The Phillips curve

The price inflation Phillips curve can be written as
.
p f (U; V1) (8.1)
.
where p and U represent the inflation and unemployment rates, and V1 is a
vector of variables that influence its slope and position. These include eco-
nomic variables such as productivity growth, an import price index, and as a
measure of external demand conditions, unemployment in the trading part-
ner countries. There are also institutional variables, included to capture the
effects of different and changing industrial relations systems. Other expla-
nations of differences in the position of Phillips curves among countries
have included such regulatory measures as payroll taxes and various dimen-
sions of the welfare state, particularly the ratio of unemployment benefits to
wages, with mixed results.9 Rather than isolating individual regulations,
which are relatively easily changed, we emphasize institutions that have a
broader and more persistent influence on labour market behaviour.
The political preference function

The political preference function measures the disutility (M) of pairs of
unemployment and inflation rates. It is assumed to be strictly convex, ensur-
ing that it yields strictly concave indifference curves. It can be written as
.
M M( p, U; V2) Mp, Mu 0 (8.2)
where V2 is a vector of political and institutional variables influencing its

slope and position. The parameters of the preference function vary with the
political party in power, and it is expected that left-leaning governments will
attach a relatively greater weight to unemployment than will right-of-centre
governments, yielding steeper indifference curves. Put simply, the left-leaning
government will accept a greater rise in inflation to achieve a given reduction
in unemployment than will the right-wing government. Custom and tradi-
tion also influence preferences, causing different weights, and so different
slopes, even among countries with similarly left- or right-wing governments.
For example, compared to others, a country with a strong aversion to
inflation, such as Germany, will attach a greater weight to inflation whatever
government it elects.
Optimization
Each unemployment outcome is interpreted as the result of the government
acting to optimize its preference function subject to the existing Phillips
curve. The preference function measures disutility, so that the indifference
curve closest to the origin is preferred. In Figure 8.1 this is shown at point A,
the point of tangency between the Phillips curve (PC1) and the indifference
curve (IC1). Should the Phillips curve shift to PC2, there is greater disutility at
the optimum point B. The effect of alternative preference functions is shown
in Figure 8.2, where the steeper indifference curve (ICL) depicts the effect of
a more left-wing government than curve ICR. Given the prevailing Phillips
curve, optimization occurs at point A, with lower unemployment and
higher inflation than at point B, which would be the choice of a right-wing
government.
A PC2
PC1
IC1 IC2
U
Figure 8.1 Optimizing political preferences
PC
ICL ICR
U
Figure 8.2 Alternative political preferences
The reduced form
Our interest lies in the extent to which actual unemployment outcomes are
determined by an economy’s institutional characteristics and distribution of
power. Each observed (optimal) unemployment rate can be represented by a
reduced form equation
U U (V1 ,V2) (8.3)
where the vectors V1 and V2 contain the institutional and other exogenous
or predetermined variables.10 Estimation of this reduced form will provide
information about the importance of power and institutional variables in
explaining the differences in unemployment rates both between countries
and over time for a group of OECD economies. Problems associated with
business cycle fluctuations are avoided by using data averaged over the cycle.
The first step is to specify the variables to be used and relate them to our
theoretical model.
The vector V2 is from the political preference function, and includes
variables that determine the slope of the indifference curves. The idea that
left or right political leanings will affect the slope is tested by using the pro-
portion of left of centre votes cast in the period as a measure of effective
political preferences. Others (for example, Hibbs, 1987; Alesina et al., 1997)
have distinguished left-wing from right-wing governments by using dummy
variables that simply assume values of plus or minus one. Using left of cen-
tre votes allows a finer distinction, providing a measure of the extent to
which any government hoping for re-election must moderate its ideological
preferences. A strong left vote will move the policies of a right-wing government
toward the centre, or strengthen a left-wing administration’s ability to resist
the claims of powerful business and financial interests. Neither can the
simple left–right classification distinguish between high unemployment
countries like the United States and Canada, and Japan and Switzerland
which have low unemployment, since they all consistently elect right-wing
governments. But they have very distinct voting patterns; the average per-
centage of left votes is 38 per cent for Japan and 26 per cent for Switzerland,
compared to zero for the United States and about 15 per cent for Canada.
The use of left votes also avoids some of the measurement problems for
multi-party states that often have coalition governments. In general, the
higher the proportion of left votes, the greater the tolerance for inflation and
the stronger the preference for low unemployment.
Identical voting patterns do not imply identical indifference curves, since
political preferences also depend on a country’s history and institutions.
One source of variability is the level of aversion to inflation, proxied here by
an index of central bank independence.11 Lastly, because it was voluntary,
membership in the European Monetary System also represents political
preferences; a dummy variable is used to capture its effects. The monetary
policy of EMS members was affected by exchange rate coordination, lowering
inflation rates (Jenkins, 1996). EMS membership is therefore an additional
measure of a preference for lower inflation.
The Phillips curve defines the set of possible outcomes; its parameters are
defined by the variables in vector V1. The degree of industrial conflict is
expected to have a strong influence on the position of the Phillips curve. It
is measured here by the volume of strikes, which is lagged to allow time for
changes in industrial relations to exert their influence. Harmony in indus-
trial relations depends upon trust, particularly in wage bargaining. When
management’s assessments of costs and productivity are believed, wage
claims will take them into account, reducing conflict and the likelihood of
strikes, and improving the inflation–unemployment trade-off.12 The volume
of strikes is a more direct and more sensitive measure of the wage bargaining
environment than the structure of collective bargaining used by others (for
example, Calmfors and Driffill, 1988). The position of the Phillips curve also
responds to changes in economic conditions, for example, the international
economic environment. We account for external demand conditions by
using unemployment in each country’s trading partners’ economies, weighted
by its exports to GDP ratio. This weight allows for differences in openness
that determine the degree of exposure to external demand. Finally, lagged
inflation is included as a determinant of the position of the Phillips curve,
but we use the average inflation rate in the previous business cycle.
Therefore it is not a simple inflationary expectations variable; instead, it
measures the cumulative effects of past inflation on the position of the
Phillips curve. These effects can be traced to institutional changes in the
post-war era, especially the increasing power of labour. Backed by this power,
labour’s claim to ‘fairness’ in wage settlements induced employers to accept

the protection of real wages as a legitimate objective (Hicks, 1974; Perry,
1975). Past inflation can also affect the Phillips curve via the restrictive
policies it induces, in a hysteretic process. In addition, more familiar
economic variables such as productivity growth and import price inflation
are potential determinants of the position of the Phillips curve.13
The test results and some implications
We tested the model using a sample of 18 OECD countries, with four

observations for each, for the years 1960–67, 1968–73, 1974–79 and 1980–89,
which approximate the business cycles of the period.14 These observations
were pooled, and estimated using OLS.15 The variables are defined in
Table 8.3. Table 8.4 lists the countries in the sample, and reports regression
results for the reduced form unemployment equation (8.3).16 Tests for
changes in the coefficients after 1973 showed the estimates to be very stable,
with one possible exception. The Hocking specification test points to a break
in the lagged inflation variable. Its coefficient was not significantly different
from zero prior to 1974, but afterwards took a positive value, implying that
lagged inflation came to play a part in determining unemployment only after
the end of the Golden Age. This result is consistent with the greater intoler-
ance of inflation, and acceptance of higher unemployment rates to combat it,
which occurred in many countries at that time, and also with the widespread
use of restrictive policies since the mid-1970s. The coefficient of the external
demand variable (WU) is significant, with a value a little less than one. This is
expected, given the extent of trade among these countries, and sufficient
time in each period to allow the transmission of changes to take place. This
coefficient suggests that if a country exports 50 per cent of its GDP, and the
unemployment of its trading partners rises by 1 percentage point, it can
expect its own unemployment rate to rise by about 0.5 percentage points.17
Table 8.3: Definitions of the variables used in the unemployment equation
U Average unemployment rate over the period

LV Left of centre votes as a proportion of total votes cast in elections during
the period
CBI Index of central bank independence
EMS Dummy variable for membership in the European Monetary System
STR Logarithm of man-days lost to strikes per thousand workers, lagged one
period
WU Weighted average unemployment rate of the other 17 countries in the
sample, scaled by the country’s own exports to GDP ratio
LINF Average inflation rate, lagged one period
Sources: Voting data, Mackie and Rose (1991); central bank independence index, Cukierman
et al. (1992); strike data, ILO Yearbook of Labour Statistics, various issues; OECD data are used for
the remaining variables.
Table 8.4: Regression results for the reduced form unemploy-

ment equation
Equation (8.1) Equation (8.2)
Left of centre votes 4.877 4.535

(4.02) (3.77)
Central bank independence 3.046 2.810
(2.64) (2.47)
Membership in the EMS 3.016 3.149
(4.60) (4.87)
Strikes 1.005 1.001
(8.05) (8.17)
‘World’ unemployment 0.944 0.794
(WU) (4.04) (3.27)
Lagged inflation 0.195 0.037
(3.43) (0.28)
1974–89 dummy lagged 0.198
inflation (1.88)
Constant 2.7337 2.0652
(2.27) (1.68)
Adjusted R2 0.8222 0.8289
Hocking test critical value 2.0317
Hocking sp 3.5445
Notes: The figures in parenthesis are the absolute values of the t-statistics.
The 18 countries included are: United States, Japan, Germany, France, Italy,
United Kingdom, Canada, Australia, Austria, Belgium, Denmark, Finland,
Ireland, The Netherlands, New Zealand, Norway, Sweden and Switzerland.
There were four observations for each, for the years 1960–67, 1968–73,
1974–79, 1980–89.
Of greater interest to our analysis are the coefficients of the institutional

and power variables, which are all of the expected sign, and significantly
different from zero at the 5 per cent level. The ‘left votes’ variable used to
capture the distribution of power, suggests that a 10 percentage point
increase in left votes would result in a drop of approximately 0.5 percentage
points in unemployment. The institutional variables have similarly strong
implied effects. Membership in the EMS increases unemployment by about
3 per cent, ceteris paribus. Increased central bank independence also increases
unemployment rates. For example, the difference in the index between the
USA and Japan is 0.30, and accounts for almost 1 percentage point of the dif-
ference in the unemployment rates of these countries. For the period
1973–89, the annual average days lost to strikes per thousand workers for the
‘high unemployment’ economies of Table 8.1 was 692, and it was 32 for
the ‘low unemployment’ group, accounting for a 3 percentage point differ-
ence in their unemployment rates. The strong partial correlations of these
variables with unemployment, and the high overall explanatory power of
the estimates support the view that power and institutions play a significant
part in determining unemployment rates.
In the third section we noted that New Keynesian economists blame the
effect of labour-friendly institutions accumulated during the Golden Age for
the increased unemployment that followed. The cure was deregulation, to
create a more competitive, flexible labour market. Another influential view
is that institutions aid performance the closer they are to some competitive
norm. Both views are contrary to the historical record. Among the best per-
formers during this episode were Austria, Germany and the Scandinavian
economies, all characterized by extended welfare states, high taxes, high
union densities and highly regulated labour markets. In contrast economies
with institutions closer to a competitive norm, for example, Canada and the
United States, were among the worst performers.
Using our estimates to account for the change from the Golden Age to the
Age of Decline provides some numbers that support this. While EMS mem-
bership and international demand conditions account for a large share of
the increase in unemployment between these two episodes, labour market
institutions were important. In Canada, Ireland, Italy, Australia and the
United Kingdom, increased strike activity accounts for about a 1 percentage
point increase in their unemployment rates. In four of the five countries that
kept their social bargains, strikes fell, reducing their unemployment rates by
an average 1 percentage point, while in Sweden a small increase in strikes
had a minimal effect. These estimates suggest that far from hindering
performance, social bargains can assist it.
Conclusions
Galbraith has argued that by failing to take into account historical context,
economists have produced theories that lack depth and relevance. The
power structures and institutions of a country are important determinants of
economic performance. These change over time, influenced by and influ-
encing economic development. Analysis that ignores them provides at best
only a superficial interpretation of events, and at worst misinterprets them.
Our chapter supports this charge, citing developments in macroeconomic
theory over the past half century. We conclude that the currently dominant
New Keynesian macroeconomics has advocated policies to reduce unem-
ployment that are based on assumptions inconsistent with the historical
data of Table 8.1. The historical record does not support the position that
macroeconomic performance improves the closer institutions conform to
the competitive model. In fact those economies whose structure most clearly
resembles the competitive model were consistently among the high unem-
ployment performers, for example, Canada and the United States. On the
other hand, the economies with the best unemployment records, in the
Golden Age and beyond, were those in which the authorities engaged
in market interventions, establishing and maintaining labour-friendly

institutions. We also contend that underlying the decreasing acceptance of
the kind of Keynesian macroeconomics associated with the General Theory
has been its failure to include power and institutions as part of its theoretical
framework. Perhaps most damaging in this context has been its inability to
provide a general explanation of stagflation.
The remainder of the chapter presents a model that extends Keynesian
macroeconomic principles. This reformulation of Keynesian theory includes
power and institutions as determinants of aggregate demand; it is offered here
as a remedy to some of Galbraith’s criticisms. The importance of power and
institutions is supported by our econometric tests. But Galbraith’s critique of
current theory goes further, and concerns the manipulation of public prefer-
ences and the consequent induced impact on institutions. The concentration
of power in the modern economy, and its use to further consolidate its already
formidable strength has been at the root of Galbraith’s writings. This is the
overriding characteristic that he insists we recognize. Once we have done
so, any vestiges of self-regulating markets evaporate, and then we can begin to
understand how real economies work. Although we have not ventured into
analysing the use of power to form or manipulate preferences, we have taken
the first steps to investigate how power promotes the preferences of particular
groups via the policy choices that are made. This has increased the power of
our analysis by showing how power and institutions are linked to economic
policies and performance. For the future, we believe a research programme
that emphasizes case studies and historical analysis will provide the detail that
will allow us to refine and expand our results.
Notes
1. We are indebted to the Academic Vice-President’s Office, the Faculty of Science, and
the Department of Economics, all of Dalhousie University, for providing financial
support for this research.
2. This understates the length of the Golden Age episode because of an absence of
comparable data in the period before 1960.
3. Institutions can be defined as the beliefs, customs, laws, rules and norms that guide
the behaviour of individuals and groups within society. One of their functions is to
legitimize power; another is to provide the mechanisms for conflict mediation. For
this study, power is usefully defined as the ability of dominant individuals or groups
in economic relationships to make subordinate individuals or groups act in the
former’s interest. Economic and political power are distinguished by the means used
to exercise them, that is via the market or via political channels. When institutions
legitimize a power relationship, they simultaneously legitimize the economic out-
comes that flow from it. These economic outcomes are often, although not exclu-
sively, concerned with income distribution, as are many of the conflicts that arise.
4. In this analysis monetary policy is treated as a separate institution, with the degree
of independence of the central bank varying among countries. For an earlier study
employing a similar framework see Gordon (1975).
5. For greater detail see Cornwall (1994), chapters 5–7.

6. The resulting model develops earlier ideas that have emphasized the political
economy aspects of the unemployment–inflation issue (for example, Cornwall,
1994; Hibbs, 1987).
7. This model was originally used by Lipsey (1965) and later by Trevithick (1976) to
provide a definition of full employment that is consistent with other objectives of
economic policy. It is implicit in partisan control theory (for example, Hibbs,
1987).
8. There are several arguments for rejecting the use of vertical Phillips curve analysis
(for example, Cornwall and Cornwall, 2001).
9. The variables are used to measure real wage rigidities, which are then used to
explain unemployment (for example, Layard et al., 1991). Others claim that
labour market rigidities fail to explain differences in unemployment (McCallum,
1986; Freeman, 1995).
.
10. Similarly, there is a reduced form equation for inflation, p P( V1, V2 ). It should
also be noted that the vectors V1 and V2 may have some elements in common.
11. We support the proposition that central bank independence is caused by aversion
to inflation, whether this is ‘grass roots’ aversion (Debelle and Fischer, 1994) or
the view of powerful financial interest groups (Posen, 1995).
12. McCallum (1983) and Paldam (1980) provide further discussion of these points.
13. Our tests showed these to have coefficients that are not significantly different
from zero, probably the result of using data averaged over the business cycle.
14. More recent data are not included, partly because there is not a complete business
cycle, and partly because of the inconsistencies created by the unification of
Germany.
15. Using Monte Carlo simulations, Hauk and Wacziarg (2004) show that OLS applied
to averaged country data provides estimates with reduced overall bias compared
to other commonly used estimation methods.
16. For a full treatment of the model, the variables used for estimation, and additional
estimation results, see W. Cornwall (1999).
17. These numerical illustrations use the coefficients of equation (8.1) in Table 8.4.
References
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(Cambridge: MIT Press, 1996).
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Performance’, Economic Policy, 3 (1988), 13–22.
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Evolutionary-Keynesian Approach (Cambridge: Cambridge University Press, 2001).
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and its Effect on Policy Outcomes’, World Bank Economic Review, 6 (1992), 353–98.
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of Economic Policy, 11(1) (1995), 63–72.
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Technical Working Paper Series, T0296 (2004).
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Placebo?’, Banca Nazionale del Lavoro Quarterly Review, 49 (1996), 241–70.
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the Capitalist Economy (Cambridge: Cambridge University Press, 1971), Chapter 12.
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Labour Market (Oxford: Oxford University Press, 1991).
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of California Press, 1965).
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9
Reinventing Fiscal Policy
Introduction1
There has been a major shift within macroeconomic policy over the past two
decades or so in terms of the relative importance given to monetary policy
and to fiscal policy, with the former gaining considerably in importance, and
the latter being so much downgraded that it is rarely mentioned. Monetary
policy has focused on the setting of interest rates as the key policy instru-
ment, along with the adoption of inflation targets and the use of monetary
policy to target inflation. The Central Bank sets its discount rate2 with a view
to achieving the set inflation target, but the discount rate can be considered
as set relative to an ‘equilibrium rate’ so that the problem of aggregate
demand deficiency appears to be effectively dispensed with.3 This can be seen
in the operation of Taylor’s rule for the setting of the discount rate (Taylor,
1993). In Arestis and Sawyer (2003a), we critically examine the significance
of this shift in terms of monetary policy, which led us to question the effec-
tiveness of monetary policy. In the same paper we also explore the role of
fiscal policy, and argue that within the ‘new consensus’ there is barely men-
tion of fiscal policy.4 We strongly suggest there that fiscal policy should be
reinstated, and conclude that ‘fiscal policy remains a potent tool for offset-
ting major changes in the level of aggregate demand’ (p. 19). This chapter
aims to consider further that particular conclusion (see also, Arestis and
Sawyer, 1998).
We begin by considering this ‘new consensus’ and the limited nature of
its analysis. We then consider fiscal policy at length within this theoretical
framework. We find the proposition of this thinking, that fiscal policy pro-
vides at best a limited role, unconvincing. The two sections that follow
examine the possibility of crowding-out and the Ricardian equivalence theo-
rem (RET). We argue that, under specified conditions, fiscal policy is a pow-
erful tool for macroeconomic policy. A short review of quantitative estimates
of fiscal policy multipliers is provided in the section that follows, before the
final section that summarizes the argument and concludes.
105
The ‘new consensus’ in macroeconomics
The ‘new consensus’ in macroeconomics has been summarized in terms of a

simple model with the following three equations (adapted from Meyer,
2001; but see also, McCallum, 2001; and Clarida et al., 1999; it is also dis-
cussed in Arestis and Sawyer, 2002b and 2002c):
Ygt a0 a1Ygt1 a2Et(Ygt1) a3[Rt Et( pt1)] s1 (9.1)

pt b1Ygt b2 pt1 b3Et(pt1) s2, (with b2 b3 1) (9.2)
Rt (1 c3)[RR* Et(pt1) c1Ygt1 c2( pt1 pT)] c3Rt1 (9.3)
where Yg is the output gap, R is nominal rate of interest, p is rate of inflation,

pT is inflation rate target, RR* is the ‘equilibrium’ real rate of interest, that is
the rate of interest consistent with zero output gap which implies from equa-
tion (9.2), a constant rate of inflation, si (with i 1, 2) represents stochastic
shocks, and Et refers to expectations held at time t. Equation (9.1) is the
aggregate demand equation with the current output gap determined by past
and expected future output gap and the real rate of interest. Equation (9.2) is
a Phillips curve with inflation based on current output gap and past and
future inflation. Equation (9.3) is a monetary policy operating rule with the
nominal interest rate based on expected inflation, output gap, deviation of
inflation from target and the ‘equilibrium’ real rate of interest. The lagged
interest rate represents interest rate ‘smoothing’ undertaken by the monetary
authorities (see, for example, McCallum, 2001).5
From the perspective of this chapter, equation (9.1) is of particular signifi-
cance. There is no explicit mention of fiscal policy, though changes in the
fiscal stance could be seen as reflected in a change in a0. But proponents of
this model have produced a number of arguments that suggest that the
use of discretionary fiscal policy should be seen as the exception rather than
the rule. The norm for fiscal policy should be to let automatic stabilizers
operate in an environment of budgets balanced over the business cycle, and
the operation of those stabilizers may be reflected in the coefficients a1 and
a2. A number of arguments have been put forward to make the case against
the use of discretionary fiscal policy and of long-term budget deficits. The
most important, and rather more widely accepted by the proponents of the
case, are those of crowding-out and of the RET, and given their significance
we return to both below. Further arguments against discretionary fiscal pol-
icy relate to what have been labelled as ‘institutional aspects of fiscal policy’
(Hemming et al., 2002a): model uncertainty, in that longer and more uncer-
tain lags prevail than it was thought previously; there is the risk of pro-
cyclical behaviour in view of cumbersome parliamentary approval and
implementation; increasing taxes or decreasing government expenditure
during upswings may be politically unrealistic, and this may very well generate
a deficit bias; spending decisions may be subjected to irreversibility, which
Reinventing Fiscal Policy 107
can lead to a public expenditure ratcheting effect; and there may be supply-side
inefficiencies associated with tax-rate volatility. We also devote a section to
these ‘institutional aspects of fiscal policy’ below.
Fiscal policy in the ‘new consensus’
We introduce fiscal policy explicitly into the discussion through the

expansion of the equations of the model outlined in the previous section.
The government sector is explicitly included though, for simplicity reasons,
retaining the closed economy nature of the model, and the capacity level
of output, which is labelled Y*. With a simple consumption function of
the form:
Ct d1 d2(1 t)Yt1 [Rt Et( pt1)] (9.4)
where the symbols are as above, with the addition of C, consumer demand,
and t, the income tax rate. The investment function is of the form:
It d3 d4Et(Yt1) [Rt Et(pt1)] (9.5)
where I is investment demand and government expenditure is labelled G.

This leads to:
Yt (d1 d3) G d2(1 t)Yt1 [Rt Et( pt1)]
d4 Et (Yt1) [Rt Et( pt1)] (9.6)
With the output gap incorporated, this can be written as:
(Yt Y*) (d1 d3) G [d2(1 t) (d4 1)]Y*
[d2(1 t)](Yt1 Y*) d4Et(Yt1) Y*)

( )[Rt Et(pt1)] (9.7)
It is now evident that the ‘equilibrium’ rate of interest (for a zero output gap)
is given by:
(d1 d3) G [d2(1 t) (d4 1)] *

[Rt Et(pt1)] Y (9.8)
( ) ( ) [( )]
It is then clear that the ‘equilibrium’ rate of interest depends on govern-
ment expenditure, and that there is not a unique ‘natural rate’ of interest.6
It is, of course, possible to take the balanced budget case, and then the
‘equilibrium rate’ of interest would be given by:
(d1 d3) (d2 d4 1) *

[Rt Et(pt1)] ( )

( )
Y (9.9)
It is also evident that the ‘equilibrium rate’ of interest depends on the para-
meters of the consumption and investment functions. The evidence from
the US and the UK (for example) during the 1990s suggests that those para-
meters can undergo substantial changes in the form of rises in the propensity
to consume (driving the household savings rate close to or below zero) and
in the propensity to invest.
The empirical investigation of the effectiveness of fiscal policy is generally
undertaken in the context of econometric models that could be viewed as
elaborations of the ‘new consensus’ model. The resulting econometric model
is much larger and involves many leads and lags which do not appear in
the ‘new consensus’ model, as presented above, but the econometric models
generally impose the existence of a supply-side equilibrium (say the NAIRU
or non-accelerating inflation rate of unemployment) which is equivalent to
the zero output gap for which inflation is constant.7 With a policy regime
that pushes the economy towards the supply-side equilibrium (reflected in
equation (9.3) above for the determination of the rate of interest) there is
little room for output to substantially diverge from the supply-side equilib-
rium. Hence, any fiscal stimulus is soon dissipated in the context of the
model, leading to the empirical conclusion that fiscal policy is ineffective. In
view of the constraints imposed by the nature of macroeconometric models
(for example, the existence of a supply-side determined equilibrium in the
form of the NAIRU), it may be surprising that any positive effects of fiscal
policy are observed. The effects generally found for fiscal policy may be
explicable in terms of the starting point for the simulations (say in terms of
unemployment) relative to the supply-side equilibrium. Clearly if unem-
ployment is initially higher than the NAIRU, there is scope for a fiscal stim-
ulus, which would (in the context of the model) push unemployment down
towards the NAIRU. But it could be expected that any conclusions drawn on
the effects of fiscal policy would be sensitive to the starting point used.
The ‘new consensus’ model (or equivalent) provides little role for fiscal
policy. It is assumed that there is a feasible ‘equilibrium rate’ of interest
which will secure a level of aggregate demand equal to the capacity level of
output (which itself is compatible with constant inflation).8 It is, however,
pertinent to think about the effectiveness of fiscal policy in the context of a
major shift in the coefficients of equations (9.4) and (9.5). Suppose, for
example, there is a change in ‘animal spirits’ or technological opportunities
for investment, which leads to a reduction in d3 of d. For fiscal policy alone
to offset the reduction would require a change in government expenditure of
d. It should be noted that here there would be no ‘crowding-out’ due to a
change in the rate of interest, which is under the control of the Central
Bank, nor due to output being constrained to be at the capacity level. This
leads us to the question of the possibility of crowding-out and the effectiveness
of fiscal policy.
Crowding-out is not inevitable
There have been four distinct sets of arguments to the effect that fiscal policy
will be ineffective, under the general heading of ‘crowding-out’.9 The first, in
the context of the IS-LM analysis, was a ‘crowding-out’ due to a rise in interest
rates following a fiscal expansion. This was based on an exogenous money
supply and the interest rate equating the demand for and supply of money.
In that context, though, it was recognized that a sufficient increase in the
supply of money alongside an increase in government expenditure could
prevent the rise in the interest rate. In the context of endogenous money
with the interest rate set by the Central Bank, this form of ‘crowding-out’
would arise from the deliberate action of the Central Bank. That is to say, if
the Central Bank, operating on an ‘independent’ basis, responds to a fiscal
expansion by raising interest rates, then there would be some form of crowding-
out. Its extent would depend on the size of the interest rate rise, its feed
through to other interest rates, the interest rate responsiveness of expendi-
ture, and the phase of the business cycle. But the key point here is that any
‘crowding-out’ depends on the response of the monetary authority: it does
not occur through the response of the markets. Even if the rate of interest
were allowed to increase, there is still the question of the investment elastic-
ity with respect to the rate of interest. Chirinko (1993) and Fazzari (1993;
1994–95), for example, argue very strongly that the impact of the rate of
interest on investment is modest at most. Sales growth (the accelerator effect)
and cash flow effects are the dominant variables in the determination of
investment. It is, in fact, generally recognized that activity variables, espe-
cially output, have ‘a more substantial impact on investment’ (Chirinko,
1993, p. 1881). So that even if expansionary fiscal policy raised interest rates,
crowding-out would not materialize.
The second line of argument relates to the role of savings in fiscal policy.10
Consider the following identity in terms of outcomes:
DS PI GD CA (9.10)
where DS is domestic savings, PI is private investment, GD is government

deficit and CA is current account surplus (or minus current account deficit).
It is then argued that crowding-out occurs because higher aggregate demand
due to an increase in deficit ‘absorbs’ savings, which reduces investment
(see, for example, Cunningham and Vilasuso, 1994–95). The possibility
of ‘international crowding-out’ is also raised. This may come through the
exchange rate: it is postulated that higher interest rates associated with the
fiscal expansion cause capital inflows which appreciate the exchange rate,
deteriorate the CA (smaller surplus or higher deficit), thereby offsetting
the increase in aggregate demand that emanates from fiscal expansion
(see Hemming et al., 2002a, for more details on international crowding-out).
A related argument has been proposed. Rewrite (9.10) to read as:
DS FS PI GD (9.11)
where the symbols are as above, with the exception of FS which stands
for foreign saving (equivalent to deficit in CA). An increase in government
deficit (GD), then, ‘signals a decline in government saving. As a result, either
investment falls, foreign savings rise, or some combination of these occurs.
Put differently, either crowding out occurs, international crowding out occurs
or both’ (Cunningham and Vilasuso, 1994–95, p. 194).11 Clearly, both argu-
ments relating to (9.10) and (9.11) are flawed. Consider the argument related
to (9.11) first. This formulation of the crowding-out argument treats DS
as exogenously given. However, DS should be treated as endogenous in that
its size responds to changes in, inter alia, government expenditure. Then an
increase in GD could be expected to lead to an increase in DS. This could also
happen when we come to the argument of (9.10). For in both cases, it is
possible that with a higher government deficit, increases in income and
investment occur, as well as the economy’s saving, rather than a reduction of
investment. Consequently, expansionary fiscal policy will boost savings
since it raises income and investment, rather than reducing savings (see also,
Gordon, 1994). In the context of where interest rates are set by the Central
Bank, the effect of budget deficit on interest rates depends on the reactions
of the Central Bank.
International crowding-out is unlikely to materialize under the circum-
stances explored here. Fiscal policy influences the level of economic activity,
some of which spills over into imports. The exchange rate may be affected by
the change in the level of economic activity; but the precise effect is not
clear. A rise in imports could be expected to depress the exchange rate, but
the rise in economic activity may generate optimism about the state of the
economy thereby tending to raise the exchange rate. There may be a direct
effect of fiscal policy on the exchange rate in so far as the exchange market
operators react against expansionary fiscal policy and sell the currency.
However, fiscal policy may very well result in increasing imports, opening up
a trade deficit and thereby producing international crowding-out. To the
extent, however, that the rest of the world increases its appetite for the country’s
exports, no international crowding-out need occur (see Fazzari, 1993, for
more details).
The counter-argument is that all this may be true in the short run, and
only under conditions of excess capacity. But it is the short run in which we
live (and ‘in the long run we are all dead’!) and conditions of excess capacity
are a general (though not universal) feature of the market economy.12 In the
long run, it is argued that the dynamics of wages and prices ensure that fis-
cal policy crowds out private investment or increases foreign indebted-
ness (via its impact on CA in equation (9.10)). This mechanism is due to the
downward-sloping aggregate demand schedule (falling prices, given the money
stock, raise real balance thereby increasing aggregate demand).13 A fiscal
expansion leading to higher levels of economic activity is postulated to lead
to rising prices and wages, thereby reducing private demand. A number of
arguments, however, can be advanced to suggest that falling prices can go
hand in hand with falling aggregate demand. Redistribution of income and
wealth from debtors to creditors follows in the context of unanticipated price
falls. On the assumption that debtors have a higher propensity to spend than
creditors, the redistribution of real wealth caused by deflation lowers aggre-
gate demand (see, for example, Tobin, 1993). Lower income reduces cash
flows relative to debt service commitments, thereby increasing the probabil-
ity of insolvency (Fisher, 1933, and Minsky, 1975, are good examples). In
addition, there are the anticipated deflation effects, which may raise expected
real interest rates, which dampen expenditure and prevent the occurrence of
the aggregate demand effects discussed above (DeLong and Summers, 1986).
More significantly, the downward-sloping aggregate demand schedule
depends on the existence of ‘outside money’, and credit money (the domi-
nant form in an industrialized society) is largely ‘inside money’.14 The
inevitable conclusion is that it is by no means clear that the effectiveness of
fiscal policy is short-lived and damaging in the long run.
The third form of ‘crowding-out’ arose from a combination of the notion
of a supply-side equilibrium (such as the ‘natural rate of unemployment’ or
the NAIRU) and that the level of aggregate demand would adjust to be
consistent with that supply-side equilibrium. In the context of an exogenous
money supply, this came through the assertion of a ‘real balance’ effect, with
changes in the price level generating changes in the real value of the stock of
money, thereby generating changes in the level of aggregate demand.15 In
the context of endogenous money, it would come through the adjustment of
interest rate by the Central Bank. This would occur, as indicated above, if the
Central Bank adopts some form of ‘Taylor’s rule’ (provided, of course, that
interest rates are effective in that regard). As has been argued above, fiscal
policy has an effect on the level of aggregate demand, and ‘crowding-out’
only occurs if it is assumed that the supply-side equilibrium must be attained
(in order to ensure a constant rate of inflation) and that the level of aggre-
gate demand would anyway be equivalent to the supply-side equilibrium.
In the absence of some powerful automatic market forces or a potent monetary
policy, which can ensure that the level of aggregate demand moves quickly
to be consistent with the supply-side equilibrium, then fiscal policy has a
clear role to play.
The path of aggregate demand can itself influence the supply-side

equilibrium. The size and distribution of the capital stock is a determinant of
the productive capacity of the economy, and a larger capital stock would
be associated with the supply-side equilibrium involving a higher level of
output and employment. The level of aggregate demand (including the
change in economic activity and profitability) has an impact on investment
expenditure, and thereby on the size of the capital stock (Arestis and
Biefang-Frisancho Mariscal, 2000). The supply-side equilibrium may form
an inflation barrier at any point in time, but it is not to be seen as something
immutable and unaffected by the level of aggregate demand.
The fourth route of ‘crowding-out’ comes from the Ricardian equivalence
theorem. We may clarify RET in a bond-financed increase in household taxes,
holding government expenditure constant. RET makes the assumption of
equivalence between debt and taxes, and that consumers are forward look-
ing. Consumers are also assumed to be fully aware of the government’s
intertemporal budget constraint, and recognize that a tax increase today will
be followed by lower taxes in the future imposed on their infinitely lived
families. Consumers decrease their savings in the knowledge that they will
not have to pay more in the future (the debt will be less). The increase in
taxes is associated with a decrease in savings. Permanent income, therefore,
does not change as a result of the tax increase. In the absence of liquidity
constraints and with perfect capital markets, consumption does not change
(Barro, 1974). There is, thus, equivalence between taxes and debt. This
implies that an increase in government saving resulting from a tax increase,
is fully offset by lower private saving, so that aggregate demand is not affected.
Raising taxes will have no effect; the policy is totally frustrated and the fiscal
multiplier is zero. Similarly, a reduction in taxation in the present is viewed
as the prospect of future taxation (which is equivalent in present value
terms) leaving the public no better off in wealth terms. The reduction in
present taxation may stimulate consumer expenditure but the prospect of
future taxation reduces consumer expenditure by an equivalent amount.16
A range of objections have been raised against the RET. The major proponent
of the RET, Barro (1989, p. 40), lists five
major theoretical objections that have been raised against the Ricardian
conclusions. The first is that people do not live forever, and hence do
not care about taxes that are levied after their death. The second is that
private capital markets are ‘imperfect’ with the typical person’s real dis-
count rate exceeding that of the government. The third is that future
taxes and incomes are uncertain. The fourth is that taxes are not lump
sum, since they depend typically on income, spending, wealth and so on.
The fifth is that the Ricardian result hinges on full employment.17
Whilst the first four listed are, in our view, significant and valid objections to
RET, it is the fifth which is particularly relevant here. Given the importance
of the RET we discuss it at length in the next section. We concentrate, though,

on the fifth theoretical objection to which we have just referred.18
The Ricardian equivalence theorem
Barro’s (1989, pp. 47–8) discussion of the fifth objection is rather brief
(two paragraphs). He states that
in standard Keynesian analysis … if everyone thinks that a budget deficit

makes them wealthier, the resulting expansion of aggregate demand
raises output and employment, and thereby actually makes people
wealthier … This result does not mean that budget deficits increase aggre-
gate demand and wealth in Keynesian models. If we had conjectured that
budget deficits make people feel poorer, the resulting contractions would
have made them poorer. Similarly, if we had started with the RET notion
that budget deficits did not affect wealth, the Keynesian results would
have verified that conjecture. The odd feature of the standard Keynesian
model is that anything that makes people feel wealthier actually makes
them wealthier (although the perception and actuality need not correspond
quantitatively). This observation raises doubts about the formulation of
Keynesian models, but says little about the effect of budget deficits.
Moreover, in equilibrium models that include unemployment (such as
models with incomplete information and search), there is no clear inter-
play between the presence of unemployment and the validity of the
Ricardian approach.
In the simplest Keynesian model:
Y C I a cY I
or,
aI
Y
1c
If ‘feeling wealthier’ means that a or c rise, then income (Y) rises, and people
are indeed ‘wealthier’. Clearly if an action by government (increasing expen-
diture, lowering taxes) generates adverse expectational responses (for ex-
ample, leading to falls in consumer expenditure or in investment) then the
government action has less effect, and the overall impact may be zero or neg-
ative. When taxation is reduced, people do have more money to spend, and
so it is not unreasonable to believe that they will feel wealthier, will spend
more and income will rise. Thus, it can be postulated that lower taxation will
(in general) make people feel wealthier and spending will rise.
If the RET proposition held, then the size of the budget deficit is irrelevant
for the level of aggregate demand. In particular, a balanced budget would be
compatible with full employment (or more generally with the supply-side
determined equilibrium), and hence (for a closed economy) savings and
investment would be equal at full employment. In those circumstances,
there would be no reason for fiscal policy: the problem of any deficient
aggregate demand would have been solved. But it could also be noted that if
there is a discrepancy between intended savings and investment, then that
discrepancy can never by overcome through the use of fiscal policy. If, for
example, savings would exceed investment at a level of income correspond-
ing to the supply-side equilibrium, that difference could never be dealt with
if the RET hypothesis held.
However, when fiscal policy is approached in ‘functional finance’ terms,
that is a budget deficit is run by the government because there is a difference
between savings and investment at the desired income level, then the RET
approach is scarcely relevant. In the absence of a budget deficit, the excess of
savings over investment cannot occur (and the discrepancy is dealt with
through a fall in income, reducing savings until brought into line with
income). In this regard it can also be noted that much of the variation in the
budget position of government occurs as a result of fluctuations in private
demand, with the operation of the ‘automatic stabilizers’ of fiscal policy.
Barro (1989, pp. 38–9) also argues that
abstracting from chain-letter cases where the public debt can grow forever
at the rate of interest or higher, the present value of taxes (and other
revenues) cannot change unless the government changes the present
value of its expenditures. This point amounts to economists’ standard
notion of the absence of a free lunch – government spending must be
paid for now or later, with the total present value of receipts fixed by the
total present value of spending. Hence, holding fixed the path of govern-
ment expenditure and non-tax revenues, a cut in today’s taxes must be
matched by a corresponding increase in the present value of future taxes.
The ‘chain-letter case’ can be viewed in the following way. Take a budget
deficit (primary, that is, excluding interest payments on debt) to GDP ratio of
d, then it can be readily shown that the government debt to GDP ratio
would converge on b d/( g r) where g is the rate of growth of GDP and r
is the (post-tax) real rate of interest on government debt. If g r, then the
debt to GDP will stabilize though the amount of outstanding debt will con-
tinue to rise (in line with GDP). But, if g r, then the debt to GDP ratio
would not stabilize and attempts to run a continuous budget deficit would
lead to escalating government debt. It should, though, be noted that if g r,
then any size of deficit will lead to escalating debt to GDP ratio, though
obviously the build-up will be slower the smaller is the budget deficit. On the
other hand, if g r, then any size of budget deficit can be sustained. The limits
on the budget deficit could then arise if the rate of interest on government
borrowing rose with the size of the budget deficit. The impact of a budget
deficit on the rate of interest may well depend on the purpose of the budget
deficit. When the budget deficit is viewed in terms of ‘functional finance’,
that is the deficit is run for the purpose of securing a high level of economic
activity and does so by absorbing the excess of private savings over invest-
ment, then the budget deficit need not put upward pressure on the rate of
interest.
It can be agreed that the response to an increase in government expenditure
(not matched by a change in taxation) would include a commensurate increase
in savings. However, that increase in savings can come from a change in the
level of income (the Keynesian view) or a change in savings behaviour (the RET
view). For a closed economy, G T S I, and hence S G T I. For
simplicity assume that T and I are constant, then s⌬Y ⌬sY ⌬G. The
Keynesian emphasis is on ⌬Y, whereas the RET is on ⌬s (savings propensity rises
as consumption propensity falls in the face of government expenditure and the
prospect of future interest payments and taxation).
Institutional aspects of fiscal policy
We have argued that fiscal policy appropriately applied does not lead to
crowding-out, and in that sense fiscal policy will be effective.19 But there may
be other causes that can produce ineffectiveness in fiscal policy. These other
causes have been summarized in the second section above under the general
title of ‘institutional aspects of fiscal policy’. This section explores some of
the issues which arise.
The first issue concerns what may be termed ‘model uncertainty’: the
operation of fiscal policy requires forecasts of the future course of the econ-
omy, and uncertainty over forecasts increases the difficulties of making deci-
sions over fiscal policy. It increases the likelihood that fiscal policy would
turn out to be inappropriate. Some have argued that in terms of model
uncertainty, there is evidence that longer and more uncertain lags have pre-
vailed recently than was previously thought the case (Hemming et al.,
2002a, p. 8). Model uncertainty is, of course, not new in economics and eco-
nomic policy in particular. Friedman’s (1959) notion of long and variable
lags in monetary policy is perhaps the best known. This clearly shows that
long and variable lags are not a reflection of fiscal policy alone. Indeed many
of the issues raised here would also apply to monetary policy: where there
may also be model uncertainty and long and variables lags between policy
announcement and effect. Indeed, monetary policy and fiscal policy both
draw on the forecasts of macroeconometric models, and uncertainty over
the models would apply with equal force to monetary policy as to fiscal policy.
Further, monetary policy (in the form of interest rate decisions) involves
frequent decision-making (for example, monthly for the Bank of England,

every six weeks for the Federal Reserve) and attempts fine tuning. Fiscal
policy, in contrast, typically involves infrequent decisions (often annual),
and could be described as more like ‘coarse tuning’.20 It could be argued that
the ‘fine tuning’ nature of monetary policy means that it suffers more from
problems of model uncertainty than does fiscal policy.
The second issue relates to the argument that fiscal policy is in practice pro-
cyclical rather than counter-cyclical.21 In particular, it has long been argued
that the various lags of decision-making, implementation and impact may
mean that fiscal policy which is intended to stimulate the economy during a
downturn may come into effect when the economy has already recovered
(and similarly for fiscal policy designed for a boom period coming into effect
when the economy has turned down). The strength of this argument depends
on the relationship between the length of the business cycle and the lags
of fiscal policy. For example, a four-year business cycle and a two-year fiscal
policy lag would indeed lead to fiscal policy being pro-cyclical.
The notion of the pro-cyclical nature of fiscal policy is justified by resort to
arguments relating to the cumbersome parliamentary design, approval and
implementation. We may actually distinguish between inside and outside
lags in this context. Inside lags refer to the time it takes policymakers to
appreciate that fiscal policy action is necessary and to make the required
decisions. Clearly, inside lags depend on the political process and the effec-
tiveness of fiscal management. Outside lags refer to the time that it takes
for fiscal measures to affect aggregate demand (Blinder and Solow, 1974).
Discretionary policy measures, particularly when they involve policy depar-
tures, new forms of taxation and expenditure initiatives, are likely to be sub-
ject to long inside lags. Variations in tax rates and in social security benefits
can potentially be made with relatively short inside lags.22 But automatic
stabilizers, by their nature, involve little by way of inside lags.
Outside lags are expected to be more variable than inside lags and would
vary, depending on the fiscal measure utilized, on the institutional set-up of
the economy in question and the period under investigation.
One difference between monetary policy and fiscal policy arises from the
former being much less subject to democratic decision-making than the lat-
ter. Changes in tax rates require parliamentary or Congressional approval;
changes in interest rates do not. But long and variable outside lags may be a
feature of monetary policy as much as (or more than) fiscal policy. The
inside lags of fiscal policy could be substantially reduced by the adoption of
a ‘fiscal policy rule’ (Taylor, 2000) analogous to a ‘monetary policy rule’
(Taylor, 1993). To the extent that this is the right rule (that is, places much
emphasis on full employment), there could be a role for such a rule; espe-
cially so if the rule relates to the fiscal stance, leaving the issue of composi-
tion of taxation and of public expenditure to be determined through the
democratic process.
The third issue is the idea that fiscal policy may entail a ‘deficit bias’. This
may be due to a number of factors. Increasing taxes/decreasing government
expenditure during upswings may be politically unrealistic. Alesina and
Perotti (1995) refer to a number of institutional factors to explain the possi-
bility of a deficit bias. Voters and policymakers may be unaware of the
government’s intertemporal budget constraint,23 and as a result favour budget
deficits; they may wish to shift the fiscal burden to future generations; policy-
makers may wish to limit the room of manoeuvre of future governments
strategically in terms of fiscal policy; political conflicts may delay fiscal
consolidation in terms of sharing the burden of adjustment amongst various
social groups, thereby producing a deficit bias; spending decisions may be
subjected to irreversibility, which can lead to a public expenditure ratcheting
effect.
The presence of a deficit bias does not necessarily make fiscal policy any
less effective, though it may constrain governments to engage in further
deficit spending in the face of a recession.
It has been argued that large and persistent deficits may be a reflection of
this deficit bias. But those deficits have to be measured against what is
required. The persistence of unemployment in market economies suggests a
general lack of aggregate demand, and hence a requirement for fiscal stimu-
lus. Any tendency for savings to outrun investment also requires a budget
deficit to mop up the excess net private savings. We can then distinguish
those budget deficits which are required to sustain demand and to mop up
excess savings to ensure desirable levels of economic activity, which we will
call necessary deficits. In contrast, unnecessary budget deficits are that part
of deficits which take economic activity too high (on some criteria such as
beyond full employment). This distinction clearly implies that a bias in
favour of necessary deficits is consistent with the argument advanced in this
chapter, whereas any bias towards unnecessary deficits is not.
The fourth issue arises from the notion that supply-side inefficiencies
associated with tax-rate volatility are possible. This issue is strongly related
to the way in which changes in taxes affect the supply of labour, and also
changes in capital taxes affect saving and investment. These considerations
are expected to have a significant impact on internationally mobile labour
and capital. However, ultimately these considerations depend heavily on the
empirical evidence adduced on the impact of tax changes on the supply of
labour and capital, and thereby on growth. This empirical issue, however, has
yet to be validated. Such limited evidence that exists, has not yet provided
clear-cut conclusions (see, for example, Blundell and MaCurdy, 1999; Hemming
et al., 2002a). A further comment worth making is this. Active monetary
policy involves interest rate volatility (as compared with a passive monetary
policy which changed interest rates infrequently), which would have supply-
side inefficiencies. If fiscal policy is successful, then demand volatility is
reduced, and demand volatility would generate supply-side inefficiencies in
that the level of supply would be continually changing, not to mention the
inefficiency of excess capacity.
A final issue that belongs to the ‘institutional aspects’ is the level and
degree of economic development. It is the case that most of the literature on
the effectiveness of fiscal policy has focused on developed countries. Agénor
et al. (1999) argue that because the developing world is more likely to be
influenced by supply shocks, fiscal policy as a tool of demand management
is most likely to be used far less frequently in developing than in developed
countries. A supply shock, however, is often taken to mean a cost change (for
example, oil price), but one that has a demand dimension to it (in case of oil,
imports change and so on). Clearly, a supply shock change cannot affect the
level of economic activity unless it causes demand to change as well. Within
the AS–AD model, an adverse shift in the AS curve can be offset in terms
of economic activity by a shift in the AD – albeit at the expense of a higher
price level (and leaving aside the question of how the supply side would be
identified). In the case of developing countries, it may be that collection of
taxation and so on is more difficult, but it would also seem that there may
be less call for fiscal deficits: if developing countries are characterized by low
savings and high demand for investment, then S – I would be negative, and
hence G – T would also be negative. This is the classic argument that gov-
ernments in developing countries run surpluses in order to generate savings,
which the private sector is unwilling or unable to undertake.
Even so, it is suggested that the availability and cost of domestic and exter-
nal finance is a major constraint on fiscal policy. It follows that access to
financing should determine to a large extent the size of the fiscal deficit. An
increase in the fiscal deficit beyond a level that can only be financed on
unacceptable terms may be associated with severe crowding-out effects.
Relaxing these constraints, therefore, enables fiscal policy to have significant
stimulative effects (Lane et al., 1999). An additional factor that enhances the
effectiveness of fiscal policy in these countries is the relatively high marginal
propensity to consume, which can increase the size of the impact of fiscal
policy significantly. This analysis suggests that the deficit bias discussed
above may be relatively higher in developing countries. In fact, Hemming
et al. (2002a, p. 12) provide a list of the causes of the relatively high deficit
bias in developing countries. Governance, as it relates to poor tax adminis-
tration and expenditure management, is probably the most important and
significant item on the list. In terms of the distinction drawn above, this
would be ‘unnecessary’ deficit bias.
Quantitative effects of fiscal policy
This section draws on published work on the empirics of fiscal policy. We

do not offer our own empirical work but rely instead on already published
evidence. We may distinguish between evidence adduced from developed
and from developing economies. This distinction is necessary partly for the
reasons alluded to at the end of the last section, but also for reasons which
have to do with data deficiencies in developing countries. For all these rea-
sons there is rather less evidence on the short-run impact of fiscal policy
for developing rather than for developed countries (Hemming et al., 2002a).
We begin with the available evidence on developed countries.
Following Hemming et al. (2002a), we comment on three substantive
components of the available evidence on developed countries. There are, to
begin with, estimates of dynamic multipliers that are designed to determine
the possible empirical impact of fiscal policy on economic activity. These
dynamic multipliers are derived from macroeconomic model simulations
and small model calibrations, as well as reduced-form equations. Studies
which draw from specific episodes of fiscal contraction in an attempt to
identify expansionary fiscal contractions comprise the second category. The
third category comprises of studies that attempt to assess the determinants
of dynamic multipliers. Consequently, interest in this concentrates upon
relationships between fiscal policy on the one hand, and other variables,
such as interest and exchange rates, investment, consumption and so on, on
the other.
On the first issue, Hemming et al. (2002a) summarize the evidence adduced
from these studies. It is suggested that short-term multipliers are positive,
ranging from 0.1 to 3.1, with expenditure multipliers being in the range of
0.6 to 1.4, and tax multipliers in the range of 0.3–0.8. Long-term multipliers
are smaller than short-term multipliers, undoubtedly reflecting some form of
crowding-out. Another recent study (Hemming et al., 2002b, p. 4) sum-
marizes the argument along similar lines: ‘Estimates of fiscal multipliers are
overwhelmingly positive but small. Short-term multipliers average around a
half for taxes and one for spending, with only modest variation across coun-
tries and models (albeit with some outliers). There are hardly any instances
of negative fiscal multipliers, the exception being that they can be generated
in some macroeconomic models with strong credibility effects.’ Small model
calibrations, essentially dynamic general equilibrium models that analyse
steady-state long-run effects of fiscal policy, produce results that show output
to respond positively to (unanticipated) increase in government expenditure
(where permanent changes have larger effects than temporary changes).
Reduced-form equation results are broadly similar.
On the second category of studies, Hemming et al. (2002b) examine fiscal
policy during recessions in advanced countries to conclude that (i) fiscal pol-
icy during recessions in closed economies is effective but with a small fiscal
multiplier; (ii) fiscal policy is not so effective in open economies during
recessions, especially when flexible exchange rates prevail; (iii) fiscal expan-
sions can be more effective when it is expenditure-based, big government,
there is excess capacity, a closed economy or an open economy with a fixed
exchange rate regime, and expansionary expenditure is accompanied by
monetary expansion.24 In terms of the determinants of fiscal multipliers, the

third category identified above, Hemming et al. (2002a, p. 36) conclude that
‘there is little evidence of direct crowding out or crowding out through interest
rates and and the exchange rate. Nor does full Ricardian equivalence or a
significant partial Ricardian offset get much support from the evidence.’
Finally, the evidence on developing countries is not dissimilar to that
obtained for developed economies. If anything fiscal multipliers tend to be
rather higher in the case of developing rather than developed economies
(see, for example, Hemming et al., 2002a, p. 33).
The overall conclusion of this rather brief summary of the empirical evidence
on the effectiveness of fiscal policy is encouraging. Fiscal multipliers and
other tests tend to provide favourable evidence for fiscal policy. Especially so
in view of the argument that in most, if not all, of the studies referred to that
summarize the results reported in this chapter, there is a long-run constraint
built into the models utilized for the purposes of the empirical exercises.
Such constraints, which we labelled above as NAIRU constraints, by their
very nature and definition, substantially contain the long-run values of the
fiscal multipliers.
Summary and conclusions
We have argued in this chapter that shifts in the level of aggregate demand
can be readily offset by fiscal policy. Consequently, fiscal policy remains a
powerful instrument of regulating the level of aggregate demand. Fiscal pol-
icy ‘can and should be called upon as a key part of the remedy’ when the
economy needs aggregate demand boosting, and ‘when the economy’s
resources are underutilised’ (Fazzari, 1994–95, p. 247). Even when the econ-
omy’s resources are fully utilized, we would still argue that to the extent fis-
cal policy can affect the capital stock of the economy (Arestis and
Biefang-Frisancho Mariscal, 2000), it can also have long and lasting effects in
this case.
Notes
This chapter was first published as P. Arestis and M. Sawyer, ‘Reinventing Fiscal Policy’,
Journal of Post Keynesian Economics, 26(1) (2003), 4–25.
1. Work on the importance of fiscal policy has been undertaken in the past at the Levy
Economics Institute. Of particular importance are the papers by Godley and
McCarthy (1997) and Godley (1999, 2001). The role of fiscal policy has been stud-
ied in this work within a consistent stock/flow model, where it is very effective in
terms of enabling imbalance in the private sector’s balance sheets to be corrected
(see also, Minsky, 1982, 1991).
2. The generic term ‘Central Bank discount rate’ is used to denote the rate of interest
at which the Central Bank is willing to supply funds. It covers rates such as the
‘repo’ rate (European Central Bank), the Federal Funds rate (USA, Federal Reserve
System), the discount rate (UK, Bank of England), and so on.
3. The ‘equilibrium rate’ is where savings and investment are brought into equality
at full employment or some other supply-side equilibrium level of employment or
output.
4. With the implication, presumably, that fiscal policy does not matter, whereas the
focus is on monetary policy and the use of interest rate policy to target inflation.
5. Variations on this theme could be used; for example, interest rate ‘smoothing’ in
equation (9.3) is often ignored, as is the lagged output gap variable in equation (9.1)
so that the focus is on the influence of expected future output gap in this equation.
It is also possible to add a fourth equation to (9.1)–(9.3) reported in the text. This
would relate the stock of money to ‘demand for money variables’ such as income,
prices and the rate of interest, which would reinforce the endogenous money nature
of this approach with the stock of money being demand-determined. Clearly,
though, such an equation would be superfluous in that the stock of money thereby
determined is akin to a residual and does not feed back to affect other variables in
the model. We have explored this issue and others related to whether the stock of
money retains any causal significance at some length in Arestis and Sawyer (2002c).
6. The ‘natural rate’ of interest could be said to be unique if there was no effect of
government expenditure on demand, which would be the equivalent of invoking
RET, and this is further discussed below.
7. See Arestis and Sawyer (2002a) for our summary of the Bank of England model
and its similarities with the ‘new consensus’ model.
8. The word ‘feasible’ is used in the sense of involving a positive nominal rate of
interest compatible with exchange rate targets.
9. These arguments are examined in much more detail in Arestis and Sawyer (2003a).
10. Our second line of argument on the crowding-out issue, draws mainly on
Cunningham and Vilasuso (1994–95) and Fazzari (1994–95).
11. In fact Cunningham and Vilasuso (1994–95) argue strongly that ‘demand man-
agement policies may be largely ineffective, and in some cases, contribute more
to the problems than to the solutions’ (p. 187). The main reason given is the ‘struc-
tural, institutional, and regulatory changes’ since the 1970s, which ‘have altered
the rules of the game, with the result that aggregate policy measures have failed to
stimulate total spending’ (p. 188). Fazzari (1994–95) rebuffs this proposition on both
theoretical and empirical grounds.
12. If full employment (or some other desired level of economic activity) can be
reached and sustained by private aggregate demand, there would be few who
would advocate stimulating fiscal policy. But the advocates of fiscal policy take the
view that full employment is a rare occurrence and that private aggregate demand
is often insufficient to sustain full employment (Say’s law does not operate).
13. It should be noted that the extent of crowding-out is, of course, affected by price
flexibility. In general terms, it can be argued that ‘Price flexibility, even if it is limited
in the short run, will tend to narrow the range of values taken by fiscal multipliers,
and in particular to limit the influence of the exchange rate regime’ (Hemming
et al., 2002a, p. 5).
14. Even when there is ‘outside money’ (high-powered money) and the relevant measure
of the money stock is a multiple of high-powered money (determined by the size
of the credit multiplier), the amount of money in existence depends on people’s
willingness to hold that money. The stock of money is demand-determined. If
prices fall, then the demand for money falls, and the stock of money falls, and
there is no real balance effect.
15. This could be a long adjustment process, but it is the ‘automatic’ one invoked in
the context of the NAIRU.
16. An important assumption of the process discussed in the text is that Ricardian
behaviour implies full consumption smoothing to offset intergenerational
redistribution imposed by government debt policy. Tax burden is redistributed
among generations with families reversing the effect of this redistribution through
bequests. However, the more realistic case of partial consumption smoothing
invalidates Ricardian behaviour (Mankiw, 2002).
17. We might add further objections to the list. Less than perfect foresight; partial
liquidity constraints; a non-altruistic desire to pass some of the current fiscal
burden to future generations (Mankiw and Summers, 1984; Blanchard, 1985) are
a few of them. There may also be significant distributional effects, assumed to be
negligible by the RET proponents (see below in the text for relevant arguments).
Furthermore, empirical work on the RET produces evidence that is mixed at best
(Cunningham and Vilasuso, 1994–95). A more recent study reaches even more
negative conclusions for the RET; clearly, ‘There is little evidence of direct crowd-
ing out or crowding out through interest rates and the exchange rate. Nor does
full Ricardian equivalence or a significanct partial Ricardian offset get much
support from the evidence’ (Hemming et al., 2002a, p. 36).
18. There are interest rate premia and credibility effects as well as uncertainty consid-
erations that can affect the size of the fiscal multipliers. With fiscal expansions
and debt accumulation, risk premia that reflect the risk of default or increasing
inflation risk reinforce crowding-out effects through interest rates (Miller et al.,
1990). They may also raise fears of future balance-of-payments problems, and
thereby lead to foreign investment reduction and capital outflows. Similarly, to
the extent that a fiscal expansion is associated with increased uncertainty (in that
future deficits have a negative effect on confidence), households may accumulate
precautionary savings and firms may delay irreversible investment (Caballero and
Pyndick, 1996).
19. This is to recognize that an attempted fiscal expansion in the context of a fully
employed economy would involve ‘crowding-out’ to some degree. The extent of
the ‘crowding-out’ would depend on how far supply can respond to increase in
demand, and even at what is regarded as full employment there can be some elas-
ticity of supply (firms hold some excess capacity, there are ‘encouraged’ worker
effects and so on).
20. This refers to discretionary fiscal policy: it could be said that the automatic stabilizers
are operating all the time.
21. The operation of the ‘automatic stabilizers’ provides a counter-cyclical compo-
nent of fiscal policy. The pro-cyclical argument applies particularly to the discre-
tionary changes in fiscal policy.
22. This is not entirely true in that it may not be the case in all parliamentary systems.
In the UK for example, the fiscal measure of a change in the duty on alcohol,
tobacco, petrol and so on is made quickly and implemented within hours (often
6 p.m. on budget day). It is subject to retrospective approval by parliament.
23. This appears to accept the intertemporal budget constraint as a reality, which may
not be the case. In another paper (Arestis and Sawyer, 2003b), we argue that this
depends on whether the rate of interest is higher or lower than the rate of growth.
24. An interesting case that has been discussed in the literature (initiated by Giavazzi
and Pagano, 1990) is the case of Ireland and Denmark where, it is alleged, contrac-
tionary fiscal policy is associated with expansion in economic activity. We would
dispute this result on the basis that it is other factors which explained the expan-
sion of economic activity; it is, thus, the expansion that enabled budget deficits to
be smaller than otherwise. This is a classic case of ‘simultaneity bias’ (Eichengreen,

1998). Also, omitted variables may very well be responsible for the results obtained
in these fiscal consolidation episodes. Exchange rate depreciations that normally
accompany fiscal contractions may be more responsible for the expansion in
economic activity rather than the fiscal action itself (Hemming et al., 2002a, p. 25).
More specifically in the case of Ireland, Walsh (2002, p. 1) argues that a number of
factors contribute to the expansion, ‘a low exchange rate, the inflow of FDI to
high productivity sectors, and wage moderation following the return to centralised
wage agreements in 1987. Labour market reforms, including a tightening of the
social welfare regime and a switch of spending from income support to active
labour market policies, played a positive role.’
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10
Alternatives for the Policy
Framework of the Euro
Introduction
The euro was introduced as a ‘virtual’ currency in 1999, and completely

replaced the national currencies of the 12 participating countries in early 2002.
In considering policy arrangements for the euro, there is now (at the time of
writing in late 2004) nearly six years of experience of the eurozone on which to
draw, and to some degree experience from the preceding decade as countries
sought to meet the convergence criteria for membership of the eurozone.
Table 10.1 provides a summary of some key figures for the eurozone as a whole
since 1999. Growth has been sluggish since 2000 and unemployment has
remained high at 8 per cent or above (and with considerable variation between
countries and regions). Inflation has been above (albeit not much above) the
2 per cent target for most of the time since 1999. Budget deficits have generally
risen, and many countries have exceeded the 3 per cent of GDP limit under the
Stability and Growth Pact,1 and the cyclically adjusted budget deficit has aver-
aged nearly 2 per cent of GDP (and under the SGP, this figure would be zero).
The economic slowdown from 2001 onwards (which has had relatively lit-
tle impact on the unemployment rate) has had the readily predictable effects
on the budget deficit position: economic slowdown lowers tax receipts and
raises some forms of public expenditure, leading to widening budget deficits.
Previous estimates by the EU suggest that for each 1 per cent slowdown in
growth, budget deficit (relative to GDP) rises by between 0.5 and 0.9 per cent
(Buti et al., 1997). It should not then have come as a surprise that budget
deficits rose past the 3 per cent limit in a number of countries in the face of
economic slowdown. Countries which exceeded the 3 per cent limit were
criticized and censured by the Council on Economic and Financial Affairs
(ECOFIN) on many occasions, and various promises and commitments were
made to reduce budget deficit over the forthcoming years. Changes in gov-
ernment in two countries (Portugal and Greece) resulted in the incoming
government declaring that previously issued statistics on the size of the budget
deficit were wrong and understated the size of the deficit.
126
Alternatives for the Policy Framework of the Euro 127
Table 10.1: Recent macroeconomic data for the eurozone
1999 2000 2001 2002 2003 2004
Annual rate of 2.8 3.7 1.7 0.9 0.5 1.6

growth of
GDP (%)
Unemployment 9.4 8.4 8.0 8.4 8.8 8.8
rate (%)
Annual rate of 1.2 2.1 2.4 2.3 2.1 1.7
inflation (%)
Budget deficit 1.3 ⫺0.1 1.7 2.3 2.7 2.8
as percentage
of GDP
Cyclically 1.1 1.5 2.0 2.1 1.7 1.6
adjusted budget
deficit
Note: Figures for 2004 are forecast as on June 2004.

Source: OECD, Economic Outlook, June 2004.
Although in a number of countries, the budget deficit rose, the figures for
the cyclically adjusted budget deficit suggest that this was the operation of
the automatic stabilizers, and that if anything fiscal policy was being tight-
ened. In general, national governments have been constrained from using
active fiscal policy to counter the economic slowdown. The operational
difficulties of the SGP have become self-evident, and the rules which it has
sought to impose have been widely broken.
The European Central Bank (ECB) is the only federal economic agency, but
its remit is the control of inflation which has been persistently above the tar-
get level. The ECB appears to have been slow to recognize the beginnings of
the slowdown in economic activity, and when it did recognize the slowdown
did not cut interest rates in an aggressive manner on a par with the Federal
Reserve. But the ECB in terms of its own mandate was faced with inflation at
or above its target level alongside a economic slowdown: attention to its
mandate and to establish ‘credibility’ with the financial markets pushed it
towards maintaining a tight monetary policy.
The European Convention began work in early 2002 to draw up what is
widely referred to as a European Constitution. The Convention reported in
June 2003, and after its proposals were not accepted by national governments
in the summit held in December 2003, a revised version was accepted by all
25 national governments in June 2004. At the time of writing, the Treaty
(Treaty establishing a Constitution for Europe: document CIG 86/04 available
on the website of the European Union) awaits ratification, whether through
parliamentary votes and/or national referenda.
The work of the European Convention provided a timely opportunity to
fundamentally reform the macroeconomic policymaking frameworks of the
eurozone. It was timely because the strains and problems of the SGP were
becoming so clear to all with many countries having exceeded the 3 per cent
GDP budget deficit limit in time of economic slowdown. But the opportu-
nity was spurned. From the reports of the working groups of the Convention
there appears to have been no serious consideration of alternatives. The
macroeconomic policy frameworks will be locked into a Constitution which
will be difficult to change in the future, requiring agreement of all countries
concerned. This had been the previous situation, but the drawing up of the
Constitution did provide a window of opportunity which is unlikely to
occur again for many years to come.
Present policy framework
The present policy and institutional framework for the eurozone can be
readily summarized. The European Central Bank (ECB) which is ‘independent’
of the political authorities in the European Commission and national gov-
ernments and of the European Parliament is entrusted with using monetary
policy to pursue ‘price stability’ which it has interpreted as inflation below
2 per cent per annum and that ‘it shall support general economic policies in
the Union in order to contribute to the achievement of the Union’s objectives’.
The monetary policy instrument is the use of interest rates (and it forgoes
forms of monetary policy such as credit controls).
There is a requirement for the EU budget to be balanced and hence no
fiscal policy is exercised at the EU level (and the EU budget is itself rather
small at just over 1 per cent of EU GDP). The fiscal policy of national gov-
ernments is (in principle) subject to conformity with the Stability and
Growth Pact which imposes an upper limit of 3 per cent of GDP on budget
deficits, with the view that budgets will be broadly in balance or small sur-
plus over the business cycle. Automatic exemption was in place for falls of
GDP of more than 2 per cent and discretionary exemptions for falls in out-
put of between 0.75 per cent and 2 per cent, which would represent very
major recessions. A system of non-interest bearing deposits which could turn
into fines was also in place, but has not been invoked despite a number of
budget deficits exceeding 3 per cent (in face of economic slowdown but not
of declining output).
This policy framework can, in our view, be understood by reference to
the ‘new consensus in macroeconomics’ (which we have discussed exten-
sively elsewhere, for example, Arestis and Sawyer, 2003a, 2004a). This ‘new
consensus’ can be summarized in the following three equations:
Ygt ⫽ a0 ⫹ a1Ygt⫺1 ⫹ a2E (Ygt⫹1 ) ⫺ a3 [Rt ⫺ Et ( pt⫹1)] ⫹ s1 (10.1)

pt ⫽ b1Ygt ⫹ b2 pt⫺1 ⫹ b3 Et ( pt⫹1 ) ⫹ s2 (with b2 ⫹ b3 ⫽ 1) (10.2)
Rt ⫽ RR* ⫹ Et ( pt⫹1 ) ⫹ c1Ygt⫺1 ⫹ c2 ( pt⫺1 ⫺ p )
T
(10.3)
where Yg is the output gap, R is nominal rate of interest, p is inflation, and pT

is inflation target, RR* is the ‘equilibrium’ real rate of interest (that is the rate
of interest consistent with zero output gap which implies from equation (10.2)
a constant rate of inflation), and si (with i ⫽ 1, 2) represents stochastic shocks.
Equation (10.1) is the aggregate demand equation; equation (10.2) is a
Phillips curve; and (10.3) is a monetary policy operating rule (in effect
replacing the old LM curve). There are three equations and three unknowns:
output, interest rate and inflation. This model has a number of additional,
and relevant, characteristics. Equation (10.1) resembles the traditional IS, but
expenditure decisions are seen to be based on intertemporal optimization of
a utility function. There are both lagged adjustment and forward-looking
elements; the model allows for sticky prices (the lagged price level in the
Phillips curve relationship) and full price flexibility in the long run. The
term Et(pt⫹1) in equation (10.2) reflects central bank credibility. A central
bank that credibly signals its intention to achieve and maintain low infla-
tion will be ‘rewarded’ by lower expectations on the rate of inflation. The
inclusion of term Et(pt⫹1) in equation (10.2) indicates that it may be possible
to reduce current inflation at a significantly lower cost in terms of output
than otherwise. It contains the neutrality of money property, with inflation
determined by monetary policy (that is the rate of interest), and equilibrium
values of real variables are independent of the money supply. The final char-
acteristic we wish to highlight is that money has no role in the model; it is
merely a ‘residual’, and this is more extensively discussed in Arestis and
Sawyer (2003b, 2005).
This model is notable for in effect ignoring fiscal policy though a shift in
the parameter a0 could be used to represent a change in the fiscal position.
Monetary policy through interest rate changes is presumed to be effective in
influencing the level of aggregate demand and thereby the rate of inflation
(which is viewed as a demand-pull rather than cost-push phenomenon).
Further, the rate of interest can be varied such that the level of demand is
consistent with a supply-side equilibrium (where the output gap is zero).
There is a form of classical dichotomy here as well in that monetary policy
has no long lasting effects on the real side of the economy though there are
short-run effects on output.
This framework represents the economy as essentially stable around a level
of output for which the output gap is zero, and in which inflation is
demand- (rather than cost-) determined and is addressed through variations
in the rate of interest. There is no role for fiscal policy which is excluded
from the model with the emphasis on the role of monetary policy.
European Central Bank and monetary policy
The argument for an independent Central Bank with a remit to control

inflation is based on two premises. First, and as reflected in the ‘new consensus
macroeconomics’ outlined above, there is a separation between the monetary

side and the real side of the economy akin to the classical dichotomy, and
monetary policy can target inflation without impacting on the real side
(employment, growth and so on) of the economy. This was recently
expressed by Mervyn King, Governor or the Bank of England when he said
that ‘Monetary policy determines inflation and the supply capacity of the
economy determines the rate of growth. In the short run, however, it is
reasonable to suppose that when the economy is running at above-normal
levels of capacity utilisation there is upward pressure on inflation, and
the opposite to hold when the economy is running below capacity’ (speech,
12 October 2004).
Second, (unelected) central bankers and their economist advisers are
perceived as more inflation-averse than elected politicians, and have a repu-
tation for being tougher on inflation. When faced with a short-run trade-off
between inflation and unemployment, the central bankers will be less
tempted than the politicians, it is argued, to set interest rates (and monetary
policy more generally) in a way that favours reductions in unemployment
rather than reductions in the rate of inflation. Central bankers are deemed to
be ‘more conservative’ (Rogoff, 1985) than politicians and less likely to be
tempted by the (short-term) gains from lower unemployment.
We reject these arguments. Monetary policy can have effects on the real
side of the economy. It is widely recognized that it will do so in the short
run through the effects of interest rates on the level of aggregate demand
(as reflected in the ‘new consensus’ model). But, we would argue that it can
have significant effects on the exchange rate and on the level of investment,
and as such have potentially long lasting effects. Indeed, if monetary policy
does not impact on the exchange rate and investment, it is likely to have
little impact on the level of aggregate demand. Further, monetary policy has
limited impact on inflation and is a weak policy instrument for the control
of inflation (Arestis and Sawyer, 2004a). Fiscal policy also has effects on
aggregate demand, exchange rate and so on and indeed we would argue has
in some sense more effect. As both fiscal and monetary policy are impacting
on the level of aggregate demand, and also both policies are impacting on a
range of other economic variables of policy importance, this suggests that
fiscal and monetary policy should be coordinated. This is difficult to achieve
when the Central Bank is independent of political influences and not answer-
able to any political authorities.
An independent Central Bank with the task of targeting inflation has
become the ‘conventional wisdom’ of the past decade or so. A number of
countries have (to a greater or lesser extent) moved towards such arrange-
ments. We would though argue that not only is the case for an independent
Central Bank rather weak, but also it has the status of being something of a
current fad. Two decades ago, controlling the growth of the money supply
was seen as the (rather painless) answer to inflation, and was similarly given
‘conventional wisdom’ status. From that perspective, building an independent

Central Bank with control of inflation as its sole specific objective into a
Constitution which is difficult to readily change is a folly when the fashion
for an independent Central Bank is likely to change.
It was indicated above that a major argument for an independent Central
Bank was that the Central Bank would singlemindedly pursue inflation control
and would not be able to influence and be unconcerned with the real side of
the economy. This would further imply that the Central Bank should have
no particular views on supply-side policies. But we find that the ECB regu-
larly comments on policies other than monetary policy and advocates courses
of action which lie well outside of its remit. A few recent examples illus-
trate this and the essentially neo-liberal agenda which is promoted by the
‘independent’ Central Bank.
As regards fiscal developments, the latest budgetary news is a source of

concern. While some euro area countries will maintain a sound budgetary
position, a significant number are expected to record deficits close to or
above 3 per cent. The aggregate euro area fiscal deficit-to-GDP ratio is
expected to increase somewhat, as is the debt-to-GDP ratio. In the coming
years, important challenges for the consolidation of public finances will
have to be faced. Member States need to renew their consolidation efforts
and should not rely on one-off measures, so as to comply with their com-
mitments under the Stability and Growth Pact and to foster confidence.
They must also set the right priorities in public finances, towards struc-
tural reform, innovation and competitiveness. This would very much
support the Lisbon agenda and thereby promote economic growth, foster
job creation and reduce unemployment.
Concerning the European fiscal framework, the Governing Council is
convinced that substantial improvements in the implementation of the
Stability and Growth Pact are possible and would be beneficial. At the
same time, the Governing Council warns against changes to the text of
the Treaty or the Regulations which form the basis of the Pact. The Pact is
key to ensuring macroeconomic stability on a sustainable basis. It is a
framework which is necessary to preserve sound fiscal policies in the euro
area, for which strict surveillance and effective peer pressure on national
budget policies are indispensable.
(ECB, 2004b, p. 6)
In order to decisively overcome the obstacles towards greater employment
growth and to reduce the trend or structural level of unemployment,
further comprehensive labour market reforms are of the essence.
(ECB, 2004b, p. 7)
Given the signs that the economic recovery will continue, it is particularly
important that fiscal policies and structural reforms play their part in
improving the economic fundamentals of the euro area. It is regretful that

recent fiscal developments have not been helpful in this respect. A growing
number of countries are reporting significant imbalances and fiscal
consolidation efforts fall disappointingly short of commitments. In order to
strengthen confidence in a sustainable upswing, it is now essential that clar-
ity about the future course of consolidation of fiscal policies is re-established
in all countries concerned. This requires credible measures with an empha-
sis on structural expenditure reform so that imbalances are redressed,
tax/benefit systems become more growth-friendly and social security
systems are put on a sound financial footing. These measures, together
with a revived momentum towards effectively implementing structural
reforms in labour and product markets, would provide very valuable
support to the current economic upswing.
(ECB 2004a, p. 6)
A credible strategy of fiscal consolidation combined with structural reform
should also contribute to long-term fiscal sustainability and higher poten-
tial growth by improving supply conditions. In particular, reforms of tax-
benefit systems could increase incentives to work and invest while reducing
pressures on social budgets. Reforms of the pension and health care systems
are urgently needed in many countries to raise labour force participation
and prepare for the future fiscal costs of population ageing. Furthermore,
reducing inefficient public spending can help to finance tax cuts.
(ECB, 2004a, p. 60)
The use of monetary policy for the control of inflation presupposes that mone-
tary policy is an effective instrument for that purpose and we have argued else-
where that it is not so (Arestis and Sawyer, 2004a). We could also note that a
further argument for the independence of the Central Bank is that it can be
given the remit to control inflation and be answerable for the achievement of
that objective. The Bank of England (Monetary Policy Committee), for example,
has to explain in an open letter to the Chancellor of the Exchequer any failure
to keep inflation within 1 per cent of the target rate, and a similar requirement
is in place in New Zealand. In contrast, the ECB does not have to answer for its
failure to meet its objective, and notably the ECB has failed to meet the inflation
target in most years (as can be seen from the figures in Table 10.1).
Monetary policy inevitably suffers from the ‘one-size-fits-all’ problem.
It is well known that the setting of an interest rate which rules across many
economic areas poses difficulties – the rate which is appropriate for a coun-
try experiencing high demand and perhaps inflationary pressures is not the
same as that appropriate for one facing low demand and perhaps deflation.
Indeed, monetary policy may address the average inflation picture but cannot
address differences in inflationary experience across the euro area countries.
There is evidence of significant disparities in inflationary experience despite
the convergence of inflation that was required by the Maastricht criteria
(and indeed a number of countries would not now satisfy the inflation con-
vergence conditions of the Maastricht Treaty).2 Further, the impact of interest
rate changes is likely to differ markedly across countries.
A major feature of the first six years of the euro (since its introduction as a
virtual currency in January 1999) is the large movements in its value, notably
against the dollar, but not confined to that. From a starting value of
1 euro ⫽ $1.18 it fell almost continuously to reach a low of $0.82 in late 2000.
After a period around this low value, it began a climb, starting in April 2002,
to regain and then surpass its opening value, and to peak at $1.28 (in early
2004 and again in October). It is often difficult to account for these move-
ments in the exchange rate – we can certainly say that they do not reflect
changes in ‘fundamentals’ (see our attempt to understand the initial fall in the
value of the euro, Arestis et al., 2002). In a general sense the euro/dollar
exchange rate may reflect sentiment on the relative prospects of the two
economies. The recent decline in the value of the dollar may be associated
with a realization of the large scale of the American current account deficit.
These swings in the euro/dollar exchange rate do not only impact on the
United States and the eurozone countries since many countries link their cur-
rency with either the dollar or the euro, and consequently their own exchange
rate position is much affected by the euro/dollar exchange rate oscillations.
These large movements in the exchange rate are not conducive for decision-
making with regard to participation in trade or to undertaking foreign invest-
ment. The volatility of the exchange rates not only discourages trade but
also exacerbates the vulnerability of national economies to external events. As
the exchange rate fluctuates, imports and exports, and then the distribution
of employment and output between countries, are subject to ups and downs.
The importance of the exchange rates between the dollar, euro and the
yen, and the harmful effects of the volatility of exchange rates strongly point
towards the development of mechanisms which could help to stabilize the
trilateral exchange rates. The volatility between the three major currencies
affects most international trade since many currencies are linked with one
(or more) of those major currencies. The existing volatility, associated with
speculative bubbles in the exchange markets, could well be having detri-
mental effects on trade and foreign direct investment.3
Any attempt to stabilize the exchange rate of the euro would necessarily
involve the ECB and other Central Banks, and coordination between the
Central Banks would be particularly important. Interest rates would be used
to influence the exchange rates, but it is interest rate differentials that are
particularly relevant; hence the need to coordinate interest rate decisions in
order to arrive at the required interest rate differential. But the reliability of
the effect of interest rate changes on the exchange rate weakens the useful-
ness of interest rates in this regard. Interest rates are currently used to target
the rate of inflation, though much of the effect of interest rates on inflation
may come through the exchange rate. The policy indicated here requires a
broadening of the remit of Central Banks to clearly include an exchange rate

target. The interest rate instrument is likely to be rather ineffectual in
this regard, and hence direct intervention by Central Banks in the exchange
markets would generally be required. The ability of a single Central Bank to
intervene in the exchange markets is limited by its own reserves. The com-
bination of Central Banks is in a much stronger position to intervene, in part
because they have a greater volume of reserves. But the main reason is that
while a Central Bank is limited by its own foreign reserves, the Central Bank
of the currency which is not under pressure can buy to an unlimited extent
the currency under pressure. Any policy aiming to establish stable exchange
rates between the major currencies would require some significant institu-
tional changes within the EU, including changes in the objectives of the ECB
to include that of the external value of the currency; and interest rates would
have to be set with regard to their effects on the exchange value of the euro.
Monetary policy has become virtually synonymous with variations in
the interest rate, which have an uncertain effect on the rate of inflation and
economic activity. Alternative forms of monetary policy should also be
considered (Arestis and Sawyer, 2005). Explicit forms of credit control imple-
mented by the Central Bank, or other government agencies, could be used to
supplement interest rate policy. There are well-known difficulties with the
use of credit controls. They can be evaded (legally or otherwise) through
switching from regulated to unregulated forms of credit including the devel-
opment of products which fall outside the range of regulation and the switch
of lending to overseas sources. Credit controls may have some effect in restrain-
ing credit and thereby expenditure, but the relaxation of credit controls may
do little to stimulate expenditure during a downswing.
Credit controls may have a role to play in slowing down the development
of asset price bubbles, which may be worthwhile in so far as the extent of the
subsequent downturn is a function of the extent of ‘irrational exuberance’.
These are circumstances which may be better tackled by controls over the
volume of credit rather than attempting to prick the bubble through tradi-
tional monetary policy measures that use the price mechanism of interest
rate increases. Appropriate forms of credit control may be focused on sectors
where ‘overexuberance’ is developing, rather than using the blunt instru-
ment of interest rate changes which impacts on all sectors of the economy.
Credit controls may be implemented in a variety of forms, and those which
operate through reserve ratio requirements would appear to be feasible.
The major changes which are required in respect of monetary policy are:
(i) A reformulation of the objectives of the ECB to include high and sus-
tainable levels of employment and economic growth (and indeed these
objectives should also be firmly embedded in the European Constitution).
(ii) The ECB must be made accountable to the European Parliament, and its
statutes changed so that it can clearly be involved in the co-ordination
of fiscal and monetary policies, and indeed that ultimately it can take
instructions from other European bodies such as ECOFIN.
There are some other changes which would also be desirable. Any reference
to the growth of the money supply should be discarded in recognition that
a Central Bank cannot in any way control the growth of the money supply.
The development of alternative instruments of monetary policy should also
be considered. The role of the ECB in securing stability in the European
financial system should be emphasized and a clear requirement made that
the ECB acts as a lender of last resort.
Stability and Growth Pact
The operational problems of the SGP are well known, with a number of
countries now breaking the 3 per cent of GDP limit on budget deficits.
The argument for some form of SGP governing the macroeconomic poli-
cies of national governments comes from a realization that there are spillover
effects from one country’s fiscal policy into other countries. It is often said to
have its origins in the suspicions of some countries (for example, Germany)
that other countries would be ‘profligate’ (for example, Italy) to their indi-
vidual and collective detriment. It is, of course, one of the ironies that it was
Germany that was one of the first to break the 3 per cent deficit rule – in part
because of their financial requirements for reunification. This line of argu-
ment appears to have been based on the idea that if one country ran ‘excessive’
deficits it would place upward pressure on the interest rate on that govern-
ment’s bonds. But those bonds would be denominated in euros and the
upward pressure on interest rates would spread to other countries. This line of
argument is faulty in two respects. First, if one country borrows ‘excessively’,
which in this context would mean at a level which brings into some doubt its
ability to repay and meet interest payments, then its credit rating would suf-
fer and it may well be faced by higher interest rates on its government bonds.
But unless there is some ‘association of guilt’, there should not be a spillover
into the credit rating of other governments. In a similar vein individual states
within the United States have differing credit ratings, and one state’s rela-
tively poor credit rating does not lead others to have poor ratings.
Second, there is little evidence that budget deficits and interest rates are
linked. At least in the short run, the key interest rate is set by the Central Bank
and other interest rates are built up on that key rate. Any association between
budget deficit and interest rate would then arise from the policy responses of
the Central Bank to the budget deficit position. Further, as argued in Arestis
and Sawyer (2003c, 2004b) when governments pursue functional finance,
that is running budget deficits in order to ‘mop up’ private net savings, then
there would be no upward pressure on interest rates through the capital mar-
ket. Finally empirical evidence does not suggest that budget deficits do have
a major impact on interest rates. For example, in a paper which is generally

hostile to Keynesian macroeconomic policies, Cunningham and Vilasuso
(1994–95, p. 190) have to concede that ‘[u]nfortunately, empirical studies
examining the relationship between interest rates and fiscal deficits are far
from conclusive’ and that ‘whether fiscal deficits are associated with higher
interest rates has yet to be resolved in the economics literature’ (p. 191). And
in a similar vein, ‘[t]he lack of supporting empirical evidence linking interest
rates to budget deficits is troublesome’ (Wyplosz, 1991, p. 168). Further, ‘the
empirical results on interest rates support the Ricardian view [that there is no
effect of budget deficits on real interest rates]. Given these findings it is remark-
able that most macroeconomists remain confident that budget deficits raise
interest rates’ (Barro, 1989, p. 48). If the argument is deployed that (govern-
ment) borrowing puts upward pressure on interest rates, the argument has to
be extended to cover all forms of borrowing since it could be expected that
all forms of borrowing place the same degree of upward pressure on interest
rates, which would lead to suggestions that all forms of borrowing should be
subject to upper limits!
There is, however, a basic requirement for some coordination of fiscal pol-
icy across member countries. In part this arises from a recognition that fiscal
policy has a significant impact on the well-being of economies. There are
(at least) two reasons for supporting coordination. First, the eurozone (or EU)
as a whole requires a mechanism for responding to adverse economic shocks
which impact on all economies – that is shocks which are widespread rather
than being limited to a few countries. A coordinated fiscal policy is required
to confront a coordinated shock. Second, there are important spillovers
between countries in the integrated economies of the EU: expansion of
demand in one country raises demand for the product of other countries,
and in the EU context where there is relatively little trade outside of the
EU most of the demand effects will be felt by other member countries.
Coordination of fiscal policy would mean that one country’s fiscal policy
would take into account the effects of fiscal policy in other countries.
The question then arises as to what type of coordination should be sought
and the mechanisms of coordination to achieve the coordination. There are
(at least) two broad approaches to fiscal policy. The first, which is closely
reflected in the present SGP, is to aim for some form of balanced budget,
albeit allowing the budget position to vary over the business cycle. The sec-
ond is to use the budget deficit in pursuit of economic objectives such as
high levels of employment. The first approach is concerned with the budget
being balanced over some time horizon and the objective of fiscal policy
becomes the balance of the budget. There is some recognition that there may be
some ‘automatic stabilizers’ in play such that in an economic downturn, the
budget position tends to move into deficit and that helps to cushion the eco-
nomic downturn. But there is no recognition that the general achievement
of high levels of demand may require budget deficits (in the case where a
high level of demand would generate a surplus of savings over investment).
The second approach views fiscal policy as one of the instruments of eco-
nomic policy, which can be used to strive for specified economic objectives.
A budget deficit or surplus (or indeed balance) is not then sought to meet
some predetermined figure but rather is used in conjunction with other policies
to maintain high levels of demand in the economy.
One of our major criticisms of the SGP is that some predetermined budget
deficit limit is imposed, whether or not that budget deficit well serves the
macroeconomic objectives. By focusing on limits on budget deficits, what
should be the other objectives of macroeconomic policy, such as high levels
of economic activity, are overlooked.
There have been many calls to operate the SGP in a ‘more flexible’ manner.4
The flexibility may take the form of raising the upper limit on budget
deficits, taking a more relaxed view on countries whose deficit exceeds 3 per
cent (or whatever limit is set). But these calls do not address the major issues.
At present the SGP has in place rules which are only observed in the breach,
bringing the notion of rules into disrepute, and a so-called more flexible
approach would not resolve that issue except through obscuring the rules
sufficiently that no one knew what they were. But any rule which maintains
the notion that national governments should be constrained to balance the
budget over the cycle or to limit the size of deficit in any particular time
period does not address the major problems of the SGP. The SGP in effect
imposes a ‘one-size-fits-all’ fiscal policy on all countries, no matter what
their economic circumstances are.
There is no reason to think that a balanced budget over the business cycle
suits all countries (or indeed any). A well-known identity (though generally
forgotten by advocates of the SGP) drawn from the national income accounts
tells us that: (Private Savings minus Investment) plus (Imports minus Exports)
plus (Tax Revenue minus Government Expenditure) equals zero, which is in
symbols:
(S ⫺ I) ⫹ (Q ⫺ X) ⫹ (T ⫺ G) ⫽ 0 (10.4)
Individuals and firms make decisions on savings, investment, imports and

exports. For any particular level of employment (and income), there is no
reason to think that those decisions will lead to
(S ⫺ I) ⫹ (Q ⫺ X) ⫽ 0 (10.5)
But if they are not equal to zero, then (G ⫺ T), the budget deficit, will not be
equal to zero, since
(G ⫺ T) ⫽ (S ⫺ I) ⫹ (Q ⫺ X) (10.6)
The SGP in effect assumes that any level of output and employment is
consistent with a balanced budget (G ⫺ T ⫽ 0), and hence compatible with
a combination of net private savings and the trade position summing to
zero. But no satisfactory justification has been given for this view.
Another suggestion for amending the SGP is that the budget deficit
constraint be shifted from the present one of an upper limit of 3 per cent of
GDP and that the budget should be balanced over the cycle to one in which
these limits apply to the current account of the budget, with investment
funded by borrowing. As a practical matter, this would represent an improve-
ment in that more leeway would be available for budget deficits to be used
for fiscal policy purposes. However, it still does not overcome the major
problems of the SGP. First, it retains in place the view that the budget (albeit
the current account) should be in overall balance and that the budget position
should conform to some arithmetical rule. It relates the size of the budget
deficit to the needs for public investment which shift over time.
Second, for these purposes this distinction between the current account
and the capital account is irrelevant. For an individual it may be recommended
that borrowing be limited to capital expenditure on the basis that the anticip-
ated financial returns from the capital expenditure will be sufficient to meet
the interest payments on the borrowing. But, in general, the government
does not receive a direct financial return on its capital expenditure, since it
does not sell the output produced by the capital equipment. There can be
indirect returns in so far as government investment (for example, in infra-
structure) aids growth and thereby high tax returns. But some forms of gov-
ernment investment (for example, in defence equipment) clearly do not aid
growth, and many forms of government current expenditure such as education
and health do contribute to growth and higher future taxes.
Third, a rule such as balancing the budget (whether current account or
total) over the cycle with an upper limit on deficit in any particular year nec-
essarily runs into the ‘one-size-fits-all’ problem. There is no reason to think
that the appropriate size of the capital account and the appropriate size of
the budget deficit would coincide. Some countries would have more require-
ments and uses of capital investment than others, and some countries would
have need of greater budget deficits than others. There is no reason to think
that the requirements for public investment would match the requirements
for budget deficit. Public investment should be determined by the costs and
benefits of such investment, and the budget deficit by reference to striving
to attain macroeconomic objectives such as full employment.
The second approach to fiscal policy indicated above can be linked with a
‘functional finance’ approach (Lerner, 1943; Kalecki, 1944) in which budget
positions should be set to pursue macroeconomic objectives including the
highest sustainable level of employment. Budget deficits should be incurred
in so far as they are necessary to achieve these objectives, and not subject to
arbitrary rules (such as balanced budget over the cycle).
Under the present arrangements, national fiscal policies could be said to

be coordinated by the Stability and Growth Pact, though subordinated may
be a better word than coordinated (except that as it has turned out the rules
of the SGP have frequently been broken). The rationale for the present form
of coordination comes from the notion of spillover effects between national
economies and the interests of one country in the effects of other countries’
fiscal policy. In the approach taken here, the case for coordination of fiscal
policies arises from the following considerations:
(i) When the eurozone (or EU) is impacted by shocks (for example, a general
rise in the price of oil) which affects all of the economies (albeit not
to the same extent), a coordinated response to a generalized shock is
appropriate.
(ii) There are likely to be substantial spillover effects between national
economies given the extent of trade between them, and hence a fiscal
stimulus in one country will raise demand in neighbouring countries.
The setting of fiscal policy is one country then needs to take into
account what is happening to fiscal policy in neighbouring countries.
(iii) Monetary and fiscal policies both affect the level of aggregate demand,
exchange rate and perhaps the rate of inflation, and that points towards
coordination between monetary and fiscal policies.
The coordination of national fiscal policies faces many difficulties. A major

one arises from the question of what are the aims of fiscal policies and what
are perceived to be the effects of fiscal policy. Under the present arrangements
it could be said that the aim of fiscal policy is a balanced budget and that the
perceived effects of budget deficits are generally negative (for example, lead-
ing to high interest rates and inflation). It is clearly difficult for two (or more)
individuals (or countries) to coordinate their activities if the purpose and
effects of coordination are matters of dispute between the parties concerned.
Thus, we would argue, coordination of national fiscal policies needs to be
based on a shared set of objectives – and here we would advocate the inclusion
of the objectives of high and sustainable levels of demand and economic
activity. Coordination would also benefit greatly from shared views on
the need for active fiscal policy and on the effects of fiscal policy. And
this requires a sharp change from the prevailing ‘conventional wisdom’
embedded in the SGP.
A rather more direct form of coordination of fiscal policy would come
from the development of EU fiscal policy. The development of such a policy
would require a large increase in the scale of the EU budget and the ability of
the EU to operate a budget deficit (or indeed a budget surplus).
The requirement for a significant EU budget was acknowledged in the
MacDougall Report of 1977 (Commission, 1977, vol.I: 14) which estimated
an amount of 7.5 per cent of EU GDP as necessary to manage a monetary
union. Goodhart and Smith (1993) and Currie (1997) argue that a rather
lower figure for the EU budget, provided that it was well targeted to aid
stabilization, would suffice, but their figures of around 2 per cent would still
be double the current level of the EU budget. We would favour a somewhat
larger figure, say of the order of 5 per cent, which would include measures to
enhance investment and economic development in the less prosperous
regions. But the significant point here is the need for an EU budget which is
not constrained to be balanced as at present and which can be utilized for
EU-wide stabilization purposes.
Concluding remarks
At the heart of our approach is the view that the achievement of full employ-
ment and sustainable and equitable growth should be the major objectives
for economic policy in the European Union. The achievement of these objec-
tives requires, among other matters, the use of macroeconomic (monetary
and fiscal) policy to secure high levels of aggregate demand and the building
of adequate productive capacity. Calls for more ‘flexible’ labour markets
are largely irrelevant where full employment, which requires high levels of
demand and of capacity, is concerned. Thus we argue for a reorientation of
macroeconomic policy with the major objectives of full employment and
sustainable growth, with a full role being played by fiscal and monetary policy
in the pursuit of those objectives.
Notes
1. In 2003, four countries recorded budget deficits of over 3 per cent, namely Germany
(3.8 per cent of GDP), Greece (4.6 per cent), France (4.1 per cent) and the Netherlands
(3.2 per cent); Portugal had brought their deficit down from over 4 per cent to
2.8 per cent in 2003.
2. In the year to September 2004, the rate of inflation varied from 0.2 per cent in
Finland to 3.2 per cent in Spain: on the basis of the members of the eurozone the
average of the three lowest inflation countries was 1.1 per cent and three countries
had inflation more than 1.5 per cent above that reference level.
3. One recent review, undertaken for HM Treasury in the UK, concluded that ‘even from
this subset of evidence, is that negative impacts are not very large’. But they go on to
say that ‘estimates of the maximum gains to trade from the complete elimination of
exchange rate volatility are in the region of 15 per cent, while the consensus estimate
of these studies is typically less than 10 per cent’ (HM Treasury, 2003, p. 28).
4. For example, under an article headlined ‘Paris and Berlin Seek Relaxation of Fiscal
Rules’, the Financial Times, 27 October 2004, reported that ‘France and Germany
will push for a substantial relaxation of the stability and growth pact that would go
beyond amendments to European fiscal rules that have been proposed by the
European Commission’ and ‘Gerhard Schröder, the German chancellor, said after a
joint meeting of the French and German cabinet. “Member states should be given
more room, for instance to invest in research and development.” ’
References
P. Arestis and M. Sawyer, ‘Macroeconomic Policies of the Economic and Monetary
Union: Theoretical Underpinnings and Challenges’, International Papers in Political
Economy, 10(1) (2003a), 1–54.
P. Arestis and M. Sawyer, ‘Does the Stock of Money Have any Causal Significance?’
Banca Nazionale del Lavoro, 56(225) (2003b), 113–36.
P. Arestis and M. Sawyer, ‘Reinventing Fiscal Policy’, Journal of Post Keynesian Economics,
26(1) (2003c), 4–25. (Chapter 9 in this volume.)
P. Arestis and M. Sawyer, ‘Can Monetary Policy Affect the Real Economy?’ European
Review of Economics and Finance, 3(3) (2004a), 9–32.
P. Arestis and M. Sawyer, ‘On Fiscal Policy and Budget Deficits Intervention’, Journal of
Economics, 1(2) (2004b), 65–78.
P. Arestis and M. Sawyer, ‘The Nature and Role of Monetary Policy when Money is
Endogenous’, Cambridge Journal of Economics (forthcoming 2005).
P. Arestis, I. Biefang-Frisancho Mariscal, A. Brown and M. Sawyer, ‘Explaining the
Euro’s Initial Decline’, Eastern Economic Journal, 28(1) (2002), 71–8.
R. J. Barro, ‘The Ricardian Approach to Budget Deficits’, Journal of Economic Perspectives,
3(2) (1989), 37–54.
M. Buti, D. Franco and H. Ongena, Budgetary Policies during Recessions: Retrospective
Application of the ‘Stability and Growth Pact’ to the Post-War Period (Brussels: European
Commission, 1997).
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Public Finances in European Integration, chaired by Sir Donald MacDougall,
Economic and Financial Series no. A13 (Brussels, 1977).
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Viable?’ Journal of Post Keynesian Economics, 17(2) (1994–95), 231–48.
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by the Economist Intelligence Unit, January 1997.
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ECB (2004b), Monthly Bulletin, October 2004.
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no. 5/1993, The Economics of Community Public Finance (1993), 417–55.
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11
Promoting Growth and Welfare in
a Changing Europe: Economic
Analysis and Policy
Jean-Luc Gaffard
European Union economic performances: the

data and the debate
The problem that is common to all European economies is how to maintain

full employment, social achievements and levels of welfare. The common
answer is growth and innovation, that is, access to the most advanced tech-
nologies – the way to revamp the growth process. As to achieving this, there
is today a prevailing consensus, derived mainly from unfavourable compari-
son with the performance of the US economy, which consists in promoting
the emergence of a new institutional framework and enhancing potential
growth rates.
The desire to improve poor European economic performance since the
mid-1980s that gave rise to the Single Market Programme and more recently
led to the so-called Lisbon process has failed. The late 1980s and the late 1990s
are the only two episodes of relatively high growth in the past two decades.
Overall growth slowed from the 1980s in spite of the implementation of
far-reaching reforms in both the macro-environment (consolidation of pub-
lic finances and lower inflation) and micro-environment (Single Market
Programme, Uruguay Round and labour market reforms).
First of all, the macroeconomic performance of the EU has been disappoint-
ing in comparison to the US. Instead of growing faster than the US through
the assimilation of existing technologies and organizational designs, as in
the post-war period, the EU has achieved a lower growth rate and a higher
unemployment rate than the US. Since 1970, the GDP per capita gap between
the EU-15 and the US has remained roughly constant. While US growth has
generated employment and maintained working hours, Europe’s employment
performance has been weak and working hours have fallen consistently. The
labour supply in the US has increased substantially because of demography
and higher participation rates. While the EU population grew by a mere
0.4 per cent per annum between 1991 and 2000, that of the US increased
by 1.2 per cent. At the same time, the EU employment rate (the share of
142
Promoting Growth and Welfare in a Changing Europe 143
population of working age actually employed) increased by only 1 percentage

point while that of the US increased by 5 percentage points. With average
working hours also increasing, the US labour input continued to rise strongly
throughout the 1990s. This stimulated growth as well as a strong increase in
labour productivity in the latter part of the decade. Then, during that period,
for the first time in three decades, growth in US labour productivity and in
total factor productivity (TFP) outstripped that of the EU, while the US was
forging ahead.
Within the EU, performances during the 1990s were by no means homo-
geneous. The so-called cohesion countries exhibited higher growth rates and
converged on the EU average. A slow-growth group, made up of Germany,
France and Italy, had a significant impact on the overall performance because
of their high weighting in the EU economy. A mixed group, composed of
Finland, the Netherlands and the UK exhibited a relatively high growth rate.
According to the prevailing consensus, such bad performances in Europe
are the result of institutional mistakes that prevented the economy from
simultaneously reaching all the standard policy objectives: high growth
rate, full employment, price stability and external balance. Thus, Europe
was unable to enter the new age, that is, the age of the so-called knowledge
economy, despite the huge transformation that has taken place over many
years. This consensus is built on a theoretical framework that focuses on the
structural properties of the economy, that is, mainly on technologies and
institutional rules that govern behaviours and the working of the markets.
This framework considers macroeconomic interventions to ensure stability
and balanced public budgets as a preliminary step, once the economy is
stabilized, to structural reforms aimed at favouring innovation processes.
In particular, macro-governance should consist in promoting separate and
independent institutions, each of them being in charge of a unique objec-
tive: the European Central Bank has to maintain price stability, and is not
concerned with growth and employment issues; the Growth and Stability
Pact is supposed to enforce fiscal deficit limits; and the competition policy is
conducted by the Commission with the task of promoting free trade and
minimizing monopolistic distortions. The intended structural reforms, on
the other hand, are those reckoned to allow the realization of a perfectly
competitive market, the focus being on the labour market, whose rigidities
are stressed as a main obstacle to the working of competition. This is the
recipe proposed for making innovative choices, so as to be at the frontier of
technological development, and hence to gain access to higher growth and
full employment: in fact actually to gain access to the knowledge economy.
However, as a capitalistic society, Europe has always been knowledge-
based. Thus the first question is not whether Europe will be knowledge-based
or not, but rather what response Europe will make to the challenges posed by
the huge transformation of its environment. The second question is whether
Europe will be able to capture the potential gains of wealth associated with
the development of new technologies and market extensions. This, in the

macroeconomic conventional wisdom, is dependent, as we have observed,
on the existence of given conditions that will assure the required behaviours.
The substantial departures from all sorts of steady-state behaviours exhibited
by the larger European countries since the mid-1970s, and more recently by
Japan, render it conceptually difficult to maintain some of the fundamental
propositions of macroeconomic conventional wisdom. First of all, there is
not a unique attractor (the potential growth rate) towards which transition
economies have been evolving, which would be defined with respect to the
properties of technological change and institutions. In the long run, coun-
tries that are similar in terms of fundamentals (that is, technology, prefer-
ences) do not necessarily converge to the same steady-state path where per
capita income (a welfare measure) is equalized across countries. Oscillations
no longer appear as deviations from a fixed trend – the potential growth rate –
determined beforehand by technologies and institutions. They are, rather,
one way in which an out-of-equilibrium growth process can be realized.
Coordination failures affect productivity, investment and employment, all
typically endogenous variables in the growth process. The chains of various
events taking place in the shorter run affect the potential rate of growth of
any economy. Thus active economic policies – aimed at regulating existing
dynamic mechanisms, or at supplementing them with compensating
mechanisms – are required to interact dynamically so as to correct distor-
tions that may result from an initial shock, thus re-establishing the internal
consistency of the economy and rendering a smooth evolution of it viable.
The required mix of interventions, on the other hand, should not be imple-
mented once and for all. It must be modified along the way, closely following
and adapting to a process that, being affected by a variety of perturbations,
takes on shape and direction as it goes.
In this perspective, the EU needs to exhibit better coordination, which, of
course, has institutional implications, but not necessarily the same as those
derived from the previous analysis. In fact, in an imperfect world, it is not
possible to establish analytically a unique ranking of alternative institutional
arrangements. It cannot be proved that the closer the economy is to the
benchmark (that is, perfect competition and the more flexible world) the
more efficient it will be.
Why has Europe been growing so slowly?

Institutions and technology
Standard analysis of the economic performance in Europe consists in charac-

terizing the properties of a given attractor and so relates long-run perfor-
mance to the nature of technologies and institutions.
In the first three decades after World War II, Europe achieved a remarkable
catching-up process, combining high growth, full employment, and high
levels of social protection. The institutions and policies developed in this

period seem to have been appropriate to the conditions of the time. The main
idea that prevails today is that the ability of these institutions and structures
to deliver growth and welfare performance has declined as the European econ-
omy has reduced the distance to the technological frontier. Overall, such insti-
tutions are considered as an obstacle to innovation. In brief, institutions that
would be appropriate for imitation would not be appropriate for innovation.
According to this analysis (Acemoglu et al., 2002), for these thirty years,
Europe was catching-up with the US through investment and factor accumula-
tion, and through imitation of leading-edge technologies. This corresponded
to the generalization of an already mature technology and well-known orga-
nizational patterns, previously discovered and experimented with in the US.
In this context, significant economies of scale associated with standardized
products resulted in industry structures dominated by large firms partly pro-
tected both in product and financial markets. These firms developed long-
term relations with suppliers of funds. They also offered long-term relations
and job security to their workers. New entry and the competitive drive that
it gave were not crucial. In this context, macroeconomic policy was only
aimed at managing the aggregate demand. Microeconomic management
was reduced to regulating firms operating in industries characterized as natural
monopolies and promoting national champions in some other industries
without really considering competition issues.
According to this view, this system breaks down as the patterns of both
consumption and production change, and shift towards different types of
goods and services, more customized, and requiring a different form of indus-
trial organization. Briefly,
once European countries had moved closer to the technology frontier and
also with the occurrence of new technological revolutions in communica-
tion and information, innovation at the frontier would have become the
main engine of growth. This in turn called for new organisational forms,
less vertically integrated firms, greater mobility, both intra- and inter-firm,
greater flexibility of labour markets, a greater reliance on market finance
and a higher demand for both R&D and higher education. However, these
necessary changes in economic institutions and organisations have not
yet occurred on a large scale in Europe and it is this delay in adjusting our
institutions which accounts to a large extent for our growth deficit.
(Sapir et al., 2003, p. 29)
This translates into the following key conditions for removing the poor
record of job creation in Europe.
● To the extent that rivalry among firms and strong fluctuations in their mar-
ket shares make it easier to innovate at the frontier, the new growth regime
requires the elimination of all the obstacles to this rivalry and a free entry.
The regulatory environment must encourage start-ups, be conducive to the
challenging of established positions, and stimulate entry and exit.
● To the extent that selection among projects and also among more or
less skilled managers is needed for sustaining innovation at the frontier,
the new growth regime requires developing stock markets and promoting
the mode of governance associated with them in order to guarantee the
opportunity for innovators to appropriate a huge fraction of the revenues
of their innovation.
● To the extent that microeconomic instability, and hence hiring and firing
of employees are the main aspect of the innovation process, the new
growth regime requires facilitating the match of supply and demand
for the different skills in different industries and different locations by
enabling firms to hire and fire more easily. This will be the key condition
for improving the poor record of job creation in Europe.
In this context, macro-stability, far from being the result of a well-managed

process of change, appears as the precondition of such a process, assimilated
to the introduction and the acceptance of so-called structural reforms. This
macro-stability is regarded as a set of rules or behaviours that achieve monetary
stability and fiscal discipline, and are given once and for all, being supposed
efficient at whatever moment they are applied.
Implicitly, attractors associated with each set of technologies and institu-
tions toward the economy are supposed to converge. Several attractors exist,
which implies that societies have to choose between them, that is, between
low growth and high unemployment on the one hand, or high growth and
low unemployment on the other.
Indeed, according to the most extreme defenders of this consensus:
a critical point has been reached in a number of European countries, not

so much because of the overall macroeconomic performance (the current
slowdown is milder than the previous one) but because of budgetary prob-
lems (including the adverse consequences of labour market rigidities for
the financing of valuable benefits such as pensions and health care as well
as for long-run living standards) and the feeling that ‘globalisation’ is making
the burden of labour rigidities unbearable.
(EEAG, 2004, p. 3)
This renders it all the more necessary and urgent to carry out structural
reforms that concern labour markets. In this view, the only obstacle is pre-
sumed to be a political one: the main beneficiaries of the existing system
have the capacity to blockade the reforms that reduce or eliminate their
revenues. So what is at stake is the identification of a set of policies to reduce
unemployment that would meet much less political opposition. ‘This includes
liberalising product markets; introducing a simple “firing tax” that would be

paid to the worker as severance payment instead of the current system of
legal procedures; replacing welfare payments for the poor with in-work benefits
such as earned income tax credits; and ensuring that the search activity of
the unemployed be tightly monitored with sanctions in the form of reduced
benefits if search is not active’ (ibid., p. 3). Moreover, if measures aimed at
improving the Stability and Growth Pact are insufficient or hard to carry out,
the EU member states should introduce an institutional reform that would
consist in delegating ‘the actual decision-making process regarding varia-
tions in actual public deficits or specific taxes around levels determined by
Parliament to an independent Fiscal policy Committee’ (ibid., p. 7).
These considerations can and must be challenged, first from an empirical
and historical viewpoint. Reconstruction and catching-up cannot be assimi-
lated to steady growth. Most of the difficulties that European economies
faced in this period are the same as those faced by economies engaged in an
innovation process properly defined as an out-of-equilibrium process. On
the other hand, the macroeconomic policy in that period was far from being
reduced to the management of an aggregate demand. It was also, and mainly,
a policy that successfully managed the supply side of the economy, thanks to
an appropriate management of productive (financial and human) resources
(Hicks, 1959). On the other hand, in the last two decades structural reforms and
adoption of fixed policy rules have not prevented increasing unemployment
and productivity slowdown in European countries.
Why has Europe been growing so slowly? Structural change

and coordination failures
In fact, the key issues to be addressed might not revolve around the possibil-
ity of convergence towards some pre-determined equilibrium growth path.
They might be about the nature of growth regimes in the history of our
economies and their relevant stability features. As a matter of fact, the
central stylized fact revealed by international comparisons is the diversity of
evolution across countries that have already faced the same kind of shocks
and have had access to the same technologies. This diversity is closely
related to the nature and the profile of the accumulation process.
The diversity of growth regimes can be analysed with reference to the posi-
tion and the movement of the economy within the framework space defined
by the growth rate of labour productivity and the growth rate of investment
per employee (Böhm and Punzo, 2001). It is possible to contrast economies
that have reached a nearly steady state (when the growth rate of productiv-
ity is more or less equal to the growth rate of investment per employee) with
economies that experiment with structural changes defined as alternations
between two growth regimes, respectively characterized by a high and a low
growth rate of investment per employee with respect to the growth rate of
productivity. Such alternations reveal the existence of changes in growth

regimes, that is, structural fluctuations.
In the case of the US economy, there is no clear trace of significant changes in
growth regimes during the last two decades. On the other hand, most European
countries, as well as Japan, were exhibiting wild and recurrent changes
in growth regimes (Böhm et al., 2001; Gaffard and Punzo, 2005). Such a high
degree of structural instability may account for their poor employment and
productivity performance vis-à-vis the US; and it can largely be explained
by coordination failures that concern both individual behaviours and eco-
nomic policy. Some crucial episodes in the growth process of the different
countries lend support to such conjecture.
Most European countries, and notably France, Germany and Italy, experi-
enced fairly irregular growth from the late 1970s onwards. This has taken the
form of alternating growth regimes. In the 1980s, as the major shortcoming
of coordination failures, including economic policy failures, real constraints
emerged which, being too stringent, implied that recovery would raise infla-
tion pressures, boost inflation expectations, and hence suggested restrictive
monetary policies. In reality, the lack of productive resources following the
first negative (oil prices) then positive (technological) supply shocks has to
be deemed to be responsible for the stagflation phenomenon. Restrictive
monetary policies implemented with the aim of curbing a rate of inflation
perceived to be too high, had the side effect of making the productive resource
constraints ever more severe. Abrupt switches in growth regimes, as appear
in the investment–productivity framework space, have been the typical
outcome (Böhm et al., 2001; Gaffard and Punzo, 2005). Such structural insta-
bility factored out into a productivity slowdown and a rising NAIRU (non-
accelerating inflation rate of unemployment).
Later on, attention was focused on inflation performance. A stable price
level and above all a strong exchange rate (particularly in France) became
primary objectives, pursued through a restrictive monetary policy, and even-
tually a lower inflation process did prevail. During the 1990s, share prices
normalized by productivity more or less held their ground in Germany,
France, Italy and Spain, while they were strongly increasing in the US
(Fitoussi et al., 2000). This confirms that liquidity constraints remained high
on this side of the Atlantic, while being relaxed on the other. In the EU-area
to come, while the economy needed a more intense accumulation of capital,
investment was sacrificed with the consequence of progressively lowering
the notional growth rate, that is the output growth rate compatible with non-
accelerating inflation (on this concept see Hicks, 1977, p. 99). Inappropriate eco-
nomic policies were responsible for the irregular and low growth performance.
As a benchmark, let us take the Netherlands which, instead, does show a
kind of convergence towards a quasi steady state in the late 1980s and the
1990s. The crucial episode is the long-lasting expansion that began in the
middle of the 1980s. The inflation trend rose from 1987 to 1991, but this did
not trigger any immediate, counterbalancing policy response. Thus, steady

growth continued through to 1992 whereas most of the European countries
went deep into recession. Inflation run-up was not permanent, at any rate.
The episode is therefore significant in so far as it reveals the working of a
superior coordination mechanism whose main aspects are, on the one hand,
a loose banking policy with respect to the price level, and on the other hand,
regulated wage movements. As is well documented, the point of departure of
this new procedure was the 1982 Wassenaar agreement on wage restraints
accepted by Dutch unions. This agreement outlined a concerted income
policy, which has successfully dampened the inflationary effects of final
demand pressures and has also permitted the Central Bank to implement a
comparatively less restrictive monetary policy. Such a policy mix, then,
could be aimed at boosting investment spending at a time when it was nec-
essary. On the other hand, since the early 1980s, the Netherlands has seen its
rate of employment rise, clearly mimicking the rise in share prices (normal-
ized by productivity) (see Fitoussi et al., 2000). This, of course, may lend sup-
port to the theory that sees a key role played by asset prices in employment
determination, an idea that belongs to equilibrium models. But it also may
be used as evidence in support of a distinct conjecture, namely that releasing
liquidity constraints – here thanks to stock market bubbles that push capital
costs down – allows firms to fare better through transition to the new tech-
nologies and thus capture the associated productivity gains.
Let us take, as another example, the United Kingdom, which also appears
to have managed to steer relatively clear of the severe growth regime instability
of other countries. After experiencing pronounced structural fluctuations
from 1978 and 1994, similar to those experienced by France, Germany and
Italy, it seems to have regained a stability corridor (Böhm et al., 2001; Gaffard
and Punzo, 2005). The crucial junction in the UK’s evolution appears to have
been between the late 1980s and the early 1990s; starting with a strong expan-
sion in the late 1980s, the boom in borrowing being its widely accepted
explanation. Due to a lucky combination of financial liberalization, high
confidence and high asset prices, this ignited and sustained a boom of
both investment and consumption. At the same time, the Bank of England
refrained from tightening policy immediately after inflation started to rise.
The historical experience of the UK in the early 1990s can be likened to that
of the US in the early 1980s: policy easing in response to recession.
The truly important difference between most European countries and the
US is likely to be this: in the US the rate of investment has remained constant
and investment has always actually increased following supply shocks. This
has mainly been due to the fact that ‘policy has not generated bouts of
severe inflation and so has not had to generate bouts of recession to control
it’ (Romer, 1999, p. 32). On the other hand, at the same time, the stock market
bubble pushed capital costs down and allowed firms to carry out their
desired investments. As a consequence, the rate of growth consistent with
price stability has risen, and correlatively the NAIRU has decreased. The US
economy did not experience structural fluctuations to the same extent as
some other, perhaps core EU, countries (Böhm et al., 2001; Gaffard and
Punzo, 2005). However, the US investment boom in the late 1990s was
unsustainable. Higher productivity growth in the late 1990s encouraged
firms to become over-optimistic about future returns. The inevitable result
was over-investment in new technologies in view of reasonable profit expec-
tations. In other words, excessive liquidity levels would have favoured
equally excessive investment in the new sectors. Now, as profits are starting
to plunge, share price evolution is going into reverse and firms are being
forced to cut their investment plans.
Recent evolution and the connected policy issues for the Japanese econ-
omy can easily be accommodated within this same analytical framework. At
the beginning of 1991, the Japanese economy entered an extended period of
slow growth, eventually leading to a definite recession, that is still ongoing.
Slowdown and then actual contraction have been viewed as the correction
and backfiring of an unsustainable boom, whereby the actual growth rate
would have been for a while above the potential one. Similar explanations
have imputed the fundamental cause of the slowdown to the reduction in
the rate of potential output as coming from a change in the demographic as
well as in the total productivity factor trends. However, estimates of the gap
between actual and potential output consistently conclude that it cannot
exceed 4 or 5 per cent, so that not only demand policies as they are currently
recommended, but perhaps to a greater extent, policies promoting a better
inter-temporal coordination between supply and demand, do have an
important role to play. To see why, consider the beginning of the 1990s:
there was an evident break in inter-temporal coordination the main aspect
of which was an excessively low consumption ratio while increased savings
were not being converted into productive investment. This resulted in
dramatic growth regime switches and related structural fluctuations (Böhm
et al., 2001; Gaffard and Punzo, 2005). To appreciate the contrast: until 1985
the Japanese economy had been basically near a steady state. Thereafter,
it clearly exited from its own stability corridor to experience a structural
fluctuation, with irregular alternating growth regimes.
To summarize, the different productivity trends in Europe and the US in
the 1990s and the apparent disappearance of the productivity paradox in
those years in the US confirm the scenario that focuses on coordination fail-
ures. On the one hand the poor performance of productivity in Western
Europe is the result of a reduced process of accumulation (also characterized
by strong fluctuations) due to a tight monetary policy, and more generally to
a wrong policy management. On the other hand a stable and substantial rate
of investment is behind the positive productivity trend in the US. Ex post,
this is an obvious explanation of the difference. But behind these different
accumulation processes, different coordination mechanisms have been at
work, the one actually sustaining this process, the other failing to do so.
Different coordination mechanisms that cannot be reduced to the properties
of technology or the character of incentive systems but involve the harmon-
ization over time of all the elements involved in the adjustment process.
This scenario also leads to the conjecture that good coordination of the
process of accumulation of capital, not price flexibility, is the main reason
for the satisfactory performance of the United States, although the behav-
iour of prices may have helped. Strong wage flexibility associated with a
strong increase in personal inequalities has not resulted in perturbations of
economic activity because strong growth made possible by good coordina-
tion mechanisms has led to a huge creation of jobs and hence to stability of
wage shares. In Europe, where the restrictive policies adopted have checked
the process of capital accumulation, strong fluctuations of the wage shares in
gross national products due to mistakes in economic policy have contributed
to exacerbating the existing distortions, instead of helping to reduce them.
The real challenge of the economic

transformation of Europe
The economic transformation of Europe, involving technological change,

enlargement of the EU and competition with emerging economies (China,
India) and the US, requires a new deal to promote growth and enhance social
welfare and cohesion. The key issue to be addressed is not the realization of
the institutional conditions supposed automatically to enable the choice of
best technology practices and hence the convergence towards a predeter-
mined optimal growth path. We have to look at growth as the result of an
adaptive process that allows discovery of the relevant information and
hence captures the potential gains associated with the development of new
technologies and market extensions. The real issue is about the necessarily
complex set of conditions that regulate the process of accumulation and
restructuring of capital and hence determine the actual growth rate of the
potential output. This set cannot be reduced to the choice of an institutional
arrangement presumed optimal. Thus, contrary to the current consensus,
macroeconomic stability, far from being regarded as a prerequisite of growth –
as a set of rules aimed at guaranteeing monetary stability and fiscal discipline –
will result from a process that requires discretionary interventions. The rationale
of these interventions is quite the opposite of that presiding over the measures
making up the policy consensus previously expounded.
In this perspective, monetary policies should be aimed at promoting
banking behaviours and structures that sustain necessary investment instead
of maintaining a devastating constraint on firms’ behaviours in order to
maintain full price stability. The protection of employment, and more gen-
erally institutional rules that favour social cohesion, should be viewed (and
amended) as a means of allowing the economy to deal with turbulence;
hence guaranteeing the effectiveness of the learning process. Competition

and regulatory policies should be oriented in such a way as to consider market
imperfections as integral and necessary aspects of the production and the
dissemination of knowledge in a market economy, that is, as the natural
features of an economic process driven by creative destruction. Cohesion
policies should make it compatible to promote growth in each region or
country and maintain an economic and political equilibrium between them.
Monitoring monetary and financial constraints

Bringing down inflation was the explicit goal of monetary policies in Europe
during the 1980s and the 1990s. This led to a remarkable nominal conver-
gence. But what was the impact of monetary stability on economic growth?
The prevailing evidence points to lower investment and lower growth rates
as the main effect of such a stabilization.
As a matter of fact, accumulation and the restructuring of productive
capacity following a supply shock are characterized by coordination prob-
lems concerning, in the first place, the production process but extending to
all economic activity (Amendola and Gaffard, 1998, 2003). The main aspect
of the problem is insufficient investment in productive capacity with respect
to the requirements of an economy facing technological changes to be
maintained in a quasi steady state with full employment. In a fully coordi-
nated economy the appropriate required investment would be immediately
and spontaneously achieved without inflation and unemployment. Otherwise,
an external intervention is necessary to contain inflation and absorb unem-
ployment. The main problem is to provide the required flow of productive
resources over time so as to keep a balanced structure of productive capacity
and thus progressively eliminate market imbalances. The process of restruc-
turing of productive capacity necessarily results in inflationary pressures
(and/or deficits in the trade balance in open economies) because the goods
on which the wages will be spent cannot be provided out of the product of
the labour that is newly employed.
The Central Bank then has a choice. It can try to curb inflation as soon as
possible, with the consequence of exacerbating the initial negative impact of
the shock on output and employment. In this case, the investment necessary
to carry out the innovation process cannot be realized. We will have less pro-
duction and less labour demand. This may in fact result in a lower inflation
if not a price deflation and in cumulative unemployment. This is the recent
experience of the major European countries as the result of the policies fol-
lowed to comply with the Maastricht rules and the ECB policy of pursuing
the target of price stability. In conclusion, restrictive monetary policy has
been one of the major obstacles to a successful transition because it has cre-
ated an inappropriate volatility of investment spending. Moreover, targeting
(and realizing) a too low rate of inflation has made it impossible to reduce
the real interest rate and by so doing to favour the growth process.
The Central Bank can, alternatively, decide on an accommodating monetary

policy characterized by the acceptance of a transitory inflation aimed at
enhancing the growth process in the future, thus simultaneously re-absorbing
inflation and unemployment. In this case, the possibility of keeping a bal-
anced structure of productive capacity will re-establish the coordination of
economic activity and make the innovation process viable, with positive
results in terms of productivity and employment (Amendola and Gaffard,
1998, 2003).
If we look at the European experience, we see that a substantial loosening
of monetary conditions in the late 1980s and the late 1990s preceded the
only two episodes of relatively high growth in the past two decades. The accom-
modating monetary policy seems to have been the major factor, though not
the only one, behind recent European growth, while Europe is really facing
a structural change. While European policymakers (and distinguished scholars)
like to blame all the euro area’s economic woes on inflexible labour markets
and high taxes, the major difference between the EU and the US with respect
to their performances is that over the past three years America has enjoyed
much looser monetary and fiscal policies which have bolstered consumer
spending. Adjusting for the impact of the economic cycle (deficits widen in
downturns as tax revenues shrink), America’s structural budget has shifted
from a surplus of 1 per cent of GDP in 2000 to an estimated deficit of 4 per cent
this year. Over the same period, the euro area has seen no net fiscal stimulus.
Interest rates have fallen by 5.5 percentage points in America, twice the fall
in the eurozone. A weaker dollar is also helping to boost American exports
and company profits. The combined stimulus has helped to cushion what
would otherwise have been a much steeper downturn in the United States.
In the same vein, while Japan is blamed for the rather light structural reform
that has been carried out, for the first time in a decade, in early 2000 it enjoyed
an upswing that could actually last. The real explanation is that the Bank of
Japan’s monetary policy has now become steadily and credibly expansionary.
The Bank of Japan has used an unorthodox monetary policy, printing a lot of
money through a ‘quantitative’ easing policy, while the interest rate is zero.
Moreover the central banker has said that this accommodating monetary pol-
icy will not stop until year-to-year inflation has been positive for a good while.
In other words, the Central Bank has adopted an inflation target that has been
determined with respect to a growth rate objective. Briefly, if monetary policy
continues to be expansionary, and if government does not repeat the mistake
of raising taxes, then recovery should be lasting.
Indeed, such a policy will be efficient, as it will make corporate restructuring
and more general structural changes easier. According to the tenets of the
new orthodoxy, even in the case of a recovery enhanced by easy monetary
policy, countries should engage in structural reforms (privatization, deregula-
tion). We intend to prove that these reforms may result in turbulence that
hampers growth and innovation instead of boosting them.
Maintaining protection of employment

and social cohesion
The prevailing policy consensus stresses the flexibility of the labour market
as the primary object of policy intervention. Today’s prevailing view in the
literature and in most political circles is that the possibility of hiring and
firing freely, besides offering wages at a freely chosen level, is an incentive to
investment in more advanced and more productive technologies.
As regards this issue, most labour market theories hold that employment
protection, that is, administrative and legal constraints and the benefits and
payments made to laid-off workers, increases the length of unemployment
and makes the labour market less reactive and more stagnant. The main idea
is that risk-averse employers are likely to take into account the potential
future costs of hiring before deciding whether or not to hire workers. It fol-
lows that the extent of job reallocation should be lower in countries with
strict employment protection than in more flexible ones, and hence the
growth rate should be lower. To avoid paying firing costs the countries with
a rigid labour market will then tend to produce goods with a relatively estab-
lished and hence stable demand. They will thus concentrate on ‘secondary’
innovations, aimed at improving existing products: less risky but bringing
about lower increases in productivity.
Along this line goes the explanation of the different productivity perfor-
mances in the recent past in the United States (where primary innovations
are stimulated by low firing costs due to a flexible labour market) and in
Europe (where strong employment protection and high firing costs have
favoured mainly secondary innovations aimed at just improving existing
products: less risky but bringing about lower productivity gains).
First, it is worth mentioning that labour market rigidity in certain countries
is, to say the least, doubtful. Contrary to the common belief, countries with
substantial employment protection like France and Italy exhibit stronger
flexibility and dynamism of the labour market – measured by gross worker
turnover – than the UK and even the USA, whose labour markets are pointed
out as outstanding examples of flexibility. In the same way the data show
that the gross worker turnover in so-called high-tech sectors (communica-
tion, computers, biotechnology and so on) is lower than in sectors believed
to be more traditional and characterized by secondary innovations (con-
struction, transportation, instruments, automobile tyres and so on). Indeed,
according to more general empirical studies, there is a close negative corre-
lation between protection of employment and the length of unemployment,
as well as a negative correlation between employment protection and flows
between employment and unemployment and vice-versa. However, there is
no correlation between protection of employment and the unemployment
rate. Moreover, there is no negative correlation between the extent of job
reallocation (the labour turnover) and the strictness of labour market regula-
tions. In other words, labour mobility is not lower in some ‘rigid’ European
labour markets than in the US. As a matter of fact, some of the most rigid
European labour markets are characterized by sizeable job-to-job shifts,
which coexist with a large job reallocation rate and a low unemployment
turnover (see Boeri, 1999). Therefore, the labour market institutions of most
European countries would not inhibit the mobility of workers in response to
changing patterns in supply and demand. Employment protection would
not be an obstacle to technological change and growth.
The real effect of employment security regulations and of the partial
reforms recently carried out that extend the number of short-term contracts
and make the labour market more flexible would be only to favour a seg-
mentation of this market and the appearance of a new category of workers:
the ‘short-term’ workers. This segmentation might even be an obstacle to
workers’ mobility and growth by preventing voluntary quits from ‘solid’ jobs
(ibid., p. 85). However, behind the scene, what the tenets of the current
orthodoxy always promote is the moderation of wages. The proof is that the
main criticism concerning partial reforms and the introduction of two cate-
gories of workers consists in deploring their failure to change wage mecha-
nisms: this strategy would increase the protection of insiders (permanent
workers), thus creating excess wage pressure and eventually reducing unem-
ployment (Bentolila and Dolado, 1994). Thus, the problem really lies in
the effect of wage moderation and wage flexibility on the viability of the eco-
nomic process. In our perspective that implies considering coordination
issues beyond the state of labour markets, a high turnover associated with a
weak protection of employment would likely entail decreasing wages with-
out guaranteeing any creation of jobs, and may even induce inappropriate
wage flexibility and strong turbulence on the labour markets.
On the other hand, a more important point, favourable market (in partic-
ular, labour market) conditions are supposed not only to foster investment
but also favour the ‘right’ investment, that is, the choice of the technology
leading to primary innovation. That is to say that the underlying production
theory implies that the new productive capacity and its adequate utilization
(the technological gains) are the automatic result of the availability of given
productive resources and of the way in which they are combined (the tech-
nology), which also determines the efficiency with which these resources
are used in the process of production. This view mistakes the distinction
between growth and technical change and, as a consequence, the role of the
market in this context. As a matter of fact there is no automatic economic
gain resulting simply from scientific or technical advances. Actually obtain-
ing the returns of innovation depends not so much on the intrinsic charac-
teristics of given technologies as on the coordination of economic activity,
both at the micro and the macro level, through which innovation is carried
out. The adoption of technologies that potentially allow for substantial pro-
ductivity gains may actually result in a waste of productive resources, as the
recent crisis in some sectors of the ‘new economy’ demonstrates. What really
matters is not to choose to invest in a primary innovation, but to realize the

conditions under which the potential gains of the adoption of new produc-
tion technologies, even when these lead to the appearance of an increasing
variety of goods and services, are actually transformed into effective econo-
mic returns. The working of labour markets – the higher or lower flexibility/
rigidity, the wage policy pursued, more employment protection or less, and
so on – must therefore be looked at in the perspective of the viability of an
economic process that has its own evolution and might or might not achieve
its ends depending on the successful working of the required coordination
mechanisms. In this light, especially when we consider that learning is a
main aspect of a thorough innovation process, flexibility rather discourages
long-term investment in human capital by employers, since the worker may
not stay in the firm, and also discourages investment in firm-specific skills
by workers, since they may not be a fair return for that investment in the
absence of job security. Contrary to what has often been considered, it is not
true that, at a time of rapid change and a need for adjusting both production
and skills quickly, flexibility in the sense of lessening the protection of
employment comes to the fore. As a matter of fact, restructuring depends on
learning and learning goes well not because turbulence is systematically
favoured but because it ends in stabilized structures.
Rebuilding a comprehensive competition policy

Since the late 1980s the European Commission has been using competition
policy as a tool for liberalizing markets. This policy plays an essential role in
ensuring that market opening does lead to the achievement of potential pro-
ductivity and variety gains. It increasingly questioned whether mergers and
acquisitions were indeed guided to promote innovation. It exercises control
over public aid to avoid distortions through subsidies to some companies.
It has been active in promoting a reorientation from aid to individual compa-
nies or sectors to less distorting horizontal measures addressing specific market
failures. It acknowledges the evolving dimension of the markets and promotes
rivalry, new entry, and hence turbulence at the micro level that is supposed to
sustain macroeconomic stability. It goes hand-in-hand with deregulation and
privatization. This policy is defined with respect to a benchmark, the state of
perfect competition, which implies that it is aimed at systematically approach-
ing this state in each industry. In other words, it is defined and applied in iso-
lation, and it is supposed to participate as such in welfare maximization.
Things are much more complex. The difference between competition policy in
Europe and in the US is that in the latter case this policy interacts with the
other dimensions of public intervention in a way that privileges innovation
and growth in an imperfect world; it is not systematically aimed at establishing
a world that would be as close as possible to perfect competition.
When defining competition as a process, it is not only aimed at equalizing
supply and demand in a given market and technological environment, but
also has to adapt both structure and technology to opportunities created by

expanding markets. Through this adaptive process, rivalry is the means for
productivity gains to be transformed into lower prices for the benefit of con-
sumers and normal profits for the benefit of entrepreneurs. This rivalry does
not preclude the stabilization of the market structure. Thus, several firms can
coexist on the market, despite the existence of increasing returns, remaining
differentiated not so much because they supply differentiated goods, but
because they are each one at a different step of the life cycle of the produc-
tion process. This is a situation in which competition causes the rate of
investment in product development to rise or fall towards the level at which
this investment yields only a normal return. It is also a situation in which the
prices charged by the firms reflect decreasing average costs so as to allow the
benefits from innovation to be distributed to consumers. Finally, this is a
situation in which the stability of market shares is obtained: there are in fact
neither new entries nor exits from the market. All these considerations not
only qualify a dynamic equilibrium, but also what should be the competitive
conditions consistent with the effective realizations of the innovation gains
and hence with increasing returns (Amendola et al., 2003). Indeed, the main
issues to be addressed are about the conditions that allow innovative firms
to be successful and the industry to reach the required stable structure.
As a matter of fact, resource constraints largely determine the viability of
evolution processes and the emergence of appropriate industrial structures.
Let us take the case of the sectors of the so-called new economy. In these
sectors, banks and financial markets, more interested in the perspective of
growing markets than in current profits, have allowed an excessive capacity
competition. As a consequence, a shakeout has occurred, following a strong
decrease in the market value of shares. Monopoly practices (and regulatory
practices) setting bounds on price and investment behaviours would have
helped the industry converge to the appropriate structure. On the other
hand, excessive flexibility made the shakeout unavoidable, thus involving
huge welfare losses. Thus no structural criterion that would be a guideline for
competition policy applies. The automobile industry and the personal com-
puter industry offer clear evidence of this by exhibiting very similar patterns
of evolution, despite their strong difference from a technological viewpoint
(Mazzucato, 2002). Both have experienced ‘a high degree of turbulence dur-
ing the first 30 years: high entry and exit rates, short firm life spans, radical
innovation, and rapidly falling prices’. Both have experienced ‘the highest
stock price volatility during these periods in which the forces of creative
destruction were the strongest’ (ibid., p. 343). In fact, a lesson emerges from
this study. The working of markets, including financial markets, is essential
in the determination of outcomes. It is much more important than the
nature of the product and the technology, which only appear at the end of
the process. Apparently, the shakeout occurred shortly after the emergence
of a dominant design, that of mass production. But this does not mean that
this design is the cause of the shakeout. On the contrary, it is the result of
this process, which is necessarily a selection process. Although competition
between technologies is without any doubt an important aspect of techno-
logical change, the result of this competition is not determined by the intrin-
sic characteristics of these technologies but by the working of coordination
mechanisms.
Thus, similarities and differences between the EU and the US should be
attributed less to the market structures and behaviours themselves than to
their articulation with the monetary and financial conditions. The common
belief that the United States experienced a much bigger bubble than the
eurozone is false, so far as the corporate sector is concerned. During the late
1990s, European companies went on an even bigger borrowing and invest-
ment binge than did corporate America. Total corporate investment (capital
and financial) in the euro area rose from 14 per cent of GDP in 1997 to
24 per cent in 2000, eclipsing America’s investment boom. European firms’
corporate-financing gap (investment minus internal funds) rose from 4 per cent
of GDP in 1997 to a record 14 per cent in 2000 and most of that was filled by
debt rather than equity financing. Corporate debt has risen much more
dramatically than in America from 60 per cent of GDP in 1997 to 76 per cent
in 2002. This legacy of over-borrowing and over-investment is currently
holding back growth in the eurozone. Only general conditions of competi-
tion can explain these structural cycles that have been much more accentu-
ated in Europe than in the US. As regards the entry process, they also explain
that the main difference between the US and the EU does not lie in the num-
ber of firms that has been created in each industry (for example, biotech-
nologies) but in the post-entry employment growth which is much faster in
US than in EU companies. Not only entry-exit processes per se but also the
growth performance in the years after entry matter. An entry-exit process is
necessary but it must result in a new stabilized market structure that pro-
motes growth. Thus, the nature of the selection procedure is at stake, which
implies an assessment of the exact role played by imperfect competition in
this procedure and also of the influence of policies that contribute to deter-
mining the resource constraints. Empirical analysis of the pre-exit perfor-
mances of manufacturing firms shows that exiting firms are not always the
less productive ones (Bellone et al., 2003; Nishimura et al., forthcoming).
This might be due to the way both financial resources and human resources
are really allocated between the different firms. That is, this might be attrib-
uted to labour market working and labour organization, and to banking policy.
In other words, the emergence of competitive and efficient structures does
not depend on competition policy only.
This calls for a deeper understanding of the role of competition and regu-
lation policies. In our view a competition policy is no longer devoted to
maintaining a given market structure presumed optimal. A regulation policy
is no longer devoted to artificially creating industry conditions that would
be equivalent to the optimal ones. Out of equilibrium, a market structure

that maximizes the growth of productivity emerges as the result of the work-
ing of coordination mechanisms that are nothing but market connections
(imperfections). A regulation policy may help to establish these connections,
while a competition policy should be devoted to their control. These con-
nections are not market failures in the standard sense. They must not be
removed but put into place, and this may require monopolistic practices.
In short, a regulation policy needs to favour the emergence of market
structures that foster innovative choice. A competition policy should repress
misconducts that are an obstacle to innovation processes. As a matter of fact,
the same structure that promotes an innovative choice may lead firms to
capture rents to the detriment of consumers. This is the reason why compe-
tition policy must complete a regulation policy. This is also the reason why
it cannot be reduced to an intangible rule referring to an optimal market
structure.
Finally, competition and regulation policies cannot be dissociated from
macroeconomic policy. Growth processes require interventions that must
be narrowly articulated one with the other. It is not true, as the prevailing
growth philosophy goes, that growth would result from full competition
joined to a neutral macroeconomic policy. Contrary to common belief, we
need monopoly practices that articulate with active public policies in order
to make viable innovation processes. Maybe here lies the main difference
between the EU and the US.
Rebuilding cohesion policies: the new geographic challenge

The majority of the theoretical models dealing with the international
context repeatedly stress technology and institutions in the standard way as
the ‘fundamentals’ determining both the growth rate of different countries
and the spatial distribution of economic activities. The relevant attributes of
technology in this case are local externalities, transport costs, costs of com-
munication of new ideas and knowledge and R&D spillovers (Krugman and
Venables, 1995; Martin and Ottaviano, 1999; Baldwin et al., 2001). The way
to take advantage of technology when dealing with different countries and
regions of the world is the same as that advocated for given economies:
a perfectly competitive market, as assured in this case by a full liberalization
of world trade. True, there is the necessary inequality resulting from the
processes of agglomeration as a consequence of trade liberalization, and the
increasing returns associated with this agglomeration, but inequality does
not hamper all the countries engaged in international trade from taking
advantage of it. Thus, for example, in most models people from less devel-
oped countries are supposed to benefit from welfare gains due to the lower
prices of new consumption goods (with the underlying implicit assumption
that the loss of ‘industry’ most likely resulting from international competition
does not result in persistent unemployment).
These models miss the crucial question: what are the internal and external
coordination conditions that allow the effective appropriation of the potential
returns of technology, that is, those which make viable the process on which
growth actually depends? They also miss another crucial question: to what
extent do the relative size of the region or country and the demand comple-
mentary threshold make sense in the adjustment process?
In fact, the real difference between countries in Europe lies not in the
nature of an institutional arrangement that would be more or less close to
the benchmark, but in the coordination conditions, which, in the euro area,
are strongly related to the size of each country, and their implications for
the rationality of policy reaction. A small open country can always react effi-
ciently to a negative macroeconomic shock by reducing taxes and moderat-
ing wage increases, and hence attracting foreign capital flows. This is
justified by the fact that the demand for its goods and services is mainly an
external one. Although small countries exhibit low unemployment rates,
balanced budgets, and also higher inflation rates than the average, it is not a
solution for large countries to adopt similar measures through structural
reforms. A large country that would adopt the same adjustment measures in
relation with the same given rules would be engaged in a pro-cyclic policy
that would result in a cumulative downswing and higher unemployment
because the larger part of the demand is internal. This conflict is at the heart
of issues that the EU has to face. It explains political divergence between
Germany, France or Italy, on the one hand, Austria, Ireland or the Netherlands
on the other hand. It might become more acute with enlargement and
the required catching-up of the new member states, most of which are small
countries.
Within the EU, countries are not all converging towards the same pattern
of growth. Moreover, as a result of strong dynamic interdependencies, this
generates perturbations that hamper the overall growth process. This is so
because institutional architectures and policies do not focus on improving
coordination among different countries.
Conclusion
Reference to the comparison of the US and Europe’s performances, which is

today the leitmotiv of all arguments on economic policy, confirms the scenario
focusing on coordination failures that we have drawn.
On the one hand, poor growth and productivity performance in Western
Europe results from a reduced process of accumulation (also characterized by
strong fluctuations) due to a tight monetary policy, and more generally to a
wrong policy management. On the other hand, a stable and substantial rate
of investment is behind the positive productivity trend in the US. Ex post,
this is an obvious explanation of the difference. But behind these different
accumulation processes, different coordination mechanisms have been at
work, the one actually sustaining this process, the other failing to do so.
Different coordination mechanisms that cannot be reduced to the properties
of technology, price (and wage) flexibility or the character of incentive
systems, but involve the harmonization over time of all the elements
involved in the adjustment process.
Institutions matter. However, they have to be considered in relation to the
adjustment process required by structural change rather than in relation to
the presumed performance in the long run.
Their role has to be altogether redefined, to be one of helping reduce the

irregularity in the growth process generated by e.g. technology shocks and
generally innovation, rather than in determining the growth trend. They
do contribute to the latter by accomplishing the former task. Effective
institutional systems contribute to regular dynamic patterns, not those
that just incorporate stronger incentives for growth. The reason is that
innovation in its variety of forms is by its very nature a break up and implies
a discontinuity: e.g. a break up in the existing production structure and
markets. It brings about adjustment costs and specific problems of coordi-
nation between economic activities. Depending on the way these new
problems are dealt with, an economy’s growth is more or less regular and
accordingly the productivity and output gains reaped out of innovation
greater or smaller. The challenge is to render the technological and insti-
tutional evolution as gradual as possible. This being their appropriate role,
economic policy needs only go the same way.
(Gaffard and Punzo, 2005)
Note
This paper owes very much to my collaboration with Mario Amendola.
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Part III
Economies in a Global Context:
a Programme of Action
12
The Future of the International
Financial System
Paul Davidson
Despite the continuing support for the ‘Washington Consensus’ within the
IMF, the World Bank and the US Treasury, most astute observers of the inter-
national financial system recognize that there is something seriously wrong
with the existing system. Although many recognize the symptoms of a severe
malady in the system, few realize what the fundamental flaws of the system
are. Accordingly, few can prescribe the correct medicine to cure the illness or
a vaccine to protect the international financial system from relapse.
The calls for some changes to the international financial system appear to
come from many economists. For example, in an issue of World Development
(2000) there was a symposium where economists, including Irma Adelman,
Joe Stiglitz (who was then with the World Bank), Jim Tobin, Barry Eichengreen,
Stanley Fischer (who was then with the IMF) and myself recommended
reforms. Most of these recommendations are what I call plumbing reforms,
which attempt to put a patch on the current liquidity-leaking international
financial system (for example, transparency, a Tobin Tax, the IMF as lender
of last resort, uniform bankruptcy laws and so on) without altering the archi-
tectural foundation. As I point out in my book, Financial Markets, Money and
the Real World (2002) all these (marginal) plumbing solutions fail to remove
the fundamental flaws in the system.
The global economy is at a crossroads. It can try to muddle through with
the existing defective international financial system, hoping that marginal
plumbing patches will limit the depressionary forces of recurrent currency
crises to developing nations while sparing the major economies of the world.
Or we can produce a new financial architecture that eliminates international
financial crises and makes possible the potential of global full employment.
The Washington Consensus is the ‘conventional wisdom’
John Williamson coined the term ‘Washington Consensus’ in 1989, and

although it means different things to different people1 – and apparently
even different things, or at least different interpretations and emphasis, to
165
John Williamson at different times – the term does tend to reflect the
conventional wisdom regarding the policies necessary for an efficient inter-
national financial system. The Washington Consensus refers to ten reforms
recommended for all developing nations (Williamson, 2002):
1. Fiscal discipline
2. Reordering public expenditure priorities
3. Tax reform.
4. Liberalizing financial markets2
5. A competitive exchange rate
6. Trade liberalization
7. Liberalization of inward foreign direct investment
8. Privatization
9. Abolition of regulations that impede entry and exit of firms and market
competition
10. Securing property rights
The ‘three big ideas’ underlying these reforms are, according to Williamson,
‘macroeconomic discipline, a market economy, and openness to the world’
(Williamson, 2002). These ideas reflect the conventional wisdom regarding
the conditions necessary for global prosperity and stability.
As I will argue below (and in more detail in my book Financial Markets,
Money and the Real World, 2002) it can be shown that what most orthodox
economists mean by a policy of fiscal discipline will neither (1) avoid the
possibility of current account crises3 (in the 1990s, the US current account
deficit worsened), nor (2) produce a fully employed national or global eco-
nomic system. Trying to implement the consensus reforms with their
emphasis on fiscal discipline, the liberalization of financial markets, and the
free market competitive exchange rate has created some severe problems
for emerging market nations. So far the developed world has avoided the
contagious effects of these problems.
But if this is true, then why do so many intelligent economists (including
Nobel Prize winners) and policymakers endorse the ‘three big ideas’ of the
Washington Consensus. My immediate response to this query is embodied in
Keynes’s (General Theory, 1936, p. 158) quip: ‘Worldly wisdom teaches it is bet-
ter for reputation to fail conventionally than to succeed unconventionally.’
The fundamental flaws of the existing international

financial system
In the Spring 2003 issue of Harvard Relations Council International Review,

Nobel Prize winner Joseph Stiglitz stated what by now should be obvious to
all ‘Something is wrong with the global financial system … international
financial crises or near crises have become regular events.’ Noting that there
The Future of the International Financial System 167
have been 100 currency crises in the last 35 years, Stiglitz states ‘the question
is not whether there will be another crisis, but where it will be’. According to
Stiglitz: ‘This much is clear: the International Monetary Fund (IMF), whose
responsibility it is to ensure the stability of the global financial system, has
failed miserably in its mission to stabilize international financial flows,
arguably making matters worse.’
Thirty-five years ago, however, marked the beginning of the breakdown of
the most successful international financial system4 in the history of mankind,
the Bretton Woods system. Unfortunately, this fact did not stimulate Stiglitz
to raise the following questions:
(1) Despite the existence of the same IMF during the quarter century after
World War II, why did the Bretton Woods financial system tend to avoid
international financial crises?
(2) What was it about the international financial system during the Bretton
Woods period that encouraged (or at least did not hinder) year-after-year
of unparalleled rates of increase in the real GDP per capita for every nation
this side of the Iron Curtain?5
(3) Why were there such unparalleled growth rates even though every major
nation, including the United States, instituted some form of international
capital flow restrictions during the Bretton Woods period?
Instead Stiglitz focuses on the argument that under the current international
financial system international capital flows are a primary cause of these
recurrent international payments crises as every prudent nation (except the
United States) strives to maintain a surplus of exports over imports, that is,
each nation tries to obtain a net positive financial savings position from its
annual internationally earned income. Any net financial savings obtained
are added to the nation’s foreign reserves. Since the global economy is, in
essence, on a ‘dollar standard’, additions to a nation’s foreign reserves are
held primarily in the form of US Treasury bonds.
Washington Consensus advocates might respond that the 35-year-old
currency crisis disease described by Stiglitz occurs because: (1) national gov-
ernments have been profligate and do not exercise the necessary fiscal disci-
pline, while (2) simultaneously having permitted, or even encouraged,
fixities (rigidities) in labour and product markets, and (3) governments have
insisted that nations utilize a managed fixed exchange rate that does not
represent a competitive long-run equilibrium exchange rate – or what John
Williamson, in earlier years, referred to as ‘FEER’. (Williamson has champi-
oned the establishment of a FEER – fundamental equilibrium exchange rate –
target zone for the exchange rate, that is, a zone based on a fixed ‘competitive’
rate plus or minus 10 per cent. Williamson has argued that FEER would
simultaneously achieve internal and external balance.6)
The Washington Consensus is supported analytically by mainstream

economists’ macro models that implicitly assume the ergodic axiom which
allows that private sector decision-makers have rational expectations,7 and
that therefore unfettered private decisions in markets reliably predict future
economic outcomes. Consequently, if the government maintains fiscal dis-
cipline and unfettered financial, product, exchange rate and labour markets,
then the nation can never be afflicted with a currency crisis since ‘liberal-
ized’ markets immediately compute and establish the equivalent of FEER
and thereby achieve both internal balance at full employment8 and external
balance.9 This belief in the ubiquitous efficiency of free markets leads to the
Ronald Reagan query ‘Why should bureaucrats in Washington [or any other
seat of government] know better than the individual on how to spend the
earned income of the individual?’
In the absence of the ergodic axiom, as Nobel Laureate John Hicks (1977,
p. vii) has noted, decision-makers ‘know’ that the future is uncertain. Once
an uncertain future is recognized in one’s model, then, as Keynes’s liquidity
preference theory suggests, markets cannot always reliably predict the future.
This can lead to what some economists call financial market bubbles.
What both advocates of the Washington Consensus and critics such as
Stiglitz fail to recognize is that since the global economy is a closed economy,
there is an obvious connection between the problems caused by the propensity
to oversave in the closed economy of The General Theory and the ubiquitous
desire of all nations (except the United States) to pursue export-led growth
policy for the purpose of accumulating additional foreign dollar reserves.
This international oversaving propensity creates persistent high rates of
involuntary unemployment and liquidity problems for the global economy –
and this is true whether the global economy is on a fixed or a flexible
exchange rate system. For just as Keynes (1973) noted in his response to
Dunlop and Tarshis in the 1939 Economic Journal, significant involuntary
unemployment equilibrium can occur whether the price system is perfectly
flexible or has built-in fixities. In other words, in a global economy context,
Keynes’s analytical framework indicates that non-liberalized labour, product
and exchange rate markets and persistent government deficits are neither a
necessary nor a sufficient condition for the global economic system to have
a depressionary bias that can lead to liquidity (currency) crises.
What is the problem and what should

we do about it?
Stiglitz states: ‘At the center of the failures of the global financial system is
the global reserve system.’ Some countries, for example, Japan and China,
successfully run persistent export earning surpluses. Stiglitz correctly notes
that one country’s surplus must be some other nation or nations’ deficit.
Annual saved increments in a nation’s foreign reserves represent earned
international income that is not used to buy the products of the surplus
nation’s trading partners.
In essence, when any nation runs persistent goods and services payments
surpluses to accumulate foreign reserves, it is as if this nation is playing a
game of Old Maid and passing the black queen of unemployment and
indebtedness to its trading partners. Under the existing international finan-
cial system, nations stuck with the Old Maid must use a combination of
previously saved foreign reserves and/or international loans to pay for their
current period of excess of imports and to service their existing international
debts. Ultimately, as its foreign reserves dwindle and its international indebt-
edness increases, a deficit nation finds it increasingly difficult, if not impos-
sible, to service its outstanding international debt obligations.
To prevent default, the IMF can make new loans to the indebted nation.
The IMF loans require deficit nations to adopt ‘Washington Consensus’
reforms where (1) all domestic financial, labour and product markets must
be freed of institutional rigidities (including a government social safety net),
and (2) the nation must ‘tighten its belt’, that is, run fiscal surpluses and tight
monetary (high interest) policies. These belt-tightening policies depress the
nation’s economy in the hope that the consequently impoverished popula-
tion will drastically reduce purchases of all goods and services including
imports.
As the deficit nation tightens its belt, it tends to depress the export indus-
tries of its trading partners. Moreover, the nation’s increased international
indebtedness (as the IMF loans are added to the existing loans) enlarges the
deficit nation’s annual international debt service payments. Adding to this
burden is any decline in the nation’s exchange rate, as domestic residents
and foreign investors attempt to move their funds to a safe haven in another
country. Almost inevitably, the indebted nation cannot free itself from
the increasing weight of its hard currency international debts – except by
default. The result is a moribund economy, such as Argentina in 2002.
Citing John Maynard Keynes as the inspiration for his 2003 solution
to this currency crisis (liquidity) problem, Stiglitz suggests creating ‘global
greenbacks’ (known as special drawing rights – SDR) to be issued as handouts
(grants in Stiglitz’s terminology) to developing countries and other countries
in times of international financial difficulties. These SDRs can be converted
into hard currencies to service debts, buy imports, or supplement foreign
reserves. Unfortunately, such handouts are merely palliatives and not the
solution to the problem. Moreover, some countries will become SDR addicts,
and when the handouts end, the economic withdrawal symptoms will be
even more deadly.
The cure lies in creating a new international financial architecture, as
President Clinton called for after the 1998 Russian debt default. Unfortunately
Clinton’s clarion call went against the ‘Washington Consensus’ and therefore
was never seriously studied by Washington’s international economic
decision-makers. Stiglitz’s ‘global greenbacks’ solution fails to provide a new

architecture because he ignored some basic guidelines that Keynes indicated
were essential to avoid international financial problems and global recession-
ary forces in the post-World War II era.
Keynes and the international financial system
Keynes argued that the ‘main cause of failure’ of any traditional interna-
tional financial system, whether it was based on fixed or flexible exchange
rates, was the inability of the payments system actively to foster continuous
global expansion when persistent payment imbalances occurred. Keynes
wrote that this failure:
can be traced to a single characteristic. I call close attention to this,

because I shall argue that this provides a clue to the nature of any
alternative which is to be successful.
It is characteristic of a freely convertible international standard that
throws the main burden of adjustment on the country which is in the
debtor position on the international balance of payments – that is on
the country which is (in this context) by hypothesis the weaker and above
all the smaller in comparison with the other side of the scales which (for
this purpose) is the rest of the world.
(Keynes, 1980, p. 27)
Keynes concluded that an essential design improvement in any international

financial system requires transferring a major responsibility for payments
adjustment from the debtor to the creditor position. Keynes (1980, pp. 168–9)
also indicated: ‘We need a quantum of international currency … [which] is
governed by the actual current [liquidity] requirements of world commerce,
and is capable of deliberate expansion … We need a method by which the
surplus credit balances arising from international trade, which the recipient
does not wish to employ can be set to work … without detriment to the
liquidity of these balances.’
Accordingly, in Financial Markets, Money and the Real World (Davidson,
2002), I have embedded Keynes’s essential suggestions in a proposal to create
an international clearing union that is designed:
(1) To prevent a lack of global effective demand due to any nation(s)

oversaving by either holding excessive idle foreign reserves or draining
reserves from the system.
(2) To provide an automatic mechanism for placing a major burden of
payments adjustments on the surplus nations – since after all, the surplus
nation is in the better economic position to solve any persistent payments

imbalance.
(3) To prevent financial crises while providing each nation with the ability
to monitor and, if desired, to control movements of flight capital, or
movements of funds earned from illegal operations (for example, drug
money) or movements to avoid national taxes or to finance terrorist
operations.
(4) To expand the liquidity of the international financial system as global
capacity warrants.
(5) To encourage debtor nations to work their way out of debt rather than
await handouts, or bailouts, or to default on their international obligations.
There are eight basic elements in my clearing system proposal:
1. The unit of account and ultimate reserve asset for international liquidity
is the International Money Clearing Unit (IMCU). All IMCU’s are held only
by Central Banks, not by the public, in accounts on the books of the clearing
union institution.
2. Each nation’s Central Bank is committed to guarantee one-way convert-
ibility from IMCU deposits at the clearing union to its domestic money. Each
Central Bank will set its own rules regarding making available foreign
monies (through IMCU clearing transactions) to its own bankers and private
sector residents.10 Small-scale smuggling of currency across borders and so
on can never be completely eliminated. But such movements are merely a
flea on a dog’s back – a minor, but not debilitating, irritation. If, however,
most of the residents of a nation hold and use a foreign currency for domes-
tic transactions and as a store of value (for example, it is estimated that
Argentineans held over $5 billion in US currency at the turn of the century),
this is evidence of a lack of confidence in the government and its monetary
authority. Unless confidence is restored, all attempts to restore economic
prosperity will fail.
Since Central Banks agree to sell their own liabilities (one-way convertibil-
ity) against the IMCU only to other central bankers and the International
Clearing Agency while they simultaneously hold only IMCUs as liquid
reserve assets for international financial transactions, there can be no drain-
ing of reserves from the system. Ultimately, all major private international
transactions clear between Central Banks’ accounts in the books of the inter-
national clearing institution.
Proviso 2 permits a nation to institute international financial flow regula-
tions or controls. The primary function of capital flow regulations is to
prevent sharp changes in the bull–bear sentiment from overwhelming the
market by preventing rapid changes in exchange rate price trends; such
volatility can have devastating real consequences.
There is a spectrum of different capital controls available. At one end of

the spectrum are controls that primarily impose administrative constraints
either on a case-by-case or expenditure category basis. These controls include
administrative oversight and control of individual transactions for payments
to foreign residents (or banks) often via oversight of international trans-
actions by banks or their customers. Mayer (1998, pp. 29–30) has argued that
the 1997 East Asian currency problem was largely due to the interbank mar-
ket that created the whirlpool of speculation and that what is needed is ‘a
system for identifying … and policing interbank lending’ and banks’ contin-
gent liabilities resulting from dealing in derivatives. Echoing the Post
Keynesian theme that the economic financial system is not ergodic, Mayer
(1998, p. 31) declared ‘The mathematical models of price movements and
covariance underlying the construction of these [contingent] liabilities sim-
ply collapsed as actual prices departed so far from “normal” probabilities.’
Other capital controls include (a) policies that make foreign exchange
available but at different exchange rates for different types of transactions
and (b) the imposition of taxes (or other opportunity costs) on specific inter-
national financial transactions, for example, the 1960s’ United States
Interest Equalization Tax. Finally there can be many forms of monetary
policy decisions undertaken to affect net international financial flows,
for example, raising the interest rate to slow capital outflows, raising bank
reserve ratios, limiting the ability of banks to finance purchases of foreign
securities and regulating interbank activity as suggested by Mayer.
The recent experience of the IMF, as lender of last resort in the East Asian
currency crisis, imposing the same conditions on all nations requiring loans
for international liquidity purposes should have taught us that in policy pre-
scriptions one size does not fit all situations. Accordingly, the type of capital
flow regulations a nation should chose from the spectrum of tools available
at any time will differ depending on the specific circumstances involved. In
this brief chapter it would be presumptuous of me to catalogue what capital
regulations should be imposed for any nation under any given circumstances.
Nevertheless, it should be stressed that regulating capital movements is a
necessary but not a sufficient condition for promoting global prosperity.
3. The exchange rate between the domestic currency and the IMCU is set
initially by each nation – just as it would be if one instituted an international
gold standard. Since enterprises that are already engaged in trade have inter-
national contractual commitments that would span the change-over interval,
then, as a practical matter, one would expect that the existing exchange rate
structure (with perhaps minor modifications) would provide the basis for
initial rate setting.
Provisos 7 and 8 below indicate when and how this nominal exchange rate
between the national currency and the IMCU would be changed in the
future.
4. Contracts between private individuals will continue to be denominated

in whatever domestic currency is permitted by local laws and agreed upon by
the contracting parties. Contracts to be settled in terms of a foreign currency
will therefore require some announced commitment from the Central Bank
(through private sector bankers) of the availability of foreign funds to meet
such private contractual obligations.
5. An overdraft system will be established to make available short-term
unused creditor balances at the clearing house to finance the productive
international transactions of others who need short-term credit. The terms
will be determined by the pro bono publico clearing managers.
6. A trigger mechanism to encourage any creditor nation to spend what
is deemed (in advance) by agreement of the international community to
be ‘excessive’ credit balances accumulated by running current account sur-
pluses. These excessive credits can be spent in three ways: (i) on the products
of any other member of the clearing union, (ii) on new direct foreign invest-
ment projects, and/or (iii) to provide unilateral transfers (foreign aid) to
deficit members. Spending by way of (i) forces the surplus nation to make
the adjustment directly through the balance on goods and services.
Spending by way of (iii) permits adjustment directly by the current account
balance; while (ii) provides adjustment by the capital accounts (without
setting up a contractual debt that will require reverse current account flows in
the future).
Consequently, proviso 6 provides the surplus country with considerable
discretion in deciding how to accept the ‘onus’ of adjustment in the way
it believes is in its residents’ best interests. It does not, however, permit
the surplus nation to shift the burden to the deficit nation(s) through
contractual requirements for debt service charges independent of what
the deficit nation can afford.11 Moreover, as the current international debt
problems of African and Latin American nations clearly demonstrate,
creditors ultimately have to forgive some debt when they previously
encouraged excessive debt burdens. Under the current system, however,
debt forgiveness is a last resort solution acceptable only after both debtor
and creditor nations suffer from faltering economic growth. Surely a more
intelligent option is to develop an institutional arrangement which pre-
vents excessive debt servicing burdens from ever occurring. The important
thing is to make sure that continual oversaving12 by surplus nations can-
not unleash depressionary forces and/or a building up of international debts
so burdensome as to impoverish the global economy of the twenty-first
century.
In the unlikely event that the surplus nation does not spend or give away
these credits within a specified time, then the clearing agency would confis-
cate (and redistribute to debtor members) the portion of credits deemed
excess.13 This last resort confiscatory action by the managers of the clearing
agency would make a payments adjustment via unilateral transfer payments

in the current accounts.
Under either a fixed or a flexible rate system, nations may experience
persistent trade deficits merely because their trading partners are not living
up to their means – that is because other nations are continually hoarding a
portion of their foreign export earnings (plus net unilateral transfers). By so
doing, these oversavers are creating a lack of global effective demand. Under
proviso 6, deficit countries would no longer have to deflate their real economy
merely to adjust their payment imbalance because others are oversaving.
Instead, the system would seek to remedy the payment deficit by increasing
opportunities for deficit nations to sell abroad.
Proviso 6 embodies Keynes’s innovative idea that whenever there is a
persistent (and/or large) imbalance in current account flows – whether due
to capital flight or a persistent trade imbalance – there must be a built-in
mechanism that induces the surplus nation(s) to bear a major responsibility
for eliminating the imbalance. The surplus nation must accept this burden
for it has the wherewithal to resolve the problem.
In the absence of proviso 6, under any conventional system, whether it
has fixed or flexible exchange rates and/or capital controls, there can occur
an international liquidity crisis (as any persistent current account deficit
can deplete a nation’s foreign reserves) that unleashes global depressionary
forces. Thus, proviso 6 is necessary to assure that the international payments
system will not have a built-in depressionary bias. Ultimately then it is in the
self-interest of the surplus nation to accept this responsibility, for its actions
will create conditions for global economic expansion some of which must
redound to its own residents. Failure of the surplus nation to act, on the
other hand, promotes global depressionary forces which will have some
negative impact on its own residents.14
7. A system to stabilize the long-term purchasing power of the IMCU (in
terms of each member nation’s domestically produced market basket of
goods) can be developed. This requires a system of fixed exchange rates
between the local currency and the IMCU that changes only to reflect per-
manent increases in efficiency wages.15 This assures each Central Bank that
its holdings of IMCUs as the nation’s foreign reserves will never lose pur-
chasing power in terms of foreign produced goods, even if a foreign govern-
ment permits wage-price inflation to occur within its borders. Consequently,
the rate between the local currency and the IMCU would change with inflation
in the local money price of the domestic commodity basket.
If, however, increases in productivity lead to declining nominal production
costs, then the nation with this decline in efficiency wages (say of 5 per cent)
would have the option of choosing either (a) to permit the IMCU to buy
(up to 5 per cent) fewer units of domestic currency, thereby capturing all
(or most of) the gains from productivity for its residents while maintaining
the purchasing power of the IMCU, or (b) to keep the nominal exchange rate
constant. In the latter case, the gain in productivity is shared with all trading
partners. In exchange, the export industries in this productive nation will
receive an increasing relative share of the world market.
By altering the exchange rate between local monies and the IMCU to offset
the rate of domestic inflation, the IMCU’s purchasing power is stabilized.
By restricting use of IMCUs to Central Banks, private speculation regarding
IMCUs as a hedge against inflation is avoided. Each nation’s rate of inflation
of the goods and services it produces is determined solely by (a), the local gov-
ernment’s policy towards the level of domestic money wages and profit mar-
gins vis-à-vis productivity gains, that is, the nation’s efficiency wage. Each
nation is therefore free to experiment with policies for stabilizing its efficiency
wage to prevent inflation (or deflation). Whether the nation is successful or
not, the IMCU will never lose its international purchasing power. Moreover,
the IMCU has the promise of gaining in purchasing power over time if pro-
ductivity grows more rapidly than money wages and each nation is willing to
share any reduction in real production costs with its trading partners.
Proviso 7 produces a system designed to maintain the relative efficiency of
wage parities among nations. In such a system, the adjustability of nominal
exchange rates will be primarily (but not always, see proviso 8) to offset
changes in efficiency wages among trading partners. A beneficial effect that
follows from this proviso is that it eliminates the possibility that a specific
industry in any nation can be put at a competitive disadvantage (or secure a
competitive advantage) against foreign producers solely because the nominal
exchange rate changed independently of changes in efficiency wages and
the real costs of production in each nation.
Consequently, nominal exchange rate variability can no longer create
the problem of a loss of competitiveness due solely to the overvaluing of a
currency as, for example, experienced by the industries in the American ‘rust
belt’ during the period 1982–85. Although temporary, currency appreciation
can have significant permanent real costs, for example, industries may aban-
don markets and the resulting idle existing plant and equipment may be cast
aside as too costly to maintain.
Proviso 7 also prevents any nation from engaging in a beggar-thy-neighbour,
export-thy-unemployment policy by pursuing a real exchange rate devaluation
that does not reflect changes in efficiency wages. Once the initial exchange
rates are chosen and relative efficiency wages are locked in, reductions in real
production costs that are associated with a relative decline in efficiency
wages are the main factors (with the exception of proviso 8) justifying an
adjustment in the real exchange rate.
Under proviso 7 of our proposal the IMCU would provide its holders
with an invariant international monetary standard no matter whether
the domestic rates of inflation in the various nations converged (or not) or
accelerated (or not).
Although proviso 6 prevents any country from piling up persistent excessive

surpluses this does not mean that it is impossible for one or more nations
to run persistent deficits. Consequently proposal 8 below provides a pro-
gramme for addressing the problem of persistent export–import deficits in
any one nation.
8. If a country is at full employment and still has a tendency towards
persistent international deficits on its current account, then this is prima
facie evidence that it does not possess the productive capacity to maintain its
current standard of living. If the deficit nation is a poor one, then surely
there is a case for the richer nations who are in surplus to transfer some of
their excess credit balances to support the poor nation.16 If it is a relatively
rich country, then the deficit nation must alter its standard of living by
reducing its relative terms of trade with its major trading partners. Rules,
agreed upon in advance, would require the trade deficit rich nation to
devalue its exchange rate by stipulated increments per period until evidence
becomes available to indicate that the export–import imbalance is eliminated
without unleashing significant recessionary forces.17
If, on the other hand, the payment deficit persists despite a continuous
positive balance of trade in goods and services, then there is evidence that
the deficit nation might be carrying too heavy an international debt service
obligation. The pro bono officials of the clearing union should bring the
debtor and creditors into negotiations to reduce annual debt service pay-
ments by (i) lengthening the payments period, (ii) reducing the interest
charges, and/or (iii) debt forgiveness.18
If any government objects to the idea that the IMCU provisions provide
governments with the ability to limit the free movement of ‘capital’ funds,
then this nation is free to join other nations of similar attitude in forming a
regional currency union and thereby assuring a free flow of funds among the
residents of the currency union.
Some think that this clearing union plan, like Keynes’s bancor plan, a half
century earlier, is utopian. But if we start with the defeatist attitude that it is
too difficult to change the awkward system in which we are trapped, then no
progress will be made. Global depression does not have to happen again if
our policymakers have sufficient vision to develop this Post Keynesian
approach. The health of the world’s economic system will simply not permit
us to muddle through.
Notes
1. Williamson (2000) claimed that the term ‘Washington Consensus’ has developed
into something different from that which he intended. The Washington
Consensus concept had become what is often called ‘neo-liberalism’ or ‘market
fundamentalism’. Williamson indicated that Bresser Perreira patiently explained to
him that just because he invented the term he did not have intellectual property
rights to control its meaning. (One could suggest to Williamson that just because
Keynes invented the General Theory did not limit the perverse meaning that
neoclassical synthesis Keynesians and New Keynesians gave to the meaning of
Keynesian macroeconomics.)
2. Williamson (2000) indicated that he ‘long ago changed my description of
the fourth element of the Washington Consensus to “financial liberalization” ’.
Although the term ‘financial liberalization’ means that all regulations controlling
domestic as well as international capital flows should be abolished, Williamson
now argues that the liberalization of international financial capital flows might
have to be phased in, perhaps over decades.
3. For example even when the Clinton administration went from fiscal deficits to
fiscal surpluses.
4. Successful in the sense that during this period the average annual real growth
per capita was almost double the peak growth rate of developed nations during
the period of the industrial revolution, while the average real growth rate of
developing nations equalled or exceeded the industrial relolution growth rate
(see Davidson, 2002, p. 2).
5. For the figures see Davidson (2002, pp. 1–2). For an explanation see Davidson
(2002, pp. 225–8).
6. The internal balance implied an unspecified low rate of inflation that would be
associated with NAIRU, while the external balance was defined as maintaining a
current account balance that is ‘sustainable and appropriate’ in the medium term.
7. The ergodic axiom is one of the restrictive classical axioms that Keynes overthrew
in developing his general theory (see Davidson, 2002).
8. Or at least the natural rate of unemployment.
9. New Keynesians, on the other hand, often suggest that existing market fixities
slow down the market’s ability to establish FEER immediately and therefore they
argue for a gradual liberalization of markets, so that, in the long run at least, FEER
will be established.
10. Correspondent banking will have to operate through the International Clearing
Agency, with each Central Bank regulating the international relations and opera-
tions of its domestic banking firms.
11. Some may fear that if a surplus nation is close to the trigger point it could short-
circuit the system by making loans to reduce its credit balance prior to setting off
the trigger. Since preventing unreasonable debt service obligations is an impor-
tant objective of this proposal, a mechanism which monitors and can restrict such
pre-trigger lending activities may be required.
One possible way of eliminating this trigger avoidance lending loophole is as
follows. An initial agreement as to what constitutes sensible and flexible criteria
for judging when debt servicing burdens become unreasonable is established.
Given these criteria, the clearing union managers would have the responsibility
for preventing additional loans which push debt burdens beyond reasonable ser-
vicing levels. In other words, loans that push debt burdens too far could not be
cleared though the clearing union, that is, the managers would refuse to release
the IMCU’s for loan purposes from the surplus country’s account. (I am indebted
to Robert Blecker for suggesting this point.)
The managers would also be required to make periodic public reports on the
level of credits being accumulated by surplus nations and to indicate how close
these surpluses are to the trigger point. Such reports would provide an informational
edge for debtor nations, permitting them to bargain more effectively regarding
the terms of refinancing existing loans and/or new loans. All loans would still
have to meet the clearing union’s guidelines for reasonableness.
I do not discount the difficulties involved in setting up and getting agreement
on criteria for establishing unreasonable debt service burdens. (For some suggestions,
however, see the second paragraph of proviso 8.) In the absence of cooperation
and a spirit of goodwill that is necessary for the clearing union to provide a mech-
anism assuring the economic prosperity of all members, however, no progress can
ever be made.
12. Oversaving is defined as a nation persistently spending less on imports plus direct
equity foreign investment than the nation’s export earnings plus net unilateral
transfers.
13. Whatever ‘excessive’ credit balances that are redistributed shall be apportioned
among the debtor nations (perhaps based on a formula which is inversely related
to each debtor’s per capita income and directly related to the size of its interna-
tional debt) to be used to reduce debit balances at the clearing union.
14. As I point out (Davidson, 2002, pp. 225–8), the prosperity of the global capitalist
economy in the first 25 years after World War II was in large part due to the
fact that the Marshall Plan and other US foreign aid policies played the role that
proviso 6 sees for the surplus nation.
15. The efficiency wage is related to the money wage divided by the average product
of labour, it is the unit labour cost modified by the profit mark-up in domestic
money terms of domestically produced GNP. At this preliminary stage of this pro-
posal, it would serve no useful purpose to decide whether the domestic market
basket should include both tradable and non-tradable goods and services. (With
the growth of tourism more and more non-tradable goods become potentially
tradable.) I personally prefer the wider concept of the domestic market basket, but
it is not obvious that any essential principle is lost if a tradable-only concept is
used, or if some nations use the wider concept while others the narrower one.
16. This is equivalent to a negative income tax for poor fully employed families
within a nation.
17. Although relative prices of imports and exports would be altered by the change in
the terms of trade, the adjustment is due to the resulting income effect, not a sub-
stitution effect. The deficit nation’s real income will fall until its import surplus
disappears.
18. The actual programme adopted for debt service reduction will depend on many
parameters including the relative income and wealth of the debtor vis-à-vis the
creditor, the ability of the debtor to increase its per capita real income and so on.
References
P. Davidson, Financial Markets, Money and the Real World (Cheltenham: Edward Elgar,
2002).
J.R. Hicks, Economic Perspectives (Oxford: Oxford University Press, 1977).
J.M. Keynes, The Collected Writings of John Maynard Keynes, vol. 7, edited by
D. Moggridge (London: Macmillan, 1973).
J.M. Keynes, The Collected Writings of John Maynard Keynes, vol. 25, edited by
D. Moggridge (London: Macmillan, 1980).
M. Mayer, ‘The Asian Disease: Plausible Diagnoses, Possible Remedies’, Levy Institute
Public Policy Brief, no. 44 (1998).
J.E. Stiglitz, ‘How to Reform the Global Financial System’, Harvard Relations Council
International Review, 25 (2003), 54–9.
J. Williamson, ‘What the Bank Should Think about the Washington Consensus’, paper
prepared as background to the World Bank’s World Development Report (2000).
J. Williamson, Remarks to the Center for Strategic and International Studies, 2002.
World Development, 28 (June 2000), Special Section ‘Redrafting the Architecture of the
Global Financial System’.
13
and the Anatomy of
Russian Capitalism
Stanislav Menshikov
Introduction
In our book Capitalism, Communism and Coexistence (first printed in the

US in 1987 and subsequently translated into Russian, French and other
languages), Galbraith and I assumed that the centrally-planned economy of
Russia would slowly transform into a mixed system combining competitive
market mechanisms with active state intervention and a well-developed
social security infrastructure. Basically, we were following the concept of
socio-economic convergence between capitalism and communism, a con-
cept that was first suggested by Jan Tinbergen and John Kenneth Galbraith
and that was popular in the West in the 1970s and 1980s.
My own view at that time was that the Soviet system would slowly intro-
duce many essential features of the market economy while retaining certain
features of central planning, particularly in as much as it concerned long-
term capital investment and the determination of basic macroeconomic
proportions. I still believe today that such a course was best for my country
because in the long run it permitted the optimal combination of the best
and most efficient features of both capitalism and socialism and, in the short
and medium term, would have helped avoid the deformation and destruction
inherent in the shock transformation into capitalism.
However, the political forces that came to power after the forced resignation
of Mikhail Gorbachev and the dissolution of the Soviet Union, pursued a
different strategy which led to the prolonged deep economic crisis of
1992–1998 which reduced Russia’s GDP by more than 40 per cent. Even
today, after four years of economic recovery, the pre-reform level of GDP has
not been restored.
More importantly, the Russian economy, as it emerged in the last
decade or so, can be likened to an inertial system that is moving along a
trajectory that in the long run is self-destructive but extremely difficult to
change.
180
J.K. Galbraith and the Anatomy of Russian Capitalism 181
Russia’s inertial economic system and its prospects
The principal institutional features of this system are as follows:
● The prevalence of oligopoly and monopoly over competition.

● The dominance of oligarchic financial–industrial groups together with
a relatively weakly developed banking industry.
● The close fusion of the business oligarchy with the state while the role of
the latter in guiding the economy remains very weak.
● An excessively high share of gross profit in GDP and inappropriately high
inequality in the distribution of income and wealth.
● An excessively large share in GDP of the shadow sector, corruption and
organized crime.
These features of the system have given rise to certain negative regularities in
the behaviour of economic agents, as well as in macroeconomic dynamics.
For instance, the prevalence of oligopoly and monopoly has created a typ-
ical orientation of businesses to maximize profits less by increasing output
and sales than by maintaining inordinately high profit margins, that is, mark-
ups of price over cost. Average profit margins in manufacturing industry of
even 20 per cent are considered too low to warrant large long-term investment,
while the principal capital-generating sectors of the economy (all of them
export-oriented industries, such as oil and non-ferrous metals) are operating
at profit margins as high as 40–50 per cent.
Such a behavioural mode had already emerged in the early 1990s when
output was either falling or stagnating while high inflation was rampant.
In such an environment, increasing production was senseless and the only
rational tactic was short-term profit maximization by raising prices. In the
practice of those years, cases when companies tried to beat competitors by
underselling were extremely rare if not totally unknown. On the contrary,
every possibility and pretext was used to raise prices even when it was per-
fectly feasible to increase output by squeezing competitors off the market.
This was the rule for big and even middle-sized concerns, which dominated
both national and regional markets and used non-economic means, often
sheer force, to eliminate rivals. That was one reason, besides corruption and
the spread of organized crime, why small business never grew in importance
in the Russian economy.
After the financial crisis of 1998, the overall competitive power of domes-
tic producers in internal markets improved due to the drastic devaluation
of the ruble, and it became possible to reduce competition of imported goods.
This, for the first time since privatization, allowed profit maximization by
increasing output, not simply by marking up prices. But even in these more
favourable circumstances firms took care to raise output in such a way as to
avoid reducing profit margins. Naturally, this helped prolong inordinately
high inflation and led to a fairly fast loss of competitive advantages created
by devaluation.
In foreign economies, the prevalence of oligopoly and non-price competi-
tion often strongly stimulates qualitative changes in the utility of goods and
induces the quest for new products thus creating market niches that bring at
least temporary rents or super-profits. In Russia, however, this mode of
behaviour has not become typical. The old rule under which oligopoly and
monopoly put a brake on technical progress and product differentiation still
prevails.
It does not mean that Russian companies wholly refute exploiting new
niches in principle. No, they do so willingly but only, as a rule, when new
products have already been created abroad and all that remains is to adapt
them to the Russian market. Typical instances are the quick spread of cell-
phones and internet networks. But there are practically no examples of new
products of domestic origin, save in the defence area. Even large and poten-
tially strong companies in the automobile and civil aircraft industries where
regular model changes are a must, have not been able to achieve competitive
advantage and expand output of new products to satisfy available demand.
One of the reasons is the strong reluctance to invest capital on a long-term
basis into modernizing production equipment and building new plant. In fact,
as Western experience shows, regular changes in technologies and products
necessitate continuous large expenditures repayable only on a medium and
long-term basis. Most Russian companies, even large ones in possession of
necessary capital resources, do not have a long-term strategy of that sort. In
more than a decade of its existence, Russian capitalism had not built a single
brand-new large plant (that was not started in Soviet times) and has satisfied
its production needs mainly by exploiting existing under-utilized capacities
or formerly discovered and developed mineral resources.
Even in such a highly profitable sector as oil and gas, new capital con-
struction has been practically limited to export-oriented pipelines built and
financed by the state. Only in recent months, have private oil companies
expressed their intention to participate in the construction of new pipelines
of export orientation (from Siberia to Murmansk for export to the US and to
Da-tsin in China and the Far Eastern port of Nakhodka for export to Japan).
The only large new hydroelectric Burei dam, started in Soviet times, was put
into operation last year with great fanfare by the state-owned electric power
monopoly with President Putin in person on hand to mark the event.
Similar results in terms of stagnant technical progress and skewed capital
investment are brought by the dominance of oligarchic industrial and financial
groups. As a rule, these groups were created by capitalists who earned their
first tens of millions in murky financial and other speculative operations.
Their principal interest was not in developing and modernizing production
but in capturing the most profitable former government-owned assets and
using them for personal enrichment. In most cases, these were oil and metals
concerns of primary export orientation, which after being captured by a few

financial groups were reorganized as oligopolies. Today five leading concerns –
YUKOS, Sibneft, LUKOIL, BP-TNK and Surgutneftegaz – control 80 per cent of
the Russian oil industry; two concerns – Rusal and SUAL – control 95 per cent
of the aluminium industry; only one concern – Norilsk Nickel – controls
practically all the production of nickel and palladium.
In most groups, banks were the initial main source of primary capital
accumulation that was used to buy at bargain basement prices the profitable
mineral resource companies. After these new super-profit bases were taken
over, they – instead of the banks – became the group centres. As to the banks,
most of them, particularly after the 1998 financial crisis, were bankrupt and
lost their importance as the principle source of profits. They now became
auxiliary links, servicing and coordinating the cash flows of companies com-
posing the groups. This precluded the normal development of the banking
sector as a public utility industry serving the economy at large rather than
limited groups of insider clients.
The following is a typical description of the operations of the MDM Bank,
which is part of an oligarchic group, and closely related companies: ‘Normal
banking business has been absent in the bank during recent years. Loans
were issued mainly to group insiders while the bank itself played the role of
the exchequer for companies belonging to the group, helping optimize their
cash flows for tax purposes. Well, if there is a Russian bank that did not
engage in such activities, let it first throw a stone at MDM’ (www.gazeta.ru,
15 March 2003).
At a certain stage, such a narrow bank specialization might satisfy the
short-term interests of the principal shareholders of the groups’ companies.
However, it is already coming into conflict with their longer-range interests,
for instance in maximizing market capitalization with a view to selling out
to foreign investors. The latter would not be greatly interested in buying closed
institutions with a limited number of active clients and a narrow deposit
base. That is why some groups have been acting to increase their banks’ retail
business and local branch networks, opening up financial accounts to the
public and separating normal commercial banking business from offshore
and other money laundering operations. These developments are essential
for attempts to list shares of Russian banks on international stock exchanges
and thus lay the basis for boosting their market capitalization.
It is clear that normalization of the Russian banking industry could well pro-
ceed without necessarily integrating it into foreign banking empires. The
groups’ leaders should be vitally interested in expanding their credit activities to
a much wider range of companies beyond their own insider groups. They
should be particularly interested in promoting loans to small and medium-sized
businesses, increasing consumer credit and mortgage loans. But these areas are
slow to develop. Short-term profit maximization still largely determines narrow
group servicing as the top priority.
This phenomenon is not confined to the largest centrally located banks.

Regional and local banks have been following the same model by orienting
their operations to the immediate needs of their principal stockholders and
their companies. Thus, smaller oligarchic financial and industrial groups
have become widespread at the regional and local level. Having one’s own
bank is extremely advantageous for local tycoons who may have difficulty in
finding access to funding from the larger banks in Moscow or St Petersburg.
Living is easy under one’s own roof.
Economic development is also impeded by the close fusion of the business
oligarchy with government structures at all levels – central, sectoral, regional
and local – while government stimulation of macroeconomic activity remains
extremely weak. Contemporary market economies know two different mod-
els of interrelationship between business and the state. In one model, the
government acts in the interests of the business class as a whole. By keeping
equal distance from all principal business groupings the state can act in the
interests of the entire system and help maintain its stability. If the system
deviates from equilibrium and enters a recessionary phase the state will help
correct emerging imbalances even if its corrective activities conflict with the
interests of some groups of the business elite, and induce the economy to
return to equilibrium.
In the second model, the state is largely dependent on one or a few influ-
ential oligarchic groups. Since overall stability often conflicts with the inter-
ests of these groups the role of the state as the means to correct imbalances
and disproportions is necessarily weakened. Governments in this case tend
to lag behind private interests rather than lead them. This can negatively
affect general economic conditions and preclude economic development at
full capacity and top feasible speed.
In reality, none of the two models usually exists in its pure form. In current
market economies, both models are usually intertwined. But, as a rule, it is easy
to see which one of them prevails.
In Russia, their interrelationship is not straightforward. Some spheres are
so strongly dominated by oligarchic groups that central and regional authorities
are unable to influence their activities. Under Boris Yeltsin, not only his so-
called ‘family’, that is, a closely related group of businessmen and govern-
ment officials, was for all practical purposes subservient to a few oligarchs,
but most of the government bureaucracy was subordinated to various business
groups and acted in their interests. At times, the state resembled a manager
for clans of businessmen and corrupted officials, interlocked with organized
crime.
Vladimir Putin proclaimed equal distance of the state from the oligarchs
and declared his intention to act as arbiter vis-à-vis the business elite. It looked
like the former direct fusion of the central authorities with concrete oli-
garchic groups was coming to an end. However, the Yeltsin era institution of
meeting in the Kremlin with selected business leaders became even more
regular, as well as attempts to coordinate policy with the principal organizations

of big business. On the other hand, there are clear signs of proximity of the
president to certain new business groups that played second fiddle under
Yeltsin but would like to use their newly acquired influence in order to
capture profitable and not yet privatized chunks of government assets.
These battles proceed with mixed results. The Mezhprombank group
(allegedly close to Putin) was unable to gain control over the Slavneft oil con-
cern, which (with the support of former prime minister Mikhail Kasyanov) was
won instead by the Alfa group led by Mickhail Fridman and Viktor Vekselberg.
But Alexey Miller, whom Putin appointed to run Gazprom instead of former
boss and tycoon Rem Viakhirev, managed together with other men from
St Petersburg to consolidate control over the gas monopoly. The same group
decisively squeezed rivals out of another area – control over armaments
exports. It also looks as though the electric power industry might eventually
be taken over by people close to Putin. And the outcome of the Kremlin’s
attack against Khodorkovsky’s YUKOS is at this point predicted to lead to the
merger of that company or a large part of it into a large new oligarchic group
of banks and companies controlled by Putin and his loyalists.
It turns out that the government-arbiter model is closely intertwined
with rivalry inside the government for redivision of property and high profit
niches. But it is evident that Putin is not out to destroy the dominance of
oligarchic groups. Rather, he is integrating his own sphere of business interests
into the prevailing oligarchic structure.
This approach is also consistent with the neo-liberal model of economic
policy according to which the state should care firstly for creating a generally
favourable atmosphere for economic development by conducting reforms in
the interests of business, but should minimize its active intervention in the
economy. This model serves as the basis of the economic policy of Putin’s
government and in principle precludes any active role of the state in correct-
ing existing imbalances and restoring macroeconomic equilibrium.
One has to bear in mind that the neo-liberal model is more or less successful
in economies that grow evenly, without large fluctuations and do not suffer
from large structural imbalances. In such economies, the role of government
intervention can indeed be minor because the market mechanism tends to
spontaneously correct small temporary imbalances and fluctuations.
However, the same model when applied to the Russian economy of today is
not practical and is even harmful.
One of the two largest structural imbalances in the Russian economy is its
undue dependence on exports of energy and raw materials while other
sectors, including manufacturing, are relatively undeveloped and stagnant.
The basic reason for this imbalance is the skewed distribution of gross profit
in the economy, which tends to be continuously reproduced and has
no spontaneous mechanism for self-correction. In normally functioning
competitive markets, prolonged large deviations of sectoral profit rates from
the macroeconomic average are not possible. If profitability in one sector

substantially exceeds the average, capital tends to flow into that sector until
profitability there is equalized. This mechanism does not work if inter-sector
flow of capital is inhibited by economic, natural or other barriers. In the case
of oil and non-ferrous metals in Russia, these barriers do exist. Oil deposits
are captured by a narrow group of companies that use natural and geographi-
cal factors to close entrance to new competitors.
Equally important is the reverse effect. Since the gap in profitability
remains, excess capital created in the energy and raw materials sector fails
to find its way into other sectors where profitability is much lower. A vicious
circle is created, a trap that normal forces of competition cannot overpower.
In the competitive model, super-profits gained due to natural rent from
mineral resource exploitation are partly or wholly appropriated by the owner
of the land. In Russia, as in many other countries, private property of land is
recognized but the state still retains ownership rights to land that lies above
the deposits of oil, gas, metal ores and so on. Exploitation of mineral resources
by private companies is subject to licences granted by the state. The latter
therefore has the title to all or most of the mineral rent – above normal prof-
its earned by private leaseholders. In the early 1990s, licences for these pur-
poses were granted at bargain basement prices, that is, practically for free.
But this is not necessarily a final decision. If the government decides to
extract a much larger share of the rent than it collects today, it has all the
rights to do so. The exact share to be taxed is a matter of economic expedi-
ency, that is, determined by the need to equalize sector rates of profit as far
as possible and practical. Even the neo-liberal minded current government
seems to agree that movement in that direction is essential. The major
impediment is not so much technical issues of rent taxation, but rather the
active opposition of oligarchic groups that have considered themselves the
owners of the nation’s mineral resources and do not wish to share their
excessive incomes with other sectors of the economy.
The government attack on YUKOS involves partial redistribution of oil
rent to the state budget, but it solves the problem as an individual company
case, not as an industry rule. Other oil companies continue to appropriate
their excessive rent from oil, at least for now.
The refusal or delay in resolving this issue serves to impede Russia’s economic
development. GDP growth rates depend on growth of its sector components.
If half or more of capital investment continues to go into energy and raw
materials, then the overall growth rate of GDP will be determined by growth
in that sector. But because it is export-oriented its growth rate will be tied to
growth in foreign demand, that is, to average growth rates of the world econ-
omy. In this case, one can well forget the need to expand at much higher
rates as demanded by President Putin.
Faster rates of GDP growth are only possible under quick expansion
of manufacturing, which is oriented towards domestic markets and is not
restricted by the average growth rates of the world economy. And the only
means to accelerate growth in manufacturing is to re-channel excess capital
created in the ‘rent’ sector into other branches of the economy. Accomplishing
such redistribution without active government intervention is impossible.
But the state can only perform this manoeuvre if it gets rid in deed, not only
in words, of its dependence on the oligarchic groups that have saddled the
‘rent’ sector.
But even apart from resolving this crucial issue, the role played by economic
policy in Russia is extremely weak. The government refuses to use practically
any active forms of fiscal policy. For instance, such well known ways to stim-
ulate growth as government purchases of goods that are temporarily in poor
demand or government-financed investment into infrastructure are completely
ignored by the authorities. Even in tax policies – the only fiscal sphere where
evidence of government intervention is seen – the state acts very indecisively
and considers short-term fiscal objectives to take precedence over long-term
needs to stimulate economic growth.
Almost entirely absent is any trace of active monetary policy. The principle
government economic activity is to promote so-called structural reforms
that are centred on privatizing those parts of the economy that are still run
by the state. In the process, control by oligarchic groups is strengthened
even more while the stimulatory role of the state is further diminished.
At the same time, the role of government in reforming such crucial spheres
as the banking industry and capital markets is close to zero.
Neither has the Russian government used the powerful weapon of industrial
policy to help develop competitive domestic manufacturing and high-tech
industries. The industrial structure remains stagnant despite quantitative
growth and there is no interest shown either by business or the government
in promoting the ‘new economy’, that is, computers and informatics. In
terms of technical progress the country is completely stagnant.
A major result of oligopoly and oligarch dominance in the economy is
the permanently excessive share of gross profit in GDP and consequently the
continuously low share of wages and salaries (labour income). Apart from
the major sector imbalance cited above this is one of the principal reasons
for the narrowness of the domestic market and the impossibility to fully
utilize all capital generated inside the country. Even if the sectoral imbalance
were to be corrected, the remaining disproportion between gross profit and
labour income would preclude accelerated economic growth.
With gross profit exceeding 40 per cent of GDP the share of labour income
(after deducting net indirect taxes) stands at only 43 per cent. This explains
why personal consumption expenditure is less than half of GDP. Together
with the average share of gross capital investment at 16 per cent this is only
66 per cent of GDP. In other words, total output can be fully sold if govern-
ment purchases and net exports amount to 34 per cent of the total. Because
government purchases on the average take out another 16 per cent, a full
18 per cent has to go to net exports. This is only possible if an exorbitant part
of fuel and raw materials is sold abroad at high prices.
It is unrealistic to believe that this condition will remain for long. A better
decision is to slowly but surely increase the share of labour income and
consequently of consumer expenditure in GDP. This should help expand
domestic markets for products of Russian manufacturing.
The low share of labour income in GDP is another way of saying that
distribution of income in Russia is extremely unequal and that inequality
has sharply increased in the last decade. The gap between the top and lowest
income quintiles of the population reached 6.4 times by 2000, as compared
with only 2.6 in 1991. In the same period the Gini coefficient increased from
0.26 to 0.39. Regional and sector differences in average personal income are
extremely large, making Moscow look like a relatively booming oasis sur-
rounded by a provincial Sahara of widespread poverty, most of it permanent
and self-reproducing. A quarter of the population is living below the official
poverty line and another 45 per cent can be considered as on the brink of
poverty. According to the latest surveys by retailer research organizations
60–75 per cent of the population spend practically all their disposable
incomes on food. Only 15–20 per cent at the most match the definition of a
middle class, reducing effective consumer purchasing power to a very small
minority. To put the issue into an international perspective, Table 13.1
compares Russian figures on GDP composition with relevant US data for the
decade of 1989–99.
In the US, with more normal shares of gross profit and labour income, the
total share of personal consumption and gross capital investment is as high
as 82 per cent. Since government purchases account for 18–19 per cent
on the average, practically the whole national output is sold inside the coun-
try while a relatively small export share is fully compensated by adequate
imports.
Table 13.1: Dynamic proportions of Russian and US economies

(% shares in GDP)
Russia (1998–2001) US (1989–99)
Gross profit 40.7 34.9

Labour income 42.9 57.2
Personal consumption 49.7 66.8
Gross capital investment 15.7 14.9
Personal consumption 65.4 81.7
and gross investment
Government purchases 16.5 18.9
Net exports 18.1 ⫺0.6
Sources: Russian Statistical Yearbook (2002); Economic Report of the President of

the US (2000).
Increasing the share of labour income and reducing the share of gross
profit would allow the Russian economy to be relieved of its undue depen-
dence on external markets and create a solid foundation for sustained eco-
nomic growth oriented mainly towards the domestic market. There is no
need to decrease the share of capital investment, which is large but struc-
turally disoriented. A larger share of gross profit should be spent on mod-
ernizing and expanding productive fixed capital with the aim of reducing
the capital–output ratio and increasing economic efficiency of investment.
Making this turnaround within the bounds of neo-liberal economic policy
is hardly possible, at least not in the short or mid-term perspective. It is
therefore easy to project the direction of further economic development in
Russia in the absence of necessary corrections.
1. The economy would continue at best to grow at moderate speed that

would not permit a substantial reduction of the current gap between
Russia and industrial nations of the West in per capita GDP and living
standards. In the worst case, a drastic fall in oil and raw materials prices
will put a brake on growth and make the income gap even larger, not
smaller.
2. Technical progress will continue to stagnate, and most Russian industries
will remain non-competitive in world markets. Russia will not be able to
escape from its current position on the periphery of the world economy
and will retain its extreme dependence on the industrial world for at least
one or two decades. It is quite possible that control over key economic
assets in the country will be captured by foreign transnational companies.
3. At average growth rates and the further decline in the share of the state in
GDP, the sphere of redistribution of income will become even narrower
and the conditions for financing education, medical care, science and art
will become even worse.
4. At the same time and for the same reasons, it will become impossible to
maintain Russia’s military potential at levels necessary to guarantee its
national security. Russia’s role as a global power would further diminish
due to its economic and military weakness.
Such a perspective is not one to the liking of the Russian elite or the majority
of its population. The question arises as to possible alternatives.
Possible alternatives and policy solutions
To find alternatives to Russia’s economic inertia means determining ways to

change the current mechanism described above.
Maximalist ways have been suggested that amount to destroying the very
foundations of monopoly and oligarchic control and making the state a truly
independent and active agent helping form long-term economic processes
both in the various industrial sectors and the economy at large. These
suggestions include renationalizing some key industries and operating a
large government-owned sector within the framework of a mixed economy,
which would largely retain the principal contours of private entrepreneurship
and a market economy.
It is the consensus of most Russian economists that retaining and expanding
the market is necessary for maintaining equilibrium at the micro, meso and
macro levels. But it is also admitted that while markets are necessary to
maintain long-term proportions, they are not in a position to correct major
structural imbalances when the latter tend to become too large and rigid.
To make the necessary adjustments, the state should play a more active
role. But a substantial number of economists would argue that large-scale
renationalization at this point would be destabilizing from a political, social
and economic perspective.
A more realistic approach would be to try to tackle the same issue by
avoiding a wholesale breakdown of oligopolies and oligarchic groups but by
placing certain adequate limitations on their activities. This is possible if the
state is transformed into a truly independent power that would be able and
willing to induce oligarchs to adhere to certain clearly defined rules of eco-
nomic behaviour and refrain from attempts to unduly impose their will on
formulating policies.
In practice, even this minimalist approach could lead to sharp confronta-
tions with forces within the elite that are closely connected to the oligarchs
and are defending their interests. It is no secret that most of the leading
newspapers in the country belong to oligarchic groups and that at least some
electronic mass media are under their strong financial influence. Some polit-
ical parties fighting for seats in the parliament are known to be financed by
big business. Its strong influence can be also seen at the level of important
provincial governors and large city mayors. Fighting for meaningful anti-
oligarchic reform in these conditions is extremely difficult.
Yet, it is quite possible and indeed indispensable to educate the elite and
the population in ways to see realistic alternatives to current economic policies
and the dire need for them to be implemented in the national interest. One
has to bear in mind that there is no unanimity on these issues at the top of
the government. For instance, Vladimir Putin made quite a sensation three
years ago in his State of the Nation address to parliament when he suggested
redistributing mineral rent to other sectors of the economy. Following the
president’s initiative, some taxes were indeed raised on oil companies but
these changes were relatively minor and did not resolve the major imbalance
issue.
In the last two years, the government, while remaining under strong pressure
from the oil lobby, has officially recognized the need to improve the oil and
raw materials imbalance in the economy. A project was suggested to reduce
taxes for manufacturing industries while retaining them at current levels for
the oil and raw materials industries. This shows some movement in the right
direction but the rate of change is small, practically close to zero.
Of late, the authorities have been raising the issue of reconsidering some
of the results of privatization in the early 1990s. The issue become non-
academic when billionaire YUKOS shareholders Mikhail Khodorkovsky and
Platon Lebedev were arrested in 2003 and brought to trial on charges of ille-
gally appropriating government-owned assets and gross tax evasion. But, as
mentioned above, the drive against YUKOS is still an exception and does not
signify a drastic break with neo-liberal policies.
One of the neo-liberal dogmas is that the state should not be involved
in the economy. This may be true in countries where business is active in areas
that are particularly crucial for maintaining a healthy economy. But in Russia
this is not the case. For instance, the major structural imbalance between
mineral resources and manufacturing would not have occurred had the gov-
ernment retained ownership of the largest oil companies instead of selling
them practically for nothing. Had that happened, the issue of taxing mineral
rent would not have emerged as a major structural problem. It is not true
that privately-run oil companies show a better performance than govern-
ment-owned concerns. A careful comparison of financial reports of pri-
vately-owned YUKOS and Sibneft with that of government-owned Rosneft
shows very similar rates of reported net profitability. There is nothing par-
ticularly new in terms of products or technology that private concerns have
introduced into the enormous Soviet-built oil industry since they took over.
The same is true of the aluminium or nickel industries.
But that is ancient history today. The most pressing problem is how to
make the state the major recipient of rent earned on its oil properties. This
could be done by keeping the private oil companies running as they are but
changing the ways in which their incomes are taxed.
A recent suggestion to tax excessive rent incomes is worth considering.
A tax on mineral rent (that is, super-profit above economic or industry aver-
age) is one obvious solution. For instance, any profit exceeding the average
of 20 or 25 per cent of gross revenues should be considered a super-profit and
taxed at, say, 50 or more per cent compared with the current normal profit
tax rate of 24 per cent.
Another proposal is to introduce special taxes on capital gains of the
oligarchs and on their dividends transferred out of the country. The dividend
proposal is straightforward and provoked by two recent dividend payments
of $1 billion each by Sibneft oil company, which is obviously pure mineral
rent that has not been taxed by the government and is way above the com-
pany’s needs for domestic investment. Ninety per cent of Sibneft shares are
known to belong to Roman Abramovich. The point is that the $1.8 billion
paid out to this gentleman was officially taxed at only 4 per cent under the
existing more than liberal tax laws. That in itself is socially unfair since the
flat personal income tax rate is set at 13 per cent.
In addition, the money is being spent outside the country, including

Mr Abramovich’s $300 million acquisition of Chelsea soccer club in Britain,
buying a $90 million luxury yacht allegedly registered in the Bahamas and
ordering a new Boeing 767 for his personal use. Large dividends in excess of
$10 million should be taxed at a minimum of 50 per cent and, when trans-
ferred abroad, at an even higher rate of, say, 75 per cent. This would be a fair
means of returning at least some of the mineral rent appropriated by the
oligarchs due to lax taxation in former years.
The capital gains tax proposal is a more tricky affair. For instance, in the
case of YUKOS, which in 1995 was bought for a meagre $300 million and
saw its market capitalization rise to a maximum of $33.1 billion by early
August 2003, the capital gain for the major stockholders who own above
70 per cent of the total is enormous. The reasoning is that it can be taxed
only if turned from paper into cash profits. However, there is an interesting
precedent. In the UK, following Margaret Thatcher’s privatizations, a rule
was set obliging the new owners of the privatized companies to pay a tax of
38 per cent on the capital gain in market value of their shares in the period
between their initial acquisition and a certain future date. This precedent
could also be used in Russia to help return part of the oligarchs’ windfall
profits to the government.
Alternatively, they should be taxed on the market value of their property
at a rate that is certainly higher than the 1 per cent or less tax applied to per-
sonal worth and is so small that its collection is ceded to municipalities.
Applying a tax on marketable personal assets of, say, 4 per cent would have
Khodorkovsky pay at least $320 million annually to the federal exchequer
on his $8 billion fortune. Making the tax reversible to previous years would
go a long way towards compensating the state for selling YUKOS way below
its market value.
Another pressing issue is to make easier the transfer of excess capital from
oil and non-ferrous metals into manufacturing and particularly high-tech
industries. Apart from creating additional government-run financial institu-
tions to compensate for the underdeveloped banking sector, the government
should take special measures to promote the expansion of the capital market
as a major channel of capital flows into capital-deficit industries. Special care
should be given to reforming the banking industry into a genuine public
utility, expanding the insurance business, mortgage and consumer credit,
various forms of mutual and other investment funds. When private capital is
unwilling to adequately invest in these activities, the government should,
at least on a temporary basis, set up its own institutions to close the gap.
The same is true of government concerns that could lead in developing
competitive manufacturing industries where private capital is slow and reluc-
tant to do so. The automobile, aircraft and computer industries are examples
which easily come to mind. Mixed ownership could act as a good start to spur
these largely dormant areas. German and French experience (Volkswagen,
Renault and other examples come to mind) could be used in these exploits.
Another essential area of alternative economic policy is the consistent

improvement of macroeconomic proportions in order to ascertain the nor-
mal expansion of the domestic market and adequate growth rates of the
economy. The comparison with the US illustrated above shows the inordi-
nately low share of labour income in the Russian economy. But the share of
labour income in the US was not always as high as it is today. For instance, it
was only 49 per cent of GDP in 1929 – practically the same low level as in
Russia (see Table 13.2). However, in the following decades it increased to
58–59 per cent and has oscillated around that level in the last 30 years. If such
an improvement was possible in the typical market economy of the US, it
should be possible in Russia as well, and without contradicting market rules.
In the US, this happened as a result of major structural and institutional
changes. Most of these occurred in the first two decades after World War II
and largely under the administrations of the Democratic Party (Truman,
Kennedy and Johnson) which pursued reforms in the spirit of John Maynard
Keynes and the welfare state. This led to a substantial increase of the share in
GDP of government purchases and the larger role of trade unions in deter-
mining wages. Consequently, the structure of domestic macroeconomic
demand changed drastically.
In 1929, personal consumption accounted for 75 per cent of final domestic
demand, gross investment for 14 per cent and government purchases for
only 9 per cent. This structure is consistent with relatively low taxes that do
not present a substantial deduction from either personal consumption
demand or from companies’ resources for capital investment. In 1929, tax
deductions accounted for only 2.7 per cent of total personal income and
only 13.5 per cent of corporate gross profits.
This is what big business in Russia considers an ideal macroeconomic
structure today. But that 1929 structure led to the Great Depression, in
which consumption demand turned out to be grossly inadequate and the
economy was helpless in the absence of government anti-cyclical policies
and stabilizers. That lesson has been largely forgotten today, but it is worth
recalling. Russia is not at all immune from depressions of the old US type.
Table 13.2: Macroeconomic proportions in the US, 1929–99

(% of GDP)
1929 1957 1981 1999
Labour income 49 56 59 58
Personal consumption 75 62 62 68
Gross investment 14 15 17 17
Government purchases 9 22 20 18
Net exports 0 1 0 ⫺3
Gross profit 44 36 34 35
Investment as % of gross profit 34 42 50 49
Source: Economic Report of the President of the US (2000).

But America was then so apprehensive of a possible repetition of the Great

Depression that it reached the necessary conclusions. By 1957, the share of
personal consumption in GDP fell to 62 per cent, but government purchases
rose to 22 per cent, fully compensating for the potential loss in aggregate
demand, while gross investment remained practically unchanged at 15 per cent.
The new structure of final demand reflected the increased role of government
as a factor of economic stability and was consistent with higher taxes. Tax
deductions from personal income rose to 11.5 per cent (on the average),
taxes on corporate profits rose to 48.7 per cent. The personal tax increase by
8 percentage points ‘ate up’ part of consumer demand, but because the share
of labour income rose by 7 percentage points – from 49 to 56 per cent of GDP –
one compensated for the other. It is also noteworthy that a 3.5-fold increase
in the corporate profit tax did not negatively affect the share of gross invest-
ment. In fact, business now spends nearly half of its gross profit on capital
investment instead of a third in 1929.
The rise in labour income reached its peak in 1981, that is, by the end of
the welfare state reforms. After that, particularly as a result of Reaganomics
and following the neo-liberal dogma of minimizing the role of government,
the share of labour income started falling. This turnaround marked the end
of government cooperation with trade unions and a more aggressive policy
towards labour.
Between 1929 and 1957 aggregate labour income rose at an average annual
rate of 6 per cent, faster than growth of nominal GDP at 5.5 per cent. At that
time the unions succeeded in imposing the rule under which growth in money
wages should compensate for both the rise in labour productivity and con-
sumer price inflation. This principle was recognized in collective agreements
and while helping create a weak inflationary background, it also promoted
growth in aggregate demand and helped make recessions weaker and shorter.
In Russia, the role of trade unions is extremely low. What an alternative
income policy needs is to guarantee by legislation labour’s more active role
and the need for the faster growth of aggregate labour income compared to
GDP for a substantially lengthy period. Russia could make use of the experi-
ence of indicative planning in France where the government together with
trade unions and industrialist associations determined major macroeconomic
proportions, including absolute and relative growth of labour income.
Such a policy is likely to meet strong opposition from big business, which
interprets any rise in the share of labour income as a reduction in profits. But
this is not necessarily true. Given proportions that guarantee fast overall
economic growth, profits tend to rise in absolute terms even though their
share in GDP may be reduced.
Another important point is to convince the business community that it
has to separate the issue of reducing taxes from that of reducing government
expenditure. Lower government expenditure will further reduce aggregate
demand and slow economic growth. It will not necessarily free more
resources for capital investment.
Policy recommendations
To summarize, a minimum programme of proposed measures can be

formulated in the following few points:
1. To establish effective control of the state, as proprietor of the nation’s

mineral resources, over a sufficiently large share of the mineral rent and
to re-channel it via the government budget and private capital markets
into the chronically capital-deficient sectors of the economy. This implies
the introduction of four special taxes:
● tax on mineral rent;
● tax on market value of shareholdings;
● tax on capital gains shareholdings in privatized formerly government-
owned companies;
● tax on large dividends, particularly those transferred abroad.
2. One of the basic principles of business tax policy should be equalizing
profitability in the various sectors of the economy. Sectors with higher
profitability should pay higher taxes.
3. Government should retain its presence as owner and manager of business
companies in those economic sectors where private capital is slow to
invest in modernizing and expanding competitive productive activities.
This should apply to key manufacturing industries as well as to lagging
spheres of financial and other business infrastructure.
4. Government and mixed companies should be especially promoted in sec-
tors with a particularly high potential for competition in foreign markets.
5. In general, the government sector should be used as a major means of
promoting competition. By changing its basic business rule from maxi-
mizing profit margins to increasing output at reasonable prices, the gov-
ernment sector could act as a pioneer in breaking up monopoly behaviour
in the Russian economy.
6. Government incomes policy should centre on joint determination with
trade unions and business associations of major macroeconomic propor-
tions that guarantee fast and stable growth of the economy. Particular
attention should be given to a carefully coordinated programme of raising
the share of labour income to about 60 per cent of GDP and drastically
reducing the proportion of poverty and near-poverty income groups in
the population.
7. Practical considerations, not ideologically-motivated models should be
used as the basis for economic policy decisions and long-term strategies.
14
Escaping the Squeeze: Lessons from
East Asia on how Middle-income
Countries can Grow Faster
Robert Hunter Wade
Middle-income countries continue to be under pressure to further open their

economies to free trade and investment, to privatize state-owned assets,
deregulate entry and exit to sectors, and give no preference to domestic firms
over foreign firms. The pressure comes from the global economic multilaterals
(especially the WTO, IMF and the World Bank), and from the US govern-
ment and the EU;1 and beyond ‘pressure’, the appropriateness of such moves
is ‘in the air’ of the ‘international development community’, and an operat-
ing premise of the leading English-language opinion-makers like the
Financial Times and The Economist. The consensus is justified by the claim
that these policy shifts will lead to faster rates of investment and economic
growth, and thence to faster rises in average living standards and faster falls
in the proportion of the population living below the national poverty line.
In so far as they are adopted by many countries, the benefits will spread
synergistically.
The pressure for this direction of policy shift built up through the 1980s.
John Williamson encoded them as the ‘Washington Consensus’ about desirable
policies for developing countries in 1990. However, Williamson’s original list
did not include open capital accounts and free capital movement – because
he did not think, as of 1990, that there was a consensus among relevant
people in Washington and in the ‘international development community’
that such a policy was desirable. Quite a few relevant people continued to
accept the premise of the Bretton Woods agreements, that capital movement
should be restricted in order to allow countries more room for manoeuvre in
monetary and exchange rate policy.
In the early 1990s, with the arrival of the Clinton administration,
Washington Consensus Mark I gave way to Washington Consensus Mark II.
Mark II included the items of Mark I, but also included opening the capital
account and drawing on foreign savings – in other words, borrowing abroad
in order to supplement domestic savings and thereby boost the rate of
domestic investment.2 The strategy of increasing growth by drawing on
foreign savings was taken to be self-evidently correct, its advantages too
196
Escaping the Squeeze: Lessons from East Asia 197
obvious to need evidence. The US Treasury under secretaries Rubin and

Summers became especially keen, even adamant, about this strategy. Hence
middle-income countries (and even very low-income countries, like Ethiopia)
came under intense pressure from the global economic multilaterals to open
their capital accounts, in addition to further liberalizing trade and foreign
direct investment.
How do we understand this shift? Policy preferences of international
organizations do not come out of thin air, and they are generally under-
determined by empirical evidence – or empirical evidence that withstands
independent scrutiny. It is clear beyond doubt that state attempts to alter the
composition of economic activity within national borders can go disas-
trously wrong. It is clear not just from the communist cases based on central
allocation and public property, but also from the cases of hard ‘import sub-
stitution’ in a market-based economy of the kind found in India from the
1950s to the 1970s and in New Zealand from the 1970s to 1984. But take
away the extreme cases and the evidence in favour of unidirectional liberal-
ization, privatization, deregulation and open capital accounts – Washington
Consensus Mark II – becomes much less convincing. For example, several
studies conclude that there is no evidence that countries without capital
controls have grown faster, invested more, or experienced lower inflation,
and some evidence, indeed, suggests that capital controls are associated with
faster growth. Bresser-Pereira and Nakano find that the impact of a 1 per cent
increase in foreign savings in relation to GDP on growth in GDP per capita,
for 51 countries in the period 1979–98 is just 0.005, or almost zero.3
We can understand the ascendance of the Washington Consensus Mark II
in terms of the ascendance within the United States and Britain, and a more
contested ascendance within the European Union, of a rentier-oriented form
of finance capitalism. This form subordinates the needs of industrial capital-
ism to the extraction of financial returns to the holders of financial assets,
seeking the highest returns on money capital worldwide. It opens industrial
capitalism’s ownership to takeover by financial groups through mergers and
acquisitions. Once it dominates industrial capitalism, mergers and acquisi-
tions, often hostile, become the central process of capitalist restructuring.
Internationally, this form of capitalism expands its reach more through
gaining access to ownership of assets abroad than through gaining access to
product markets for exports. It seeks to reform pensions, housing finance,
health systems, urban water and sanitation systems and the like so as to allow
a bigger scope for private shareholders and for private flows of credit repay-
ment and dividends especially to the owners of money capital in the home
economy (the US and the EU). And it seeks to extend credit to private bor-
rowers in middle-income countries in the expectation of generating debt-led
consumption booms. American economists like to present the public ratio-
nale for this stance in terms of the rich countries’ exploding age-dependency
ratios. Who is going to provide goods and services for all the retirees? They
ask. The answer is for rich countries to buy up assets in poorer countries
today, which can later be drawn down as the baby-boomers stop working.4
Poorer countries have only to allow this asset buy-up to happen.
Of course, this is not happening only in relations between the US and EU,
on the one hand, and middle-income developing countries on the other; it is
also playing out inside the EU. The tight macroeconomic policy followed by
the European Central Bank can be understood as an attempt to force the poli-
cies of democratically-elected governments, including the German and the
French, away from those expressing an alliance between (industrial) capital
and labour and towards the pro-finance policies of the Washington Consensus
Mark II. One expression is the consensus among those connected to financial
interests in Europe that the reason for high and sustained unemployment in
Europe is labour market rigidity. The key to lower unemployment, they say,
is labour market flexibility (and not, for example, a more expansive macro-
economic policy, which is where a Keynesian economist would look).
My premise in this chapter is that the governments of middle-income
countries should be cautious about embracing anything close to the
Washington Consensus Mark II. Even full-scale free trade should be viewed
with caution. Trade liberalization exposes their manufacturers to direct com-
petition with China and other East Asian producers in sectors with dimin-
ishing returns. Further, relying on large inflows of foreign direct investment
(FDI) is not likely to be an effective means of catch-up. For one thing, almost
all of the small share of total FDI that goes to developing countries goes to
only a handful; and strikingly, the concentration has not decreased over the
past two decades, contrary to the ‘evolutionist’ prediction that FDI would
spread out to more and more developing countries. In these conditions trade
and FDI liberalization may yield immiserizing growth, a ‘race to the bottom’
(working harder to stay in place).
And we now have abundant evidence that countries that rely on foreign
borrowing to accelerate their growth are quite likely to experience a serious
crisis, especially if they are already carrying a high stock of debt. All three of
the major Latin American countries adopted the ‘growth with foreign sav-
ings’ strategy through the 1990s and all experienced a serious crisis: Mexico
in 1994, Brazil in 1998 and 2002, and Argentina in 1995 and 2001/02. The
story of the East Asian crisis of 1997–98 was rather similar. On the other
hand, while these crises were bad for growth and worse for the economic
contentment of hundreds of millions of people, they did open the way to
even more intense pressure from the US Treasury and the global economic
multilaterals for the crisis-affected countries’ governments to go further than
they had already done in the implementation of the Washington Consensus
Marks I and II;5 and they opened the way for US and European firms to make
large-scale purchases of productive and financial assets at fire-sale prices.
Champions of the Washington Consensus Mark II often say that the solu-
tion is tighter prudential regulation in the developing countries, not restrictions
on foreign capital inflows. It is a disingenuous response, because we do not

have good criteria for judging when a system of prudential regulation is
‘sound’ enough to safeguard domestic financial systems that are integrated
with world capital markets. The World Bank listed those countries with
sound enough financial systems to withstand full integration into world
capital markets, in a publication of April 1997. ‘[M]ost of high-growth Asia
(Korea, Malaysia, and Thailand, with Indonesia and the Philippines not far
behind) and two markets in Latin America (Chile and Mexico, with Brazil
also ranking well).’6 The East Asian crisis began a few months later, and then
swept into Latin America.
On the other hand, some sort of strategy of delinking from markets in
the core economies, based on integration among groups of neighbouring
countries, is not a promising alternative.
Sooner or later these bad choices may induce policymakers and policy
analysts in developing countries to reconsider the thrust towards free mar-
kets as the route to catch-up development, and then to engage in a more
open-minded way with the East Asian experience of the developmental
state. The start of wisdom is to recognize that central planning is not the
same as central allocation. Communism used and discredited central alloca-
tion. But central planning in the broad sense – public authorities interven-
ing to alter the composition of economic activity within their borders, in
line with an economy-wide exercise in foresight about the economy’s future
growth, in the context of a capitalist economy – has been alive and well in
East Asia, and should – this is my subtext – be seen as an opportunity for
governments elsewhere.
I shall summarize my understanding of some of the roles of the state in
economic development in capitalist East Asia (South Korea, Taiwan, Japan)
first in the post-Second World War decades, then in the last decade or so.
Fuller argument is given in the new edition of my book Governing the Market
(2004). I wish to emphasise that (a) a lot of the sectoral industrial policies
and programmes used in East Asia were of a rather modest kind, yet in aggre-
gate probably very effective in accelerating the transformation of the econ-
omy into higher value-added activities; (b) they did not require sophisticated
calculations and a highly skilled bureaucracy; and (c) other developing
countries can and should adopt the same norms of industrial policy, even if
with still more modest, blunter, instruments. This is to reject the view of an
economist as sophisticated as Howard Pack, who concludes from his study of
Japanese and Korean industrial policy from the 1960s onwards that the ben-
efits to Japan and Korea were modest, even in the 1960s when the benefits
were highest, and that:
Countries attempting to extract the benefits from an industrial policy

that Japan and Korea obtained [NB: this implies that they did obtain some
benefits] have to possess not only an exceptionally capable bureaucracy but
also the political ability to withdraw benefits from non-performing

firms … [Thus, developing] countries should be exceptionally cautious
before embarking on such policies.7
If Pack is right, industrial policy should not be on the agenda. But he misses
a whole swathe of East Asian industrial policy of a different kind to the large-
scale, picking-the-winners kind that he concentrates on.
Why the liberal explanation of East Asia’s

catch-up is wrong
But first I need to give some indication of why I think the conventional lib-
eral explanation of East Asia’s catch-up growth is wrong – not entirely wrong
but substantially wrong. The mainstream economics literature does present
the catch-up as due in large part to steady liberalization of markets: first, lib-
eralization of the trade regime, then, liberalization of capital movements in
and out; both accompanied by a steady lightening of the hand of the state in
the domestic economy, a steady deregulation and privatization of state-
owned enterprises. All the attention is focused on the retreat of the state
from the ‘import-substitution industrialization’ phase, when the state tried
to change the composition of economic activity.
In the conventional liberal explanation the liberalization of the trade
regime receives central importance, as the key condition facilitating the rapid
growth of exports. According to a major World Bank study, countries with
‘outward-oriented’ trade regimes have shown very much better performance
on a range of indicators than countries with ‘inward-oriented’ trade regimes.
The bank concludes that the causality is from trade regime to economic per-
formance, and that the correlation between outward orientation and better
performance holds not just across countries but for one country across time:
the cross-sectional evidence strengthens our confidence that countries will
experience improved economic performance as they liberalize their trade
regimes. But the argument is full of holes. To give just a few illustrations.
First, the World Bank study’s conclusion that outward-oriented trade
regimes have better performance than inward-oriented ones obscures a
contrary finding. The study took two time periods, 1963–73 and 1973–85,
and for each period classified 41 developing countries in terms of four
categories of trade orientation: strongly outward-oriented and moderately
outward-oriented, and strongly inward-oriented and moderately inward-
oriented. The moderately inward-oriented countries had better performance,
by most measures, than the moderately outward-oriented cases. The result
that the bank celebrates – outward-oriented trade regimes have better per-
formance than inward – comes from aggregating the two sub-categories. The
‘strongly outward-oriented’ cases have such good performance indicators,
and the ‘strongly inward-oriented’ ones such bad performance indicators, as
to reverse the results for the ‘moderately-oriented’ cases.
Second, the sub-category of ‘strongly outward-oriented’ includes just three

cases, Hong Kong, Singapore and South Korea. They are all East Asian, which
raises the possibility that their outstanding performance has more to do with
‘East Asia’ than with ‘liberal trade’. Moreover, the performance of the sub-
category is mostly Korea’s, which swamps the other two. Without the one
case of Korea, the overall conclusion about outward-oriented regimes having
better economic performance than inward-oriented ones would not hold.
Third, to describe Korea’s trade regime in 1963–73 and in 1973–85 as
‘strongly outward-oriented’ is in any case a gross mis-characterization, given
that the sub-category is defined as one where ‘trade controls are either non-
existent or very low … There is little or no use of direct controls and licensing
arrangements.’ The study adds another criterion when defining the ‘moder-
ately outward-oriented’ regime, namely, low variation of effective protection
rates to different sectors of the economy; and we may presume that this crite-
rion should also apply to the strongly outward-oriented cases. There is plenty
of evidence that these criteria do not fit Korea’s trade regime in either period.8
One piece of evidence comes, ironically, from the locus classicus of the belief
that Korea got rich by having a liberal trade regime, and it is worth citing in
order to see how the liberal conclusion has been reached by selective inatten-
tion to data that would upset the liberal way of seeing things. The long-term
World Bank consultant, Bela Balassa, coordinated an intensive study of the
trade regimes of six developing countries based on data from around 1969.
The study defined a liberal trade regime as one with two basic characteristics:
(1) low average protection; (2) low variation (or dispersal) around the low
average – that is, uniform protection across all sectors. The study found that
for Korea and Taiwan, the average level of protection of manufactures in 1969
was relatively low. This was the key finding that supported the picture of a lib-
eral trade regime. Strangely, the study did not draw attention to another find-
ing that can be drawn from the same data. Dispersion of protection around the
relatively low average was quite high. Korea and Taiwan did not have a uni-
form level of protection. Within manufacturing, different sectors had quite
different levels of protection. The data in Table 14.1 illustrate this.
Table 14.1: Trade regimes, incentives to sell on domestic

market or to sell abroad, developing countries around 1969 (%)
Taiwan Korea Colombia Argentina
Effective 14 13 35 112
protection to
manufacturing
Intersectoral 23 47 56 35
dispersion
Source: Wade, Governing the Market (table 3.2, p. 56), based on Balassa
(1982).
It is likely that these differences were deliberate, the result of government

intention reflecting the wider industrial development strategy (rather than
accidental, or the result of cronyism). In contrast, where the level of average
protection is high (Colombia, Argentina) it is more likely that a given degree
of dispersion around the high average is not intentional but accidental.
In short, even the study regarded as the locus classicus of the image of East
Asian capitalist economies as having liberal trade regimes provides evidence
that contradicts its own conclusions.
Furthermore, the conventional neo-liberal explanation is wrong about
timing, and therefore about the causality from trade liberalization to growth.
Recall that it says that trade liberalization gave a strong propulsive boost to
the growth of exports and thus to broader economic growth. Dani Rodrik
has shown that this is not the observed sequence. One does not find a big
improvement in incentives to export preceding the take-off in exports, but
one does find a big improvement in investment incentives thanks in large
part to government policy changes. First came a surge of investment (in the
case of Taiwan, around 1958–60) while trade incentives remained largely
unchanged, then rapid growth of exports, then faster growth, then accom-
modating liberalization of trade. ‘The lesson from East Asia is clear’, says
Rodrik:
[T]he three East Asian ‘dragons’ with low investment rates in the early
1960s – South Korea, Taiwan and Singpore – would not have been nearly
as successful had their governments not given capital accumulation a big
push by subsidizing, cajoling and otherwise stimulating private investors.
The evidence from East Asia and elsewhere shows that investment booms
produce economic growth as well as greater export orientation [and higher
imports].9
The observed sequences in East Asia better fit the hypothesis that ‘as countries
grow richer they liberalize trade’ than the hypothesis that ‘trade liberalization
propels countries to become richer’. The priority to investment is not specific
to East Asia: a step up in investment seems to be a nearly necessary condition
of a step up in growth rates. Rodrik concludes, ‘Countries that are able to
engineer increases in their investment efforts experience faster economic
growth.’ (On the other hand, the cross-country correlation between decade-
average investment rates and decade-average GDP growth rates (1950–1990)
is not particularly strong.10)
What about the World Bank’s East Asian Miracle study, published in
1993?11 It examined eight high-performing East Asian economies (not
including China), and applied a range of tests to examine the impacts of
industrial policy. About the impacts of sectoral industrial policy (targeted at
specific sectors, such as chemicals or semiconductors) the study says, ‘industrial
policies were largely ineffective’ and, ‘We conclude that promotion of specific
industries generally did not work and therefore holds little promise for other
developing countries’ (pp. 312, 354).
It also concluded that even had they been effective in East Asia, their
administrative/political conditions are so demanding (for example, in terms
of the sophistication of the calculations for identifying sectors for special
promotion) that few other developing countries could achieve the same
success. ‘[T]he prerequisites for success [such as it was] were so rigorous that
policy makers seeking to follow similar paths in other developing countries
have often [read, usually] met with failure’ (p. 6). If this sounds like Howard
Pack, quoted above, it is no accident; for he was the consultant who wrote
the chapter in the Miracle about the impact of industrial policies.
I and others have shown why the Miracle’s evidence is not convincing.12 To
give just one reason: the problem of capturing ‘externalities’, or spillovers
from one sector to another. It turns out to be very difficult to track the effects
of spillovers across sectors. Yet they are real. Some critics of industrial policy
have pointed to the lack of correlation between the amount of subsidies and
protection given to sector X and the growth of productivity in sector X, or
even to a negative correlation, as evidence of industrial policy failure – or
even of ‘picking losers’. But the test ignores the point that East Asian govern-
ments gave various kinds of resource help to ‘infrastructural’ sectors like steel
and basic chemicals not mainly to promote productivity growth in those sec-
tors but to have spillover benefits for the users of steel and basic chemicals.
The World Bank has been a leading proponent of the idea that East
Asia got rich because it liberalized markets and followed the policy mix later
called the ‘Washington Consensus’. The East Asian Miracle was a bank research
report; and the Balassa et al. study was sponsored by the bank, while Balassa
worked as a de-facto bank staff member (de facto, because formally he was a
long-term consultant). In appraising the evidence of these and other bank
studies, it is important to bear in mind that the staff see themselves as – like
it or not – speaking for the organization. The External Affairs Department
instructs staff (including research staff) as follows: ‘Crucially, staff contem-
plating a speech, article, opinion/editorial, or letter to the editor must realize
that a disclaimer that the speaker or writer is expressing personal views is
unconvincing and usually ineffective. It also does not exempt the staff mem-
ber from following procedures, or from recognizing that they speak for the
institution.’13
To its credit, though, the Miracle study does recognize that its evidence is
hardly conclusive. ‘We cannot offer a rigorous counterfactual scenario. Instead
we have to be content with … analytical and empirical judgements’ (p. 6).
East Asian industrial policies: (I) the catch-up phase
To think constructively about industrial policy, one has to distinguish

at least three types. First, economy-wide ‘functional’ policies that include
exchange rate policies macroeconomic balance and competition policies

(including average level of protection). Second, multi-sectoral ‘horizontal’
policies, that include incentives for R&D, incentives for ‘small and medium
enterprises’, investment in port infrastructure and the like. Third, sectoral
policies, to promote specific sectors or sub-sectors or firms (the Proton auto
firm in Malaysia, for example).14 Most of the debate concerns the latter – did
it matter in East Asia and could it work elsewhere? Immediately one can intuit
how difficult it is to separate out the effects of the latter from the effects of the
first two, because of the mutually-supporting relationships among them.
No industrial policy champion would claim that the third type, sectoral
policies, can work with inhospitable policies of the first and second types.
Part of the problem of getting evidence specifically on the impact of
sectoral policies is that the policies entered into the assessment tend to be of
‘The Ten Year Plan to Develop the Petrochemical Industry’ kind. What this
misses is a great deal of activity ‘below the radar screen’, which may have
rather small public expenditure costs but which in aggregate has probably
had a powerful effect in raising the average level of technological and
production capacity of East Asian firms.
Taiwan, for example, had an Industrial Development Bureau (IDB)
comprising, in the 1980s, some 200 engineers and allied professionals, and a
sprinkling of economists. Much of the work was organized by input-output
chains. The specialists in the chain that included, say, glass, monitored care-
fully the imports of glass, the buyers of imports, the production capacity of
Taiwanese glass-makers. As part of their job they were required to spend sev-
eral days a month, at least, visiting firms in their sector. (They were not
allowed to have lunch with members of the firm they were visiting.) The aim
of their monitoring and visits was to find opportunities to ‘nudge’ the
process of import replacement and export promotion, by using various kinds
of administrative methods to ‘encourage’ the big buyers of imports to switch
from importing to local sourcing once they judged that domestic suppliers
could meet the quality and price of imports, provided they had a long-term
supply contract and some technical help.
In the case of a transnational company, Philips, importing specialized glass
for its televisions, the IDB officials informed Philips of the potential for
switching and indicated that they would look favourably on other Philips’s
requests if it saw its way to switching. Philips said no. Then Philips began to
experience longer and longer delays in its applications to import the special-
ized glass, which had previously been granted immediately. Philips protested
to the minister, who apologized profusely, said he would look into it. The
delays continued. Eventually Philips got the message and switched. The
domestic suppliers undertook the needed investment in quality, and later
were in a position to start exporting.15
The point is that this sort of nudging of firms into higher value-added
products – and jolting of transnational firms and domestic firms to establish
domestic supply relationships – has been going on across many sectors,

case-by-case, for many decades in Taiwan. It has required an honest, competent
cadre of public officials with skills in engineering and finance – though not
a particularly large one; and an array of instruments on which to draw,
which may include some capacity to manage trade (as in the Philips exam-
ple) but may also include a wide range of non-trade measures for encourag-
ing and discouraging. It has not required the sort of subtle strategic trade
calculations that seem to be required – according to conventional strategic
trade theory – in the case of cutting-edge high-tech industries in the advanced
industrial economies.
There is no question that it is difficult to pin down the quantitative effects
of this sort of below-the-radar intervention by public officials – whether pos-
itive or negative. All we can be sure of is that a great deal of it was going on
over decades, all the time, with a dedicated cadre of public officials to do it.
East Asian industrial policies: (II) forging ahead
Today Taiwan has reached the technological level of middle-ranking OECD

countries, which is an astonishing, almost unprecedented achievement
given its starting point around 1950. But it remains well behind the world
technology frontier in most sectors. For all its commitment to WTO princi-
ples the state continues to exercise economy-wide foresight, continues to
shape the composition of activity within its borders, does not let ‘the market’
take its course.
Linda Weiss and Elizabeth Thurbon remark that:
the practice of governing the market is not just about policy – GTM
[governing the market] is also, and perhaps more importantly so, about the
normative environment that sustains the will to govern the market, and
the legitimacy of governing the market as perceived by actors in the polity.
This is a point often overlooked in the mainstream literature … which typ-
ically bases its claims on observed policy changes since the [financial]
crisis [of 1997–98 – that is, claims that the Taiwan government has given
up governing the market since the crisis]. The assumption is often that if
a state has relinquished certain pre-crisis policies … it must also have
abandoned a commitment to GTM and be acting in ways broadly consistent
with the norms of competitive liberalism.16
They relate that the entrance to the Industrial Development Bureau is embla-
zoned with a quote from Goethe which captures the difference at the level of
norms between a government role based on strategic economics and one
based on liberal economics: ‘The most important thing in life is to have a
goal, and the determination to achieve it.’
Taiwan continues with the organizational structure of the developmental

state:17
● A pilot agency located in the very heartland of the state and chaired by
the third ranking political leader in the state (the vice premier), called the
Council for Economic Planning and Development.
● An operational agency that does the ‘nuts and bolts’ of industrial policy,
the Industrial Development Bureau described earlier, located within the
Ministry of Economic Affairs.
● Industry associations by sector, membership of which is obligatory, whose
secretary is semi-appointed by the government and who is responsible for
two-way interaction between the member firms and the government (and
hence not likely to let the association become a centre of political resistance
to government).
● Public R&D laboratories, notably the umbrella agency, the Industrial
Technology Research Institute (ITRI), with a staff of some 10,000 scientists
(by the mid-1980s) organized in sector-specific labs; and an even bigger
military-oriented counterpart.
The essence of the political process of national development is intense

dialogue between these organizational components of the developmental
state. Earlier, the first two tended to call the tune and the others responded;
since democratization in the late 1980s the balance of power has shifted
towards the labs and the industry associations. In particular, much of the
brainstorming takes place between ITRI labs and industry associations,
which helps to build inter-firm networks with reliable collaboration between
members.
Commonly, an ITRI lab incubates a specific technology (for example, Radio
Frequency Information Devices, a type of chip), gets it to pre-commercial
stage, takes out patents, and then spins off a sort of private firm, to which it
gives the patents in exchange for equity. Often the senior managers of the
firm are ex-ITRI, or part-time ITRI. This technique has been used for many ini-
tiatives, including the import-replacement of bottleneck components whose
recurrent delays in importing are impairing Taiwan’s entry into advanced sec-
tors. In this and many other ways, the state helps to assume a large part of the
risks of research and development of technologies to commercialization
stage.
Emphasis is given to promoting nationally-owned firms, with limits placed
on the operation of foreign firms (for example, foreign service firms). All the
time, the apparatus of the developmental state is looking for ways to maxi-
mize technology spillover from foreign firms (abroad or in Taiwan) into the
heads and hands of local firms. Equally, however, the apparatus is actively
involved in building up a large stock of Taiwan-owned firms operating
abroad – building up outward FDI – so that Taiwan is more of a reciprocal
partner than if it were only playing the role of a periphery welcoming

inward FDI from the centre. Taiwan’s outward FDI in China is well known;
but it has also built up a large stock in other developing regions as well as in
the core regions of the world economy ( Japan aside).
The underlying competitive strategy for the nation is based on recognition
that its firms, being some way off the world technology frontier, must seek
to capture second-mover advantages. Its firms are mostly unable, yet, to cap-
ture the brand-name advantages of first movers. They must be able to chase
hot products developed by first movers, push up production of specified
items quickly, and exploit scale economies before profit margins become
paper-thin. For this strategy, large firms, not networks of small and medium
enterprises, are increasingly needed; large firms which are able to produce in
large volumes and which are big enough to be of interest to first-mover firms
as subcontractors.18
The government’s role is to push on with industrial policy of all three of the
types distinguished earlier. In particular, to promote ‘industrial complexes’
or ‘urban economic commons’ or ‘growth poles’; and to promote moves in
many industrial and service sectors – but often with sector-specific and even
firm-specific instruments – into higher value-added parts of global value
chains (such as into manufacturing-related service industries, MRSIs, as part
of which the Radio Frequency Information Device mentioned earlier was
developed).19
I have been talking about Taiwan. Singapore, Japan and China also retain
major features of the developmental state. South Korea, on the other hand,
has gone some way to dismantling what used to be a model of the type. The
dismantling began in the late 1980s, with democratization and the discred-
iting of military rule – and by the same token, discrediting of bureaucratic
rule. Like a swing in fashion, many Korean economists and public officials
converted to neo-liberal economics of a fundamentalist kind, with US-
trained Korean economists in the role of modern missionaries. Their ideas
acquired power from their resonance with the interests of the large Korean
conglomerates, like Samsung, which by the late 1980s had reached the point
of organizational and technological sophistication where they saw the state
as more of an obstacle than a help. And the G7 states particularly focused on
Korea with demands that it open its markets, to avoid ‘another Japan’. By
1995 the Economic Planning Board – the pilot agency since the early 1960s –
had in effect been abolished, and the capital market had been largely opened
up for foreign borrowing and foreign financial service firms.
Yet even in Korea things are not what they seem to be. Norms of ‘governing
the market’ continue. That is, the government continues to have a legitimate
role in steering and coordinating the strategies of the private sector – it co-
ordinates a governance arrangement spanning government and autonomous
but interdependent firms, though not (as before) as a commander of specific
outcomes.
Take telecommunications liberalization as an example of gradual

liberalization carried out in a way calibrated to retain a substantial presence
of nationally-owned firms while facilitating their achievement of world
frontier capabilities.20 Before the early 1990s telecommunication services in
Korea were provided by two public enterprises (Korea Telecom and Korea
Mobile Telecom), backed by a history of heavy government regulation in
equipment and telecom services. Then in the late 1980s and early 1990s a
new technology, digital mobile telecommunications, appeared on the world
frontier. This promised a much higher demand for mobile services and
accompanying infrastructure. The conglomerates wanted to diversify into
telecoms. The US government pressed Korea to open its telecom market to
US firms; as did the prospect of GATT/WTO membership. For all these
reasons the Korean government had to privatize and liberalize the sector.
But the government recognized that telecoms would be a ‘leading sector’
on a world scale in the coming decades, and that Korea had to maintain a
strong presence of Korean-owned firms. The Ministry of Information and
Communications (MIC) began to liberalize by privatizing the mobile carrier
in 1993;21 a year later it licensed a second private carrier; two years later
(1996) it licensed three more private carriers. It not only allowed foreign tele-
com firms to invest in the private Korea firms, but required their participa-
tion (to get their technology); but only up to a limit of 33 per cent of total
equity. It also restricted the share of equity that could be owned by Korean
manufacturing companies to less than 10 per cent. It limited new entrants in
their choice of equipment, favouring Korean equipment makers, which con-
stituted an entry barrier for foreign firms; it also limited their technology
standards to government-approved ones. The whole process was aimed at
developing a strong indigenous telecom capacity before full liberalization,
quite contrary to what the US government had in mind.
At the same time, a parallel project was under way to use a public–private
partnership to do the R&D for CDMA (Code Division Multiple Access) digital
transmission technology, especially because the leading foreign telecoms
firms would not sell advanced technology to the Koreans. The ministry
formed a technology development network with the government-sponsored
Electronics and Telecommunications Research Institute (ETRI) linked to the
former public telecom company and a number of private Korean manufac-
turers, each with an assigned task. Much of the funding for this network
came from the sale of shares in the privatized public enterprise. The proceeds
were also used to subsidize the uptake of demand for telecommunications
services, including internet access, making a virtuous circle between supply
and demand. And a further loop was created by requiring new entrants into
the service market to use products and standards developed in this R&D
consortium.
As the new entrants proved themselves competitive, several of the measures
used to incubate the Korean infants were eased; the limit on the share of equity
held by foreign firms and by Korean conglomerates was raised to 49 per cent
in 1999, and the restrictions on the choice of equipment were also lifted.
By this time Korea’s signing on to the WTO telecommunications agreement
in 1997 was also pushing in the same direction.
The overall results of this ‘phased liberalization’ have been spectacular.
Korea jumped from being a nobody in world telecommunications in the
early 1990s to being a major player in the early 2000s. It has the highest
broadband penetration in the world. The Korean telecommunications case
illustrates the virtues of gradual liberalization orchestrated by the state in
line with national development objectives, where those objectives give
weight to national ownership in important sectors.
However, it has also to be said that the mass conversion of Korean policy-
makers and economists to fundamentalist free-market economics during the
1990s did result in the abandonment of the earlier emphasis on national
ownership in many sectors of manufacturing and finance. With the Asian
crisis expanding the opportunities, foreign investors came to acquire about
60 per cent of the shares of Korea’s top 20 conglomerates. Only recently has
a serious push-back begun, amid increasing domestic fears that foreign inter-
ests are extending a baleful influence over Korean industry. Leaders of some
of the conglomerates are even supporting a campaign to urge citizens to buy
shares in their companies in order to thwart the threat of foreign takeovers.22
The theory of governing the market
It is one thing to say that governments in East Asia remain committed to

governing the market; but is there any theory which might suggest why such
actions might be effective at promoting rapid economy-wide development?
Conventional economic analysis stresses that any attempt by public
agents to change the composition of economic activity away from that
which results from well-functioning markets is bound to be ineffective,
bound to thwart the expansion of comparative advantage along whose path
sustainable development lies. Measures such as protection, or domestic con-
tent or export performance requirements, withdraw resources from more
productive uses and reduce consumption. Export requirements, for example,
may worsen the trade account by reducing the export potential of other
industries.
But once the underlying assumption of perfect competition is replaced
with an assumption of oligopoly – a small number of firms and barriers to the
entry of competitors – the argument changes. In particular, the argument
changes when there are increasing returns to scale such that only some of
many potential production sites can be established, and when there are
learning-by-doing economies which give advantages to firms which estab-
lish production early. In these conditions there is scope for states, not to
‘create’ comparative advantage or ‘pick winners’ out of thin air, but to shape
and direct comparative advantage. These conditions occur frequently in the

mid-tech industries of middle-income developing countries and the mid-tech
and high-tech industries of East Asia.
For example, states can intervene in order to accelerate the move of chunks
of productive activity from existing high-cost sites abroad to host country
sites, faster than the market would. Case studies of transnational corpora-
tions show clearly that corporations operating in conditions other than
perfect competition – which is the normal case – are often slow to react to
price signals at the margin, even when they are well-informed about prof-
itable opportunities to shift locations. This is especially so when rearranging
intra-firm operations – as in relocating production out of the core regions to
a cheaper-labour site, or switching suppliers from a high-cost one at home to
a cheaper one in a developing region – would incur substantial exit costs.
The case of automobile production in Mexico provides an illustration.
Ford and Volkswagen established assembly and engine plants in Mexico
in the 1960s, with a large part of production intended for export. From this
experience it became clear to them and to other auto firms that big cost advan-
tages were to be reaped. Yet by the late 1970s their investments remained rel-
atively small, far from world-scale capacity and far from being integrated
into their global sourcing network; and other major auto makers had not
followed them in establishing Mexican plants. So in 1978–79, Mexican
industrial policy officials, aware that US car makers were under competitive
pressure at home from Japanese imports, decided to enforce a 1977 decree
that linked access to the domestic market to exports: ‘if you fail to meet an
escalating export schedule your domestic sales will be cut’. The first to
respond was General Motors, which in 1979 announced the biggest one-
time investment in its history, to be placed in Mexico. Other auto makers
soon followed GM’s lead in announcing plans for major expansion of
exports from Mexican sites, in order not to lose share in the Mexican domestic
market. But this was sixteen years after Ford and Volkswagen first began to
show the cost advantages of Mexican sites! They and the other auto firms
had resisted international comparative advantage for a long time, and it took
the ‘jolting’ of Mexican officials to break their lock-in to exit costs and other
intra-firm rigidities.23
The more recent case of auto production in South Africa provides another
illustration. Here the government after 1995 introduced an export–import
link system (similar to that in Mexico), such that an auto firm’s access to the
domestic market (with current sales of around 350,000 light vehicle units a
year and expected to grow) was made conditional on export performance,
either of finished vehicles or components in the value chain. In addition,
several complementary programmes – formulated and monitored by an auto
industry development council, comprising representatives of assemblers,
component makers, retailers, trade unions, government, plus a few academics,
who met every six weeks – helped to improve business organization and labour
relations up and down the supply chain. The whole programme was designed
to harness the rivalry between the big three German auto makers, but
also Toyota and Ford, to the benefit of the South African economy. Justin
Barnes et al. show that the selective policies targeted at the auto industry
were almost certainly effective by several measures of effectiveness, and that
they did not require large public expenditures or a sophisticated bureaucracy
making sophisticated calculations.24
Conclusions
The general point from all this is that there is a body of theory, or theoretical
insights, at hand to support a strategy of governing the market in a develop-
ing country context, based on ideas of economies of scale, learning-by-
doing, second-mover advantages, stickiness in location decisions of TNCs,
and the arbitrariness of much of ‘comparative advantage’.25 And there is also
some relevant empirical evidence, even if its conclusions about effectiveness
are open to dispute – though no more so than the evidence which purports
to show the fallacies of government efforts to change the composition of
economic activity.
The case studies show that the task for industrial policy strategists in iden-
tifying products or sub-sectors for targeting is not particularly difficult – it
involves estimating costs of production, comparing with import prices and
quality, estimating demand elasticity, and so on, the same sort of calcula-
tions as transnational corporations make every day; and it involves under-
standing the bargaining tactics of transnationals and how to turn them to
national advantage. In the more advanced of the middle-income countries it
is important for industrial policy strategists not to think only of inward FDI,
but also of outward FDI as a strategy – using banks awash with funds to make
mergers and acquisitions and perhaps green-field investments in core
economies; this helps to shift thinking out of the centre–periphery mindset
where the periphery thinks its salvation lies in obtaining resources from the
centre. Again, Taiwan and other East Asian cases show how the government
can help to orchestrate these outward investments in line with national
interest.
The more difficult task is not the policies themselves, but designing an
industrial policy bureaucracy – even if not the larger developmental state, as
above – which is motivated to achieve its intended objectives. But relatively
meritocratic agencies like Taiwan’s Industrial Development Bureau should
not be beyond the wit of many developing country states to create and
empower to do the same sorts of tasks as Taiwan’s.
In the end, the main obstacle to success lies – as Weiss and Thurbon
suggest – at the level of the norms: the legitimacy of efforts by public agen-
cies to change the composition of economic activity. Taiwan’s Industrial
Development Bureau has the Goethe quote referred to earlier. The prevailing
norm in the ‘international development community’ and in the transnational

community of economists, on the other hand, is captured in the remark of
Sir Terence Burns, chief economic adviser during the Thatcher years, ‘If we
can’t make money by manufacturing things, we’d better think of something
else to do’, or the remark of Herbert Stein, Chairman of the Council of
Economic Advisers during the Reagan years, ‘If the most efficient way for the
U.S. to get steel is to produce tapes of “Dallas” and sell them to the Japanese,
then producing tapes of “Dallas” is our basic industry.’26 Burns and Stein
reflect the assumption that the competitive model is a reasonable approxi-
mation to the real world; the Goethe quote, as operationalized in Taiwan,
reflects the assumption that the real world is better understood in terms of
oligopolistic markets, where governing the market has potentially big pay-
offs. Developing country economists and policymakers believe Burns and
Stein at peril to their economies’ catch-up with the West.
Notes
1. R.H. Wade, ‘What Strategies are Viable for Developing Countries Today? The
WTO and the Shrinking of Development Space’, Review of International Political
Economy, 10(4) (2003), 621–44.
2. See J. Williamson, ‘The Washington Consensus and Beyond’, Economic and
Political Weekly (Bombay), 12 April 2003; and Luiz Carlos Bresser-Pereira and
Yoshiaki Nakano, ‘Economic Growth with Foreign Savings?’, paper presented to
the Seventh International Post Keynesian Workshop, ‘Fighting Recession in a
Globalized World: Problems of Developed and Developing Countries’, Kansas
City, Missouri, 28 June–5 July 2002, www.bresserpereira.org.br/.
3. Bresser-Pereira and Nakano, above.
4. Kenneth Rogoff, 2002, quoted in Bresser-Pereira and Nakano, above.
5. With the qualification that they backed off open pressure for further liberalization
of the capital account. But as of the early 2000s and the George W. Bush adminis-
tration, the US Treasury has been resuming the push for developing country gov-
ernments to open the capital account, if less overtly than before. For example, all
the free trade area agreements require the other side to open the capital account.
6. World Bank, Private Capital Flows to Developing Countries: the Road to Financial
Integration (Washington DC: The World Bank, 1997), p. 59.
7. H. Pack, ‘Industrial Policy: Elixir or Poison?’, World Bank Research Observer, 15 (2000),
p. 1, emphasis added.
8. See Wade, Governing the Market: Economic Theory and the Role of Government in East
Asian Industrialization (Princeton, NJ: Princeton University Press, 2004 [1990])
chapters 1 and 11.
9. D. Rodrik, The Global Economy and Developing Countries: Making Openness Work,
(Washington DC: Overseas Development Council, 1999) p. 63. The argument
applies only to capitalist economies.
10. World Bank, World Development Report 1999/2000, Entering the 21st Century
(Washington DC: The World Bank, 2000), figure 9.
11. World Bank, The East Asian Miracle (Washington DC: The World Bank, 1993).
12. A. Fishlow et al., Miracle or Design? Lessons from the East Asian Experience
(Washington DC: Overseas Development Council, 1994).
13. Quoted in D. Ellerman, Helping People Help Themselves (Ann Arbor: University of
Michigan Press: 2004), p. 151.
14. I am indebted to an important paper by Justin Barnes, Raphael Kaplinsky and
Mike Morris, ‘Industrial Policy in Developing Economies: Developing Dynamic
Comparative Advantage in the South African Auto Sector’, Competition and
Change, 8(2) (2004), 153–72.
15. Wade, Governing the Market, p. 285.
16. L. Weiss and E. Thurbon, ‘ “Where There’s a Will There’s a Way”: Governing
the Market in Times of Uncertainty’, Issues and Studies, 40(1) (March 2004), 61–72,
at p. 63. This same issue has several other papers by political scientists and
economists about governing the market.
17. On the organizational structure of the developmental state (with specific reference
to Korea) see Vivek Chibber, Locked in Place (Princeton, NJ: Princeton University
Press, 2003).
18. A. Amsden and Wan-wen Chu, Beyond Late Development: Taiwan’s Upgrading
Policies (Cambridge, MA: MIT Press, 2003).
19. Weiss and Thurbon (2004), above.
20. This account of Korea’s telecommunication strategy is based on information in
Whasun Jho, ‘Liberalisation as a Development Strategy: New Governance in the
Korean Mobile Telecom Market’, Working Paper, Institute of Social Science, Yonsei
University, Seoul, 2004.
21. Also in 1993 the government began to privatize the other public telecom company,
Korea Telecom, but slowly. By 2002 it had sold 57 per cent of shares of KT stock to
the public, including foreigners.
22. A. Fifield, ‘S. Korea’s Business Giants Seek to Repel Invasion Force’, Financial
Times, 24 November 2004.
23. T. Moran, ‘Strategic Trade Theory and the Use of Performance Requirements
to Negotiate with Multinational Corporations in the Third World’, typescript,
Georgetown University, October 1991.
24. Barnes et al. (2004), above.
25. P. Toner, Main Currents in Cumulative Causation (London: Palgrave, 1999).
26. Cited in R. Wade, ‘East Asia’s Economic Success: Conflicting Perspectives, Partial
Insights, Shaky Evidence’, World Politics, 44 (January 1992), 270–320.
15
The Third World’s Debt Problem
Kunibert Raffer
Introduction
John Kenneth Galbraith discussed the Third World’s debt problem well
before the ‘official start’ of the sovereign debt crisis in 1982. In a paper pub-
lished by the German Federal Ministry of Cooperation in 1979 and reprinted
in the annex of the German edition of his book The Nature of Mass Poverty
(Galbraith, 1980, pp. 140ff.) he described Third World demands for debt
relief and for a new framework to resolve debt issues with a great deal of sym-
pathy. He emphasized in particular the strong Third World focus on reforms
of debtor–creditor relations, such as an appropriate role in debt rescheduling
or an international commission on debts.
Galbraith recognized that a solution was necessary irrespective of the
reasons for the debt burden. Very much a political mind, he put his finger
on the main problem: reforms of debt management would be particularly
difficult to accept for developed countries. Compromise on changing
debtor–creditor relations should not be expected soon. Unfortunately this
conclusion remains valid although some small movements in the right
direction could be observed since then.
This chapter fully shares Galbraith’s (1990) conclusions: meaningful debt
reduction is inevitable, ‘lending those countries money with which to pay
interest’ means only ‘postponing the day of reckoning’, and decent living
standards and democratic government must be protected. It presents a fair and
efficient procedure towards these goals, enabling sovereign debtors to partici-
pate appropriately in solving the debt problem which has stifled development
and resulted in catastrophes in many developing countries. My proposal
would alter creditor–debtor relations by finally introducing the rule of law,
economic sense and the protection of fundamental human rights into the
field of sovereign debts. Sketching the evolution of the debt problem since
the 1950s and showing why ‘debt management’ has not worked it compares
the proposals on the table at the moment. Finally, this chapter advocates the
internationalization of the basic elements of US municipal insolvency.
214
The Third World’s Debt Problem 215
Building up the debt fiasco
The debt problem existed well before 1982. Structural disequilibria were
identified as its root by the Pearson Report (Pearson et al., 1969), prepared at
the request of the President of the International Bank for Reconstruction and
Development (IBRD). They are the consequence of structural inequalities in
the global economy that put the Third World at a disadvantage. The struc-
tural resource gaps to which the Prebisch–Singer thesis had drawn attention
by showing evidence for secularly falling terms of trade are one important
illustration. The debt problem may thus be seen as the result of temporarily
covering up unequal and disadvantageous economic relations by sovereign
borrowing.
The Pearson Report considered the problem so urgent – even in 1969 –
that it suggested debt reduction measures. It criticized debt management for
emphasizing spending cuts and credit restrictions while neglecting the need
to sustain sound development outlays, and warned of serious difficulties
that could result from very large-scale lending. All this sounds like criticism
of present debt management. Instead of remedies, large scale Euromarket
lending took off at the very time that the Report was published. This new
wave of private lending covered up the already recognized problem created
by public creditors. Problematic facts such as the first adjustment measures
during the mid-1970s or warning voices raised throughout the 1970s –
including Galbraith’s – were simply ignored (compare, Raffer and Singer,
2001, pp. 163ff.).
The crash of syndicated bank lending in the early 1980s triggered a shift
towards multilateral lending. The Bretton Woods Institutions (BWIs) seized
this opportunity to establish themselves as debt managers by pouring
money into Southern debtors. Well before 1982 they had started ‘structural
adjustment’. The IMF, established in 1944 to provide unconditional emer-
gency resources, not to finance any programmes with conditions attached,
was first. Obviously without economic raison d’être after the demise of the
Bretton Woods system it tried to justify its further existence by carving out a
new role. The IBRD increased programme lending in violation of its own
Articles of Agreement (compare, Article III.4.vii.b). So did the International
Development Association (IDA) (compare, Article V.1.b). International
financial institutions (IFIs) were not meant to engage strongly in programme
lending or to intervene in member’s economies – rightly so, as their record
proves. Obeying their own constitutions, however, would not have allowed
them to gain the importance they presently enjoy.
In the early 1990s a new group of creditors was ushered in: private bond-
holders, who had been the main lenders to Southern sovereigns before 1940.
Euphoric statements by multilateral institutions and the OECD and regula-
tory changes opened the door. Bringing in the public at large (including
pension funds) has allowed ‘old’ creditors (including IFIs) to receive more
repayments than otherwise possible. Debts have kept growing but their
structure has changed perceptibly. Argentina and Brazil are cases in point.
‘Debt management’ by public creditors under BWI leadership has been
unable to solve this problem for decades.
These waves of lending by different creditor groups are an international
Ponzi scheme supported and driven by multilateral institutions and OECD
governments (compare, Raffer, 2004a). Finally, no new group of creditors
remains to whom substantial parts of debts can be shifted. The game of
financial musical chairs is over – losses must finally be faced. Postponing the
day of reckoning BWI debt management has prolonged suffering and
increased the damage done to Southern economies.
Official interventions also increased volatility. The risk weight given by
the Basle Committee to short-run flows to banks outside the OECD region
encouraged and fuelled short-term lending just before the Asian crisis. In spite
of at least one official document warning of the high risks of quick capital
account liberalization IFIs egged Asian countries on, right into the crisis of
1997 (Raffer and Singer, 2001, p. 151).
Soon after 1982, internationalizing corporate insolvency procedures
(Chapter 11, Title 11 of the US Code) was proposed as a means to solve the
debt problem quickly and efficiently. At that time most creditors, especially
the BWIs, defended the so-called illiquidity theory: debtors would ‘grow out
of debts’. This view, called by Galbraith (1990) ‘financial flim-flam’, justified
inactivity: nothing needed to be done. Reality was admitted much too
slowly and still remains to be faced fully. After years, the ‘Toronto Terms’ and
the Miyazawa-Brady Initiative eventually accepted the impossibility of full
repayment. James Wolfensohn is to be commended for introducing the first
Highly Indebted Poor Countries (HIPC) Initiative in 1996, which broke the
last taboo, reducing multilateral debts, once the manifest need to do so
could no longer be denied. Its second version, HIPC II (1999), remained as
unsuccessful as the first. Because of absolute creditor domination this was to
be expected: too little was given too late. The problem has been prolonged
instead of solved. Calls were made for another improved HIPC Initiative (see,
for example, Zedillo et al., 2001), HIPC III. By proposing its Sovereign Debt
Restructuring Mechanism (SDRM) for middle-income countries (Krueger,
2001) the IMF admitted reality at last, immediately trying to profit institu-
tionally from the debacle it had created through its own and other IFIs’ debt
strategies. Suddenly turning around, the IMF advocated just what it had
fiercely opposed over many years.
After decades the fiction of total repayment is definitely gone. The only
remaining question is how to distribute losses. Apparently, the SDRM is an
attempt to protect the IMF’s own claims and to gain institutional advantages
(compare, Raffer, 2002; forthcoming). A reform of debt renegotiation that
J.K. Galbraith would be likely to approve remains to be supported by important
creditors. ‘Debt management’ so far has been based on total control and
domination by public creditors. Unlike in all other cases of insolvent

debtors, developing countries are still denied any debtor protection or
debtor rights. At present one law for the rich and another law for the poor
have been established – very much as under France’s ancien régime where
the legal standing of the privileged differed from that of the Third Estate.
In contrast to Galbraith (1952, p. 175), who made a theoretical case for gov-
ernment intervention where ‘countervailing power is not fully operative’,
OECD governments and the BWIs rigged the market further by precluding
the evolution of any ‘countervailing power’ the enormous debt pressure
might well have triggered. Financing bailouts they signalled that sovereign
lending carried no risk, thus oiling the Ponzi scheme’s wheels and abolishing
normal, healthy market risk. This in turn lead to a misallocation of resources:
the South got more than it would have received under market incentives – with
obvious, problematic results.
The history of sovereign debts shows that market solutions usually prevailed
before multilateral ‘debt management’. The lack of a proper mechanism
proved a certain hindrance to quick and efficient solutions, but creditors and
debtors eventually agreed on large debt reductions. More slowly and less effi-
ciently than insolvency mechanisms would have done, insolvency solutions
were de facto achieved. Knowing that not all loans will be repaid fully, pri-
vate creditors have always accepted losses once they were sure of a debt over-
hang. This lending risk is routinely incorporated into spreads. In the case of
insolvent debtors private creditors would have to finance any costs of further
debt management themselves and à fonds perdus. Therefore they have a
strong economic interest in a quick and acceptable solution unless someone
bails them out. Sometimes – most notably in the case of Germany – insolvency
mechanisms were emulated. Interestingly Germany, whose creditors, includ-
ing developing countries, granted substantial debt relief in 1953, put up
extremely fierce opposition to less generous debt relief for Third World
debtors after 1982, arguing that creditor rights must be respected.
Public interventions, most notably BWI debt management, tilted debt
relations against the market and debtors. Unlike before WWII private creditors
were offered bailouts after 1982. As any economic textbook would predict,
they accepted. The whole debt conundrum might already be overcome
if public creditors had not chosen to interfere with the market in an anti-
Galbraithian way. In the aggregate, losses necessary to achieve sustainability
would have been lower for creditors. Unwilling to acknowledge insolvency
and to grant early reductions, the BWIs boosted nominal debts to ever more
unrealistic heights, increasing the share of phantom debts, uncollectible
claims without any real economic base that exist only on paper. By including
phantom debts in official estimates the BWIs boost the ‘costs’ of debt relief,
providing economically erroneous arguments against meaningful reduc-
tions. This hides the fact that real costs – which means money that would be
really lost as it could actually be collected from debtors totally at the mercy
of their creditors – are much lower. Economically, one cannot lose money
one cannot get anyway. Changes in creditor structures, though, brought
about quite noteworthy redistributional effects between creditor groups,
exacerbated by the fact that IFIs were able to secure an unjustified privileged
status.
Political and institutional interests vs

economic efficiency
While private creditors are in the end interested in profits not in political
pay-offs, the interests of public creditors are more complex. Traditional debt
management did not solve the debt problem, but it has changed North–South
relations fundamentally. It provided long-term political leverage to the
North, subjected debtors to strict control, and served to enforce neo-liberal
policies and further globalization. The economic sense behind a solution
‘through concessional interest rates and a repayment period of 125 years,
including 65 years of grace’ (IBRD, 2000, p. 171) or a ‘ “bullet” option’ with
an interest rate of 0.0001 per cent (the IBRD does not dare write over how
many years) remains unclear at best. Rodrik’s (1996) explanation of the debt
crisis used as an opportunity to enforce policy changes seems more convincing.
Although they should know better, all IFIs wrongly claim to be ‘preferred
creditors’. Legally and pursuant to their own statutes they have no such
status. The IMF could not deny that it enjoyed no legal or contractual status
as a preferred creditor (Boughton, 2001, p. 820). Its own executive directors
emphasized a need to treat the IMF ‘in practice’ preferentially – a legally
irrelevant view to which they were, of course, entitled. The Interim
Committee endorsed this view and ‘urged all members, within the limits of
their laws, to treat the Fund as a preferred creditor’ (ibid., p. 821; emphasis
added).
Pressurized by external auditors, the IMF started to provide for non-
payment by building up loan loss provisions after its 1986 audit. Of course,
the IMF prefers not to use this term, presumably because that might lead
people to conclude that the IMF thinks losses unavoidable, preferring fancy
wording such as SCA-1 (Special Contingent Account). The IMF’s surcharge in
order to provide against loan losses was 0.1 per cent on average in fiscal year
2003 (IMF, 2003). Its ‘precautionary balances’ were about 8.5 per cent of
credit outstanding, as of the end of October 2003 (IMF, 2004, p. 26). The IMF
had decided to increase them further by two-thirds. All other IFIs have much
higher precautionary balances, ranging from slightly more than 20 per cent
(IBRD) to over 30 per cent (Asian Development Bank) of credit outstanding.
While charging members the costs of defaults, all IFIs refuse to use this
money for its intended purpose. This resembles insurance companies charg-
ing necessary fees but refusing to cover damages. Unlike IFIs, no insurance
company would get away with such behaviour.
The statutes of all multilateral development banks foresee procedures in

the case of debt overhangs. All have built up loan loss provisions as
demanded by their statutes, but refuse to use them as intended and needed.
While the IMF has no statutory obligation to grant debt relief – but is not
prohibited from doing so either – multilateral development banks violate
their own constitutions by not giving members in distress relief as stipu-
lated. Contrary to their founders’ intentions the IBRD has refused to use
relief mechanisms, wrongly claiming that doing so would make develop-
ment finance inoperational. This is clearly false. As the IBRD is only allowed
to lend to governments or with government guarantees sovereign default
was obviously considered a possible if not necessary way out by its founders.
The European Bank for Reconstruction and Development writes off losses
and submits to arbitration (also foreseen for the IBRD), which proves that
multilateral development banks, if properly managed, can survive financial
accountability and market risk.
Economically, IFI behaviour can be explained easily. Obeying one’s own
constitution by recognizing losses and using one’s loan loss reserves for the
purpose for which they have been created would mean losing money and
probably losing influence by defusing further crises one could again manage.
Violating one’s statutes means further crisis management, additional income
and importance, and new jobs. Creditor countries have repeatedly proved
their eagerness to reward this behaviour, egging IFIs on. BWI debt manage-
ment has always tried to establish and reinforce preferential treatment of
IFIs. Both HIPC initiatives preserve IFI privileges by shifting the burden of
losses as much as possible on to other creditors, expecting them to accept
higher losses and asking bilateral creditors to fund most of the reductions
‘granted’ by IFIs. Nevertheless, HIPC I met fierce resistance both within
Wolfensohn’s own institution and from the IMF. The economic results of
HIPC are as one could expect from a creditor dominated process: Highly
Insufficient Payment Cuts. Although both HIPC initiatives already contained
trace elements of the idea of insolvency – anti-poverty measures under HIPC II
in particular – they suffered from arbitrarily set definitions (compare, Raffer
and Singer, 2001, pp. 192ff.).
Targeting ‘emerging markets’ the IMF’s SDRM carries the logic of institu-
tional self-interest further. It attempts to obtain de jure preferred status for
IFIs in an extremely self-serving way. It would protect the IMF (and other
IFIs) from losses by legally privileging multilateral claims at the expense of
both private creditors and debtors. Characterized by strong institutional self-
interest the SDRM would firmly and officially install the IMF as the overlord
of sovereign debt relief. The IMF’s Executive Board would determine the
country’s policies and decree debt sustainability. Sustainability would auto-
matically determine necessary debt reductions.
This is not encouraging, as estimating debt sustainability highlights
the inefficiency of IFI programmes with utmost clarity. For decades, overly
optimistic forecasts have inflicted damage on member countries, rendering

strategies based on such forecasts, especially debt reductions, useless. The
IMF and IDA (2004, p. 13) themselves admitted:
past experience suggesting a systematic tendency toward excessive

optimism … a common theme behind the historical rise in low-income
countries’ debt ratios was that borrowing decisions were predicated on
growth projections that never materialized … analysis of projections
made by Fund staff over the period 1990–2001 suggests a bias toward
over-optimism of about 1 percentage point a year in forecasts of low-
income country real GDP growth. The bias in projecting GDP growth in
U.S. dollar terms, however, was considerably larger, at almost 5 percentage
points a year.
There is doubtlessly a ‘need for well-disciplined projections, including by

laying bare the assumptions on which they are predicated and by subjecting
them to rigorous stress tests that explicitly incorporate the impact of exoge-
nous shocks’ (ibid.). For some three decades the BWIs have consistently
made undisciplined projections whose assumptions were not explained and
that failed to take a country’s vulnerability to exogenous shocks properly
into account. Any normal client could successfully sue such consultants and
get financial compensation. By contrast, those affected by IFI negligence,
including many of the world’s poorest people, must shut up, pay up, and suf-
fer. IFIs themsleves draw additional income from new programmes originat-
ing from the failure of previous programmes based on over-optimistic IFI
estimates. Creating debacles is economically rewarded. Solving crises with
the first programme results in less income and less influence.
IFIs, especially the BWIs, established themselves as administrators of debtor
countries. Although forcing decisions on countries they have been able to
avoid any financial accountability for their actions. The normal market
mechanism of connecting decisions and risks was abolished. This resulted in
an economically perverted incentive system. A failed project may trigger a
new loan to repair damages done by the first loan. Failed adjustment pro-
grammes call for new adjustment programmes. Lending more than if crises
had been defused efficiently IFIs earn more income. Errors and negligently
caused damage increase their importance: ‘IFI-flops create IFI-jobs’ (Raffer,
1993, p. 158; compare also 2004b). Minds more critical than mine might
even argue that there exists an institutional interest in crises, which may
explain the record of IFIs. Legally privileging IFI claims would enshrine pre-
sent perverted incentive mechanisms with devastating economic effects.
Market incentives must finally be brought to bear on the last surviving
centrally planned economies.
Under the SDRM the IMF, both a creditor in its own right and controlled
by a creditor voting majority, would continue to call the shots. All this should
be enshrined in the IMF’s Articles of Agreement. This statutory approach

would further reinforce the IMF’s position. Its complicated nature is likely
to prove a major hindrance for solutions and a big employment programme
for the IMF. The SDRM proposal is a prime example of rent-seeking (Krueger,
1974) and the welfare costs it may cause: resources are devoted to competing
for the position of head debt manager and the benefits, financial and others,
that go with it.
The BWIs admit that delaying sustainable solutions has created enormous
damages in the South. In 1992, when the end of the debt crisis was pro-
claimed and one could argue that insolvency relief was no longer necessary, the
IBRD (1992, pp. 10ff.; emphasis in original) itself lectured that insolvency
was the problem: ‘In a solvency crisis, early recognition of solvency as the
root cause and the need for a final settlement are important for minimizing the
damage … protracted renegotiations and uncertainty damaged economic
activity in debtor countries for several years.’ By simply refusing to acknowl-
edge default, even when countries had not paid anything for six or seven
years (Caufield, 1998, p. 319) the IBRD has inflicted damages in violation of
its own statutes requesting debt relief when necessary. Speaking for the IMF,
Krueger (2001) clearly acknowledged damage caused by countries ‘waiting
too long’ to opt for insolvency procedures. It was conveniently forgotten
that the BWIs themselves forced debtors to ‘wait’. They had ardently lobbied
against debt reductions, arguing that countries would grow out of debts,
repeatedly supporting this claim with highly optimistic forecasts of future
export earnings. Some three decades of debt management by public creditors
have not solved but prolonged the problem. Economically this is inefficient.
However, institutional self-interest and political influence – which one
hopes, of course, to have been irrelevant – offer a good explanation.
Developing countries are the only debtors fully and absolutely at the mercy
of their (public) creditors. Unlike in all other cases there exist no debtor pro-
tection mechanisms. Their people remain totally unprotected against austerity
policies enforced to extract more repayment at severe cost to vulnerable
groups. Over decades public creditors have forced Southern debtors to make
sacrifices ‘which would not be acceptable in Canada and the United States’
(Galbraith, 1990). Even during the era of debt slavery creditors were not
allowed simply to grab and enslave insolvent debtors. The decision of a court
was needed. Sovereign debtors and their people do not even enjoy this flimsy
legal protection nowadays. Creditors themselves decide how to proceed.
Internationalizing Chapter 9: a fair

and efficient solution
All domestic legal systems have introduced insolvency as the only economically
efficient and fair solution to debt. Its record and the fact that no one wants
to abolish it prove that it has increased market efficiency. This strongly
suggests emulating national insolvency procedures for sovereign debtors, a

process that had already been advised as the best solution by Adam Smith.
Soon after 1982 it was repeatedly proposed to use the principles of corporate
insolvency in order to solve the debt overhang of sovereign states (compare
Raffer, 2001). The self-evident fact that the issue of sovereignty is not dealt
with by corporate insolvency was used as a powerful argument against this
first generation of proposals, especially by employees of multinational finan-
cial institutions. Nevertheless Krueger’s (2001) ‘new approach’ proposed to
adapt Chapter 11 – as corporate insolvency is called in the US – which should
raise questions regarding the intention to deal with sovereigns appropriately.
Once the IMF had presented the SDRM, many opponents of sovereign insol-
vency, especially IMF staff, forgot their earlier grave reservations. As though
touched by Harry Potter’s wand, ‘arguments’ used to assert that the principles
of insolvency could not be applied to sovereign debtors disappeared.
The proposal to adapt Chapter 9, Title 11 (municipal insolvency) as the
appropriate model was made in 1987 (Raffer, 1989) to counter the legalisti-
cally correct point that corporate bankruptcy (Chapter 11) cannot be applied
to sovereign states. The special features of public/sovereign debtors need to
be taken into account. Designed to solve the problems of governmental enti-
ties, Chapter 9 is easily adaptable to sovereign debtors. Naturally, only the
fundamental principles of Chapter 9 should form the basis of arbitration
proceedings; some important and necessary domestic details are unneces-
sary and inapplicable internationally. Eligibility and authorization to be a
Chapter 9 debtor – fundamental and useful as they are within the US for
constitutional reasons – are examples.
My international Chapter 9 – also called Fair, Transparent Arbitration
Process (FTAP) by some NGOs – is described in detail elsewhere (for example,
Raffer, 1990). So are its fundamental differences to and few similarities with
the SDRM (Raffer, 2002, 2003, forthcoming). This chapter presents its main
elements, focusing on the important changes in debtor–creditor relations it
would bring about.
Respecting the rule of law

It is the very foundation of the rule of law that one must not be judge in
one’s own cause. Internationally, creditors have been judge, jury, expert,
bailiff, even the debtor’s lawyer all in one, mocking the very concept of the
rule of law. This concept must finally be respected in the case of developing
countries and their peoples. Procedures must be chaired by neutral entities.
While an institutionalized neutral entity would be technically feasible, ad
hoc entities are preferable. Assuming that new cases will be rare once the pre-
sent backlog of problems has been dealt with, any standing institution
would be severely underemployed. Also, arbitration panels established by
creditors and the debtor for each case might be more acceptable as they give
parties more say. Following traditional practice in international law each
side – creditors and the debtor – would nominate one or two persons, who in
turn would elect a third or fifth person.
My panel differs fundamentally from the IMF’s proposed ‘Forum’ (under
HIPC there is not even any comparable entity). A perfectly neutral and
disinterested entity, it would not be an IMF body without authority to chal-
lenge the IMF’s Executive Board’s decisions. Sustainability would not be
determined by the IMF but would emerge from the transparent negotiation
process between creditors, the debtor and representatives of the affected
population. Arbitrators would have the task of mediating between debtors
and creditors, chairing and supporting negotiations by advice, providing
adequate opportunities to be heard for those affected by the plan, and – if
necessary – taking decisions. As facts would be presented by both parties and
the representatives of the population in a transparent procedure, decisions
would be unlikely to involve substantial sums of money but would rather
resolve deadlocks. Agreements between debtor and creditors would need the
panel’s confirmation, in analogy to Section 943, Chapter 9. Panels would
have to take particular care that fairness and a minimum of human dignity
of the poor is safeguarded – in analogy to the protection enjoyed by a munic-
ipality’s inhabitants or, in fact, any debtor in civilized legal systems. The
concept of human rights which demands debtor protection would finally be
extended to the South.
This panel could be established more quickly than by following the
clumsy procedure proposed by the IMF. No institution would remain, looking
for new tasks to justify its further existence once the debt problem has been
solved.
Unlike the SDRM or HIPC my Chapter 9 solution would be available
to any insolvent country. It is based on objective criteria not on creditors’
perceptions. Filing for insolvency protection would trigger a stay. Immediately
following its formation the panel must endorse or reject this stay. It has to
reject the debtor’s demand if unfounded; denying the debtor any advantage
from starting the procedure. It should verify claims, as is routine in any
domestic case. This proposal (Raffer, 1990, p. 309) – initially classified as
impracticable and utopian by IMF staff – has meanwhile become part of
Krueger’s ‘new approach’ (IMF, 2002, p. 68). This gives hope that absolutely
basic legal principles, such as checking whether someone signing a loan con-
tract actually had the authority to do so on behalf of the debtor might soon
be applied to Southern countries as well.
Respecting sovereignty
Chapter 9 is the only procedure protecting governmental authorities, thus
making it applicable to sovereign entities. In the US the court’s jurisdiction
depends on the municipality’s volition, beyond which it cannot be
extended, in the same way as the jurisdiction of international arbitrators.
Municipalities cannot go into receivership. Their ‘management’ – elected
officials – cannot be removed from office by courts or creditors (only, of

course, by the electorate).
The concept of sovereignty does not contain anything more than what
Section 904 protects in the case of US municipalities. Furthermore, a public
interest in keeping the debtor functioning exists. This makes Chapter 9
especially suited for sovereign cases.
Protecting debtors and democracy

Debtors – unless they are developing countries – cannot be forced to starve
their children in order to be able to pay more. Human rights and human
dignity enjoy unconditional priority, even though insolvency only deals
with claims based on solid and proper legal foundations.
A US municipality must be allowed to go on functioning and to provide
essential services to its inhabitants. Resources necessary to assure this are
exempt. This principle must also be applied to sovereign countries. Resources
necessary to finance minimum standards of basic health, primary education
and so on must be exempt. Private creditors have always been aware that
some money simply could not be collected, for what they often call ‘political’
reasons, which is another way of describing this exemption. Anti-poverty
measures under HIPC II have, finally, recognized this principle – at least
verbally. The SDRM, by contrast, falls below this minimum standard, making
no mention of any kind of debtor protection.
Exempting resources necessary to finance minimum standards of basic
health services, primary education and so on can only be justified if that
money is demonstrably used for its declared purpose. Not without reason
creditors, NGOs, and people from debtor countries are concerned that this
might not always be assured. The solution is quite simple – a transparently
managed fund financed by the debtor in domestic currency. The money going
into that fund would not be phantom debts but money that could actually be
recouped if no debtor protection existed, as is presently the case. The manage-
ment of this fund could be monitored by an international board or advisory
council consisting of members from the debtor country as well as from credi-
tor countries. They could be nominated by NGOs and by governments
(including the debtor government). As this fund is a legal entity of its own,
checks and discussions of its projects would not concern the government’s
budget, which is an important part of a country’s sovereignty. Aid could also
be channelled through the fund, changing its character from money just set
apart from the ordinary budget towards a normal fund for the poor.
Participation of the municipality’s inhabitants is guaranteed in two ways:
1. The affected population has a right to be heard.

2. If electoral approval is necessary under non-bankruptcy law in order to
carry out provisions of the plan it must be obtained before confirmation
of the plan pursuant to §943(b)(6).
The right of the affected population to be heard would have to be exercised

by representation in the case of countries, as is part and parcel of interna-
tional Chapter 9. Affected people would have the right to defend their interests,
to present estimates and arguments, to show why or whether certain basic
services are necessary. The openness and transparency usual within the US
would become the norm of sovereign insolvency. In short, I propose to apply
the same legal and economic standards to all debtors, to grant equal treatment
of indebted people everywhere.
Further participation by parliaments or the electorate could easily be
integrated. The debtor government can choose to leave the task of nominat-
ing panel members either to the parliament or the people. Voters could,
for example, elect arbitrators from a roster. Anyone reaching a minimum of
supporting signatures by voters would have to be on this roster. One arbitra-
tor might be chosen by parliament, the other by voters. The parliament
might establish a special committee for this purpose including members of
the cabinet, as proposed in a bill drafted on the initiative of Congressman
Mario Cafiero by the Argentine opposition party ARI. This bill would estab-
lish a Comisión Representativa del Estado Nacional. Consisting of members
from both houses and the executive power, it would nominate panel members
and represent Argentina during the proceedings.
In contrast to all initiatives so far, including the SDRM and HIPC, Chapter 9
would install open, transparent procedures befitting public entities and demo-
cratic states. Democratic values and governance would be duly protected.
As in creditor countries themselves, legal and constitutional norms would
not be overruled by creditor diktat.
Fairness to everyone
Precisely like the US insolvency laws which demand that solutions also be in
the best interest of creditors my model is absolutely fair to creditors. The
moral aspect of fairness apart, this is economically necessary. Only a fair pro-
cedure will be accepted by creditors and rightly so. A fair solution will allow
former debtors new access to capital markets. Fair to the debtor and the
debtor country’s population it would implement civilized debtor protection.
Fairness to creditors demands equal treatment of all creditors as proposed
above. All debts at the time of filing for Chapter 9 must be included, private,
bilateral and multilateral. For obvious economic reasons there would be no
cut-off date as practised over decades by the Paris Club. This cut-off date is when
the debtor first asked the Paris Club for debt relief, which could be the early
1980s. With an early enough cut-off date 100 per cent ‘debt forgiveness’ may
mean a reduction of less than 1 per cent of total debts. Eventually debt relief
converges to zero, while percentages ‘forgiven’ converge to 100–100 per cent
Paris Club ‘debt relief’ without a single cent actually granted.
Another doubtful practice of the Paris Club would become obsolete.
Non-Paris Club creditors are not allowed to participate in deciding debt
reductions but are expected to grant the same relief as Paris Club members.
The weakest actor, the debtor country, is obliged to assure comparable treat-
ment to creditors excluded from decision-making. Although Paris Club
creditors demand that their debtors should not treat other creditors better –
a basic tenet of insolvency, by the way – they refuse their debtors any legal
protection against lawsuits by unwilling non-Paris Club creditors. Debtors
have been taken to court in Paris Club member countries and been declared
in breach of contract. Formally quite correctly so, because creditor govern-
ments have passed no law protecting bona fide debtors doing what the Paris
Club forces them to do. This is hard to reconcile with the aim of solving the
debt problem. As all creditors would have the right to participate in an inter-
national Chapter 9 this exclusion of some creditors could not happen.
Furthermore, a slight change in sovereign immunity laws of the few relevant
jurisdictions chosen by most loan contracts would suffice to solve the problem
of disruptive litigation (Raffer, forthcoming).
Debt reduction must be uniform, the same percentage must be deducted
from all debts. So far, all approaches – especially HIPC and the SDRM – have
made important distinctions between the private sector, bilateral loans and
IFIs. While private creditors granting debt reductions have felt the sting of
the market mechanism, IFIs increase their exposure, knowing that their
claims are politically protected. This raises the question of whether an objective
reason exists for their preferential treatment. Considering all arguments the
answer is no. The understandable self-interest of any creditor apart, there is
no reason why they should get a better deal.
Multilateral lenders argue that they charge interest below the debtor’s
market rate. Even for normal IFI lending, which is too tough to qualify as
Official Development Assistance, this is generally (but not always) an objec-
tive difference between IFIs and the private sector. There is, however,
another objective difference: commercial banks did lend aggressively but
have usually not interfered with their clients’ economic policy, while multi-
laterals have strongly influenced the use of loans and exerted massive influ-
ence on debtor economies. IFIs take economic decisions but refuse to
participate in the risks involved. They insist on full repayment, even if dam-
ages negligently caused by their staffs occur, which have to be paid by the
borrower, as discussed above. To increase IFI efficiency and to improve their
role in capital markets, market incentives must be brought to bear. The inter-
national public sector must become financially accountable for its own
errors in the same way that consultants are liable to pay compensation for
damages caused by negligence on their part, or OECD governments are liable
for damages by negligence or the violation of laws. By contrast, the IMF
has been allowed and encouraged to violate its own statutes with impunity
(compare Raffer, 2004b). Finally, the present privileged position of interna-
tional public creditors discriminates unfairly against private creditors suffering
avoidable losses because of IFI privileges when countries are unable to service
their debts. This urgently calls for mechanisms to correct present inefficiencies.
Considering the trend towards unfair discrimination against private creditors
an international Chapter 9 would also be very much in the economic interest
of the private sector.
As it is practically impossible to determine the fair share of one or more
IFIs in failed programmes, Chapter 9 provides a clear and simple solution,
finally ‘bailing-in’ the public sector, making IFIs pay for avoidable errors and
shortcomings. Symmetrical treatment in an insolvency could be the way
that the BWIs are held financially accountable. While the importance of
decisions by official creditors may vary, their impacts have always been par-
ticularly strong in the poorest countries. Lack of local expertise in participat-
ing appropriately in decision-making and high dependence on aid are the
reasons. This is fundamentally different to private creditors who usually
limit themselves to lending without any additional consulting activities. The
present practice of letting ‘recipients’ pay for failures, errors or negligence by
their creditors-cum-consultants is particularly unjustified for countries with
high IFI involvement, which have been forced to orient their policies accord-
ing to IFI ‘advice’ for quite some time. As the shares of multilateral debts are
relatively higher in the poorest countries, protecting IFIs from losses is done
at the expense of particularly poor clients, often highly dependent on solutions
elaborated by IFI staff, as well as at the expense of other creditors.
Although an improvement, symmetrical treatment is not yet a satisfactory
solution because the perverted incentive system of rewarding negligence
would largely continue to function, in particular with regard to projects.
Therefore financial accountability must go further. The right of the victims
of development finance to compensation for damages must be established.
‘Advising’ IFIs must become liable to pay damage compensation for negli-
gent or irresponsible behaviour as private consultants have always been
under tort and liability laws. This important issue is treated elsewhere (Raffer,
1993, 2004b). The effect of financial accountability on Third World debts
would be remarkably lower multilateral debt burdens.
Conclusion
After decades the need for debt reduction is finally accepted. But creditors –
especially public creditors – remain unwilling to apply what they have been
teaching to their debtors over many years: respect for the rule of law and
human rights. They prefer to continue using Third World debts as a mecha-
nism to preserve political leverage and – in the case of IFIs – to establish
themselves as administrators of the Third World although this has had sub-
stantial negative effects on vulnerable groups as well as debtor economies. To
some extent laudable moves in the right direction, both the HIPC and the
SDRM also increase the dependence of debtors and enhance the importance
of IFIs as official receivers. Nationally no longer acceptable, this debt-prison
model must be abolished internationally. Another model of treating a debt

overhang is needed to level the playing field between debtors and creditors,
as Galbraithian government interventions would do. It must assure equal
treatment of all debtors irrespective of passport or colour.
A sovereign Chapter 9 would also stabilize the international financial
architecture because the perception that creditors or speculators would
always be bailed out in the Third World would be gone. This market imper-
fection in international credit markets would be repaired.
Technically, my proposal can be implemented at once. It uses existing
concepts and mechanisms, such as arbitration or domestic US Chapter 9.
Politically much remains to be done. Differing sharply from present creditor-
dominated procedures, this fair and transparent process, which would give
sovereign debtors the rights all other debtors have, is not yet acceptable to
OECD countries. Until this changes it is better to live on the right – and
mostly white – side of the North–South divide.
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16
Global Organization and
Developing Countries: Current
Aspects of Neo-mercantilism and
the Global Framework of
Accumulation
Dimitri Uzunidis
Introduction
The world economy consists of a set of relations between economic centres

of interest and power (commercial, technological and financial), both polit-
ical and military, of unequal strengths. The structures of domestic and inter-
national markets are determined by antagonistic relations (confrontations
and pacts) between such national centres (states and firms). The institutions
and big firms of industrialized countries shape world markets through
competition while the weakest economies suffer violent fluctuations in
prices as well as fluctuations in financial markets or raw material prices.
The word ‘globalization’ indicates a strong integration of national
economies into the international flows of capital and goods as well as the
implementation of a set of rules aimed at ensuring firms and financial insti-
tutions full freedom of action through the Bretton Woods international
institutions (IMF, World Bank, WTO). The neo-liberal framework of global-
ization was proposed by the World Bank economist, John Williamson in
1989, who coined the term ‘Washington Consensus’ (see P. Davidson’s con-
tribution, Chapter 11). A transnational legal framework of accumulation
generated by the political tensions and compromises between states is being
implemented. This global legal framework of accumulation is based on the
hard and fast principle in capitalism that capital must be used at all times by
all financial, commercial and regulatory channels with a view to making the
most durable profit possible. The current attempts to form a global legal
framework of accumulation are justified by the economic crisis and the
necessity to make new investments. This changes the norms and nature of
the global expansion of capitalist production: the old norm would associate
230
Global Organization and Developing Countries 231
market expansion with generalized mass consumption, and the new one
renews the markets through ‘permanent innovation’. The rules thus applied
to capital management and transnational accumulation illustrate the priority
objective of the top countries whose positions guide the international insti-
tutions’ interventions: to preserve and reinforce the economic power of big
industrial and financial groups by giving them better and easier access to
new production resources and by improving their profitmaking potential.
Neo-mercantilism and the global legal framework
The purpose of a global legal framework is to ensure the success of neo-

mercantilistic policies1 in which the ‘rest of the world’ is an unlimited market
for national products. For Joan Robinson, mercantilism is the natural trend
of capitalism because an economy of market and private enterprise is most
of the time an economy of buyers. Such an economy comes up against the
insufficiency of effective demand. The excess situation (defined by the
excess in the supply capacity in terms of capital, money and goods with
respect to the solvent demand), as Marx and Schumpeter cleverly demon-
strated, means that firms have to continuously renew their production
processes: renovate supply, reduce costs and open new markets. They must
therefore export. Joan Robinson shows without difficulty that the capitalist
world is always, in a way, a market of buyers, in the sense that production
capacity exceeds what can be sold for a profit. A situation in which demand
exceeds what firms can physically produce and sell is often a precarious one.
The resulting investment and recruitment increase production capacities to
the point where they achieve excess production. The evolution of capitalist
society is conditioned by the forecasts made by the entrepreneurs. Profitable
areas are rapidly saturated by new investors entering them in large numbers.
Competition and the short-sightedness of entrepreneurs together with
opaque markets and the retention of any type of information lead as much
to excess production as to monopoly.
As soon as a buyers’ economy is in place, the closing down of borders
worldwide is both reprehensible and, above all, untenable. Such a policy
is bad, not only from the point of view of the assumed superiority of free trade,
but because gaining market share in the export of goods and capital is as
beneficial to the capitalists as to the workers. In order to understand the dif-
ference between free trade and new mercantilism, Joan Robinson notes that,
as full employment is not guaranteed, profit and employment levels could
be higher at all times in a capitalist country if exports increased more rapidly
than imports. ‘The trading nations have always been mercantilist at heart’
(p. 227). To champion the adoption of free-trade policies, one must mention
that the advantage of abolishing foreign trade barriers is, for the national
exporters, greater than the disadvantage of lifting their own national trade
barriers.
New mercantilism is a system which impoverishes debtors. At all times

the most powerful economies (those recording a surplus in their foreign
accounts and/or having a common currency in their international transac-
tions) have discharged their surplus (goods and capital) into the other coun-
tries while carefully selecting their purchases from those countries. They are
concerned with the maintenance of their own national activity and impose
international rules (terms of trade, ‘free trade’, bills of exchange) that ensure
the flow of surplus savings while taking no further interest in the future sol-
vency of their debtors. The latter, representing most of the developing coun-
tries, are thus pushed into the spiral of debt, and then into the degearing and
reorganization crisis.
The sadistic deflationary policies (as John Maynard Keynes called them just
after the Second World War) which were implemented in the 1980s were
combined with policies of reduction in customs tariffs, in foreign exchange
restrictions, and with policies of increased foreign trade. Such public policies
of liberalization and rationalization of the markets of capital, goods and ser-
vices have also supported big firms thus making it possible for them to
implement financial, production and commercial strategies worldwide.2 As a
matter of fact, such firms can now manage their financial, industrial, tech-
nological and, often, human assets globally as they can adjust to national
economic and political rules which, for their part, tend to become simpler
and meet the institutional investors’ expectations. A global profit strategy is
characterized by (a) transborder expansion of the activities of the firm and
further centralization of its core functions in terms of organization and man-
agement of its investment, sales and finance; (b) growth based on the inte-
gration and increase of the firm’s property through multiple acquisitions,
takeovers and alliances involving other firms as well as institutions; and (c)
integration and unification of the big firm’s industrial, financial and com-
mercial activities to the detriment of the cohesion of national economies.
Any interpretation of globalization should be based on an in-depth analysis
of the changes that have occurred in the legal and institutional framework of
competition and accumulation. Globalization and corporate global strategy
make sense only if their aim is to remove the obstacles to profitmaking.
Hence the importance of a legal framework for the promotion and protec-
tion of ‘free enterprise’ worldwide. By ‘global legal framework of accumulation’
we mean the coherent set of coercive rules, forms, procedures, competitive and
cooperative means shared by economic players whose aim is to organize
public and private economic activities on a global scale without any visible
discrimination and without any preferential treatment. Such rules may
be new (for example, compliance of all countries with the rules of free circu-
lation of capital or protection of capital ownership) or old, but they must
be respected by all signatories without any discrimination in a context of
multilateral agreements (for example, compliance with the most favoured
nation clause for foreign investors whatever their origin). This legal framework
is a global one as it confers an inalienable legal status on the economic players

whose activity goes beyond the borders of a national economy. The organiza-
tion of transborder economic activities is possible only if the international firm
acquires a legal status, that is a status that ensures it full recognition, giving it
rights and obligations in any country as long as such rights and obligations are
similar from one country to the other. In this context of implementation
of supranational rules, it is clear that all countries must review their laws and
constitutions to ensure full compatibility of their legal systems with the
oncoming international law. The liberal legal framework of accumulation is
a framework that shows how ‘economic liberalism’, as it becomes reality, is
useful to the new mercantilism of the most powerful economies.
The economic stabilization programme (see ‘Washington Consensus’)
included in the legal framework of accumulation employs the major liberal
principles:
● Budget discipline. As public deficit is a source of inflation and balance of

payments deficit, budget austerity should help the state out of debt, but
also maintain and improve purchasing power mainly for the poorest
categories of population.
● Redefinition of government expenditure priorities. Subsidies in favour of
the economy, employment and firms should take the place of direct assis-
tance to health, education and the construction of infrastructures.
● Fiscal reform. In order to fight tax avoidance and the increase of parallel
economies, and also to improve the finances of the state and boost the
economy, the government should aim at two objectives: increase the tax
base and reduce marginal rates of taxation.
● Liberalization of interest rates. The market should determine interest
rates, but the state should see to it that they be positive and moderate so
that they can be attractive to international investors. The latter may thus
contribute to financing development.
● Competitive rates of exchange. The objective is to facilitate exports.
Controlled currency depreciation should be implemented to this effect
while avoiding the inflationary spiral due to excessively low rates.
● Liberalization of trade. The promotion of exports is not possible if not
concurrent with the liberalization of trade: both tariff and non-tariff barriers
must be lifted.
● Liberalization of foreign direct investment. To begin with, foreign investment
should be free from obstacles, and then international financial institu-
tions impose the liberalization of movements of capital of all sorts (which
paved the way for major financial crises throughout the 1990s).
● Privatization. Lower public deficit, contained state interventionism, and
also more competitive firms (in liberalized markets) through more appro-
priate management – such are the main objectives of privatization most
recognized by the experts of the ‘Washington Consensus’.
● Deregulation. Market contestability should be implemented on a large

scale. All governments should be inspired by the alleged success of
this type of policy (the Reagan years): lift barriers within and outside the
markets, and facilitate free enterprise.
● Property rights. The reinforcement of property rights facilitates private
initiative and enables the informal sector to acquire property rights at
acceptable costs.
World organization and national economies in trouble
As regards international relations, the catchword of governments (and

primarily the United States government) is ‘Trade, not aid’. According to the
standard economic theory, the international division of labour and special-
ization of national economies in the products for which they have abundant
capital or labour are not only beneficial to particular countries but to the
whole world. Through the action of the relative prices of goods and agents,
costs will decrease and the standard of living of populations will improve.
The free circulation of goods and, in their absence, of capital, is the pre-
requisite for global well-being, even if in the short term some economic
adjustments would make more than one nation suffer (Krugman, 1997). But
history shows that some specializations are impoverishing and discriminat-
ing. The poorest countries suffer more from deteriorating terms of exchange
than they suffer indirectly from subsidies to rich farmers. The prices of agri-
cultural raw materials are very volatile: between 1997 and 1999 prices have
decreased by 48 per cent for cocoa, 36 per cent for tea and 46 per cent for
cotton. The recovery over the last three years should not hide that since 1995,
the terms of exchange for all the primary goods exported by the South have
deteriorated by 42 per cent in constant dollars.3 Such countries must then
borrow to pay for their imports of food and industrial products, aggravating
their trade deficits and, consequently, their external debts.
The generalizing legal framework of accumulation, with its aim of imposing
and maintaining free circulation of goods and capital, contributes to the
decreasing role of the state in the economic development process. Without
any real instruments of economic policy (money being subjected to interna-
tional rules and fluctuations, and the regulatory framework being designed
externally), most developing countries have lost control of their own
economies (many of them, in fact, have never been in control). Their nego-
tiating power with big international firms in terms of technology transfer,
employment, ploughback or protection of young industries is reduced. As
the national measures implemented to control investment or goods flows no
longer apply, national governments lose control of the economy. The prob-
lem is then an economic one. The launching of large accumulation processes
in most developing countries is due to the measures implemented for foreign
investment control in the sectors of primary resources, energy, transport,

communications, defence and security, banking and finance and so on. After
the multilateral liberalization of flows, the host country has lost its capacity
to focus foreign investment on the sectors likely to promote or reinforce its
national industries and/or to control its own market. The absence of any
efficient control over the activities of international firms reduces the spin-off
effects on local activities, curbs investment, weakens the local structures of
production and makes the economy more dependent on external resources
and more vulnerable to global market fluctuations.
In addition, the global implementation of the legal framework of accumu-
lation does not mean a better allocation of production resources worldwide.
The countries which are further advanced towards development and have
implemented adequate attraction policies will always be the ones receiving
the highest volumes of foreign investment and retaining a leading position
in international trade. The countries with good transport, telecommunica-
tion and energy infrastructures, those with the richest scientific and techni-
cal potentials, those with large financially solvent markets will be the first to
be served by global firms. The more developed the production forces on a
national basis, the easier it is for the relevant economy to integrate the global
logic of big firms. The liberalization of capital markets, the presence of posi-
tive interest rates as well as the easy terms and the ‘national treatment’
granted to internationalized firms should, for their part, offer new prospects
for the financing of development. But, according to UNCTAD (2002), in the
1990s and at the beginning of this century, 90 per cent of foreign direct
investment only concerned a small group of ‘emerging economies’, against
about 50 per cent before the start of the debt crisis. The ‘least advanced coun-
tries’ have to make do with 1 per cent of international investment. Not only
are they unattractive to investors, but they are also increasingly dependent
on public aid for development, which is far from the objective of 0.7 per cent
of the GDP of rich countries as determined at the Rio summit in 1992.
One of the main causes of the failure of development under the rules
laid down by the global legal framework of accumulation is the ‘all market’
attitude applied under the pressure of international financial institutions
encouraged by the Bretton Woods institutions. Internally, the reduction in
the social bill relative to non-profitable expenditure, wage austerity, lay-offs,
and streamlining policies following nationalizations lead to deeper social
inequalities in the countries adhering to budgetary and fiscal orthodoxy. On
the other hand, fiscal policies follow the implacable liberal logic by the terms
of which if the income of the privileged sections of the population increases,
the latter will finally invest, hire employees, distribute wages, and solve the
poverty issue. But, due to the liberalization of capital markets, those privi-
leged sections of the population invest their savings in foreign countries
and thus contribute to financing growth in the countries of the northern
hemisphere.
More serious still, the failure of the ‘consensus’ can also be attributed to
the unorthodox but fundamentally neo-mercantilistic policies implemented
by industrialized countries. As pointed out by the World Bank,4 the US gov-
ernment advocates free trade, but its agricultural, steel and ‘sensitive sectors’
policies (advanced technologies, armament) are far from complying with the
principles of ‘free enterprise’. Will the recent WTO agreements cancelling
subsidies make it possible to reverse the situation in aid of Southern produc-
ers? Each year, US producers receive $10.7 billion in subsidies, while the
whole country devotes only $3.1 billion to public aid for the development of
Sub-Saharan Africa. At the same time, in 1994 the provisions relative to pub-
lic markets in the Marrakech Agreement, which eventually led to the forma-
tion of the World Trade Organization, stipulated that the armament markets
and the markets proving ‘necessary for national security’ (art. 23) could be
excluded from the negotiation over the lifting of protectionist barriers in
international trade and financial relations. The WTO subsequently issued
the multilateral agreement on investment which excludes international
investment and public orders relative to defence and advanced technologies
from the scope of free trade. But is it possible to exclude such products without
trespassing on the wider domain of ‘traditional industries’?
The countries (North Korea, Taiwan, post-Pinochet Chile) that have not
entirely observed the above programme, or that have not observed it at
all (China, India) and that, instead of adopting full liberalization and privati-
zation policies, have privileged a strong public sector to absorb the financial
crisis and continue to develop their industries, have obtained better macro-
economic results than other comparable countries (Brazil, Argentina, the
Philippines, and so on). Such countries adopted anti-cyclic policies, even
during periods of financial crisis: increases in education, health and infra-
structure expenses, progressive taxation, control over short-term capital
inflows and so on. The countries that have not conformed to adjustment pro-
grammes have obtained better results in terms of the fight against poverty
than those that have implemented the IMF and World Bank programme.5
The virtuous cycle of accumulation and growth is closely related to deep
economic changes and especially to industrial development and diversification.
Even during the debt crisis, the economies of South-East Asia continued to
rely on high added-value, technology-intensive industries and services. On
the other hand, most Latin-American and African economies are experiencing
‘premature de-industrialization’6 (Table 16.1).
As Joseph Stiglitz points out, ‘Developing countries keep asking why the
United States, when facing an economic crisis, is in favour of expansionist
budgetary and monetary policies, whereas when they are themselves in a
similar situation, they are asked to do exactly the opposite.’7 Of course, the
Bretton Woods institutions and the international financial institutions will
not allow developing countries to act this way in times of crisis. But, further
to the setbacks suffered by neo-liberal economies in the 1990s, as well as the
Table 16.1: Share of manufacturing production in GDP per region,

1960–2000 (%)
Region 1960 1970 1980 1990 2000
Sub-Saharan 15.3 17.8 17.4 14.9 14.9

Africa
Western Asia and 10.9 12.2 10.1 15.6 14.2
North Africa
Latin America 28.1 26.8 28.2 25.0 17.8
Southern Asia 13.8 14.5 17.4 18.0 15.7
Eastern Asia 14.6 20.6 25.4 26.8 27.0
(excl. China)
China 23.7 30.1 40.6 33.0 34.5
Developing 21.5 22.3 24.7 24.4 22.7
countries
Developed 28.9 28.3 24.5 22.1 18.9
countries
Source: R. Kozul-Wright and P. Rayment, Globalization Reloaded: an UNCTAD

Perspective, Discussion Paper no. 167, United Nations Conference on Trade and
Development, January 2004.
financial crises, a measured revival of regulation and institutionalism seems

to be taking place internationally. The World Bank recommends the imple-
mentation of good governance (development of education and infrastructures,
environmental protection, fairer distribution of resources) as a necessary
condition for smoothly operating markets. A legal system is required to reg-
ulate the liberalization of the markets of products, capital and labour and
thus to prevent such problems as capital evasion and the rise of illegal and
informal activities. Institutional reform is indispensable to a better supervi-
sion of the economy, involving all the economic players (politicians, firms,
trade unions) in decision-making processes. Finally, the taxation system
should see to the fair distribution of income. However, it will also be neces-
sary to ensure that the poor may ‘have access to assets’: education, property,
micro-credit, land reform and so on. This does not mean a return to a sprawling
state, both corrupt and extravagant, but to a ‘clever state’.
The global legal framework of accumulation formalizes the neo-
mercantilistic policies of the major industrial countries while promising
developing countries the acceleration of their industrialization through free
trade. It is a matter of applying an economic model to societies ‘without
taking account of the concept of historical process’.8 Throughout his works
on development, J.K. Galbraith has always supported the need to make
allowances for the historical specificities of economies to which the super-
powers apply ready-made development programmes. Such programmes
reflect the condition of the economy of those powers and leave little room
for the social and political conditions which could make up a basis for capital
formation. Learning the lesson from the experience of old industrial countries,
in Galbraith’s opinion the prerequisite to economic development is political
development, itself conditioned by the democratization of education. The
political system should be stable and predictable, honest and efficient;
citizens, both educated and informed, should be players in this system. But
for this purpose, citizens should be educated. Education is the keystone of
the political organization from which the development process arises. ‘Free
and compulsory education of a good standard breaks off the accommodation
to the culture of poverty. But it is also closely associated with the democratic
regime.’9 Then, a good general education paves the way for more specific
education in the technical, scientific or administrative fields, making it
possible to train the ‘human capital’ required for selecting, designing and/or
using and improving the technologies which are necessary and compatible
with the economic development project. General and specific education are
also vital to the formation of a stable political system which can give a sense of
purpose to development and provide the economy with the tangible, financial,
cognitive and institutional resources it requires to this effect.
Development and institutional revival
In an open economy, how can development be oriented? What are the

conditions, and what types of institutional tools can an economy use to sta-
bilize the economy, control flows and master stocks? International institu-
tions have realized that without the state, in the absence of a representative
political system, economies sink and firms get weaker. Table 16.2 shows the
damage caused by the implementation of a liberal legal framework of accu-
mulation to the most fragile economies, and, on the other hand, some insti-
tutional agreements which are necessary to get out of the accommodation to
underdevelopment.
J.K. Galbraith militates in favour of greater determination by the IMF in its
‘cleansing action’ relative to ‘incompetent bankers and business people’ and
a kinder attitude to ‘the innocent and suffering peoples whose general
demand is necessary to the economy’.10 International dialogue is required. It
is thus necessary to accept, as Joseph E. Stiglitz said, a progressive and differ-
entiated international opening according to the national objectives of the
developing countries, as has been done by the neo-mercantilistic super-
powers which have built their economies while protecting their key indus-
trial sectors and their marketing forces. But the WTO prevents developing
countries from protecting their industries by replacing their imports by local
production or by applying higher ‘local content’ standards in case of foreign
direct investment (Agreement on Trade-Related Investment Measures – TRIMS).
It also forces those countries to enforce very strict legislation for the protec-
tion of intellectual property rights (Agreement on Trade-Related Aspects of
Intellectual Property Rights – TRIPS), which annihilates every effort aimed
at absorbing and developing new technologies. Even if the new official
Table 16.2: Patterns of development
Liberalism, globalization and Institutional revival and market

development crisis control
● Instability and political crises ● Promotion of a predictable political

● Unemployment, pauperization, system and rehabilitation of the role
deeper social inequalities of the state
● Defective markets, informal practices ● Priority to education and collective
● Unstable financial institutions social infrastructures
and regulations ● Coordinating system for market
● Neglected collective infrastructures players, and decision-making power
● Economy subject to the of the state
uncertainties of the international ● Procedures for the control of national
environment production resources (formation of
● Fragile national economy due to the capital, income, currency)
unpredictable movements of capital ● Domestic savings centralization
system
● International opening differentiated
according to national objectives
thinking about the relationship between development and international

relations is focused more on the state and institutions, it is far from opening
new forms of organization of the world economy.
Conclusion
The outlook is even darker, due to the return of bilateralism in the processing
of economic issues. While the IMF, since the crisis in South-East Asia, has
re-examined its position on the uncontrolled liberalization of movements of
capital, the US administration, outside the framework of the WTO, has started
bilateral negotiations with countries such as Chile or Singapore intended to
make them lift all regulatory barriers to capital inflow. The US administration
describes as ‘a coalition of liberators’ the group of countries which link to the
US via bilateral or regional ‘free-trade’ agreements. Brazil and Argentina would
like better cooperation between Latin-American countries, and they would
also like better access to the United States’ market for their beef, orange juice,
cotton and tobacco. The US government response is to sign free-trade agree-
ments and begin negotiations with other Latin-American countries, but also
with Asian countries (ASEAN), and countries in the Middle East, in Africa (cus-
toms union with South Africa, Morocco and so on) and Oceania (Australia).
According to forecasts, at the end of 2004, in addition to Canada, Chile and
Mexico, twelve other Latin-American countries (Colombia, Ecuador, Peru and
so on) will join the free-trade area initiated and organized by the United States.
This policy, which is also called ‘competitive liberalization policy’,11 is a
response to the relative changes in the WTO’s opinion faced with the
uncontrolled liberalization of the flows of goods and capital and further to
a number of protests by citizens and some governments of the Southern

countries. For the United States, this neo-mercantilistic policy is vital to safe-
guard its military and monetary power as well as for the benefit of its big
firms. For the governments and privileged classes of the allied countries ‘com-
petitive liberalization’ entails two major risks: their low negotiating capacity
facing such a huge economic power could lead them into the same deadlock
as the implementation of the measures of the ‘Washington Consensus’
revised by international financial institutions and it will be difficult for those
developing countries to make up their own groups of negotiators at interna-
tional conferences. By adopting the ‘my way or the highway’ approach, the
US government impedes the anticipated reform of the international institu-
tions and of the global legal framework of accumulation. But the attitude of
the governments of many developing or industrialized countries in accepting
the unilateral US position also deserves blame for the entropy and the turbu-
lence which could mark the world economy in the coming years.
Notes
1. ‘New mercantilism’ (otherwise neo-mercantilism) is a term borrowed from
Joan Robinson. See J. Robinson, An Introduction to Modern Economics (London:
McGraw-Hill, 1973); D. Uzunidis and B. Laperche, ‘Power of the Firm and
New Mercantilism: an Analysis Based on Joan Robinson’s Thought’, in L.R. Wray
and M. Forstater (eds), Contemporary Post Keynesian Analysis (Cheltenham, UK and
Northampton, MA: Edward Elgar, 2004), pp. 333–47.
2. D. Uzunidis, ‘Nature financière et économique des transnationales et cadre légal
mondial’, Alternatives Sud, vol. IX (2002).
3. World Bank, Global Development Finance 2004 (Washington DC: World Bank, 2004).
4. Ibid.
5. W. Easterly, ‘The Lost Decades: Explaining Developing Countries’ Stagnation in
Spite of Policy Reform 1980–1998’, Journal of Economic Growth, 6(2) (2001), 135–57.
6. R. Kozul-Wright and P. Rayment, Globalization Reloaded: an UNCTAD Perspective,
Discussion Paper no. 167, United Nations Conference on Trade and Development,
January 2004, Geneva.
7. J.E. Stiglitz, La grande désillusion (Paris: Fayard, 2002), p. 308.
8. J.K. Galbraith, La voix des pauvres, ou, ce qu’ils ont à nous dire sur l’économie (Paris:
Gallimard, 1984), p. 21.
9. Ibid., p. 36.
10. J.K. Galbraith, Pour une société meilleure: Un programme pour l’humanité (Paris: Seuil,
1997).
11. T. Barry, ‘Coalition Forces Advance’, ‘America’s Program’, Interhemispheric
Resource Center, Silver City, July 2004, www.americaspolicy.org.
References
P. Krugman, Pop Internationalism (Chicago: MIT Press, 1997).
UNCTAD, Annual Report (Geneva, 2002).
Index
Abramovich, Roman 191–2 Balassa, Bela 201, 203

accumulation, global legal framework of Baldwin, R. 159
230–1 Bank of England 132, 149
and concentration of resources 235 Bank of Japan 153
and developing countries 237 banks, and Russia 183–4, 192
and failure of development 235 Baran, Paul 45, 60
and meaning of 232–3 Barnes, Justin 211
and neo-mercantilism 231–4, 237 Barro, R.J. 112, 113, 114, 136
and purpose of 231 Bay of Pigs 54
and state’s decreased role 234–5 Beard, Charles 55
and Washington Consensus 233–4 behavioural economics 83–4
Acemoglu, D. 145 Bellone, F. 158
Adelman, Irma 165 Bentolila, S. 155
Agénor, P.-R. 118 Berle, A. A. 18
aggregate demand Biefang-Frisancho Mariscal, I. 112
and demand for and supply of bilateralism 239
92–4 Black, Bill 20
and institutions as determinant of 5, Black, John D. 3, 31
93–4 Blinder, Alan 67, 68, 116
and party control theory of economic Blundell, R. 117
policy 93 Bobbio, Norberto 57
and political economy theory of Boeri, T. 155
92–4: and formal model 95–9; Böhm, B. 147, 148, 149, 150
and test results 99–101 Boskin, Michael 72
and power as determinant of 5, Boskin Commission 72
92–3 Boughton, J.M. 218
Agricultural Adjustment Administration BP-TNK 183
31 Brainard, William 69
Akerlof, G. A. 75 Brazil 198, 216
Alesina, A. 117 Bretton Woods agreements 56, 167
Alfa group (Russia) 185 Bretton Woods Institutions, and Third
Amendola, M. 152, 153, 157 World debt 215, 217
American Agricultural Economics Brooks, David 83
Association 15 Bryce, Robert 36
American Economic Association 15, budget deficits
30, 37 and eurozone 126–7
Arestis, P. 105, 112, 130, 135 and Stability and Growth Pact 128,
Argentina 198, 202, 216 136–8
Aron, Raymond 57 Burns, Arthur F. 38, 67
Arrow, Kenneth 40 Burns, Terence 212
Asian Development Bank, and loan loss Bush, George W. 19, 54, 82
provisions 218
Association for Evolutionary Cafiero, Mario 225
Economics 15 Cambridge University 35–6
241
242 Index
Canada, and First World War 27 control fraud 20–1

capital, and nature of 79 conventional wisdom, concept of 17
capital controls 197 and Central Banks 130–1
capitalism as metacultural frame 78
and the common good 78, 80 convergence, and concept of 180
and democracy 59 coordination failures 7
and equilibrium 81 and European Union 144, 148,
and global legal framework of 150–1, 160–1
accumulation 230–1 corporate global strategy 232
and government’s role 81–2 corporate governance, and George
and hoarding 81, 85n8 W. Bush administration 19
and nature of capital 79 ‘Corporate Republic’ 19
and non-productive behaviours 78–9 Council for Economic Planning and
and oversight of global corporate 82 Development (Taiwan) 206
and pseudo-capitalists 78–80 Council on Economic and Financial
and relative capitalism 79, 80–1 Affairs (ECOFIN) 126
and self-interest 78, 82 countervailing power 18
and unregulated nature of 57 credit controls 134
see also neo-liberalism Crosland, Anthony 57
catch-up development, and developing crowding-out, and fiscal policy 109–12
countries 199 Cunningham, S.R. 109, 110, 136
Caufield, C. 221 currency crises, and international
Central Banks financial system 166–7
and exchange rates 133–4 Currie, S. 141
and fashionable role of 130–1 Czech Academy of Sciences 57
central planning 199
Chandler, Alfred 73 Dahrendorf, Ralf 57
China 58–9, 207 debt see Third World debt
Chirinko, R.S. 109 deficit bias
Churchill, Randolph 21 and fiscal policy 117
civic participation 56, 61 and governance 118
Clark, John Bates 80 DeLong, Brad 69, 111
clearing union, international, and Delors, Jacques 57
proposals for 170–6 democracy
Clinton, Bill 169 and capitalism 59
cognitive science 84 and economic development 48
Colander, D.C. 36 Democratic Party, and presidential
Cold War 54–5 election (2004) 82
and military establishment 42–3 Dennison, Henry 34–5
Colombia 202 developed countries, and fiscal policy
common good, and self-interest 78, 80 118, 119–20
Commons, John R. 32 developing countries
competition policy 156–9 and catch-up development 199
and European Commission 143, 156 and economic development
conservatism, and psychological 9–10, 236
bases of 84 and finance capitalism 197–8
consumer choice, and The Affluent and fiscal policy 118, 119
Society 2, 17–18 and global legal framework of
consumption, and dependence on accumulation 234–5
production 18 and good governance 237
Index 243
developing countries – continued economic policy, and party control

and governing the market 209–12 theory of 93
and industrial policy 10 economics
and militarism 48–9 and biases within 4–5, 65, 74–5, 83:
and restrictions on 238 and efficient market theory 74;
and state’s decreased role 234–5 and free trade 70–1; and growth
and supranational rules 10–11 theory 73; and inflation
and trade regimes and economic measurement 71–2; and
performance 200–2 monetarism 66–9; and natural
and Washington Consensus 198–9 rate theory 69–70; and public
see also Third World debt investment 72–3; and rational
development, and institutional revival expectations 70; and shock
238–9 therapy in Russia 73–4
developmental state, and industrial as conformist Salon 65–6
policy 206 and contradictory approaches to 1
Dickens, W.T. 75 and future of 2–3
disarmament 4, 40, 48 and research programme for 20: and
and implications of 46–7 control fraud 20–1; and
division of labour, international 234 inequality 20; and monetary
Dolado, J. 155 policy 21; and principle of
Dorfman, Joseph 29 21–3
Drury, E.C. 28 Economists Allied for Arms Reduction
(ECAAR) 40, 45
East Asia education, and economic
and crisis (1997–98) 198 development 238
and East Asian Miracle study (1993) efficient markets theory, and
202–3 management of firms 74
and economic development Ehmke, Horst 57
9–10, 199 Eichengreen, Barry 165
and industrial policy 199–200, Eisenhower, Dwight D. 49
202–3: and low-level intervention Eisner, Robert 40, 73
204–5; and role of state 205–9 elites, and social control of 4
and liberal explanation of catch-up Ely, Richard 29–30
growth 200–3 embezzlement 17
and trade regimes and economic employment
performance 201–2 and definition of full 88
Easterly, William 73 and free trade 71
Economics, Peace and Security (EPS) 40 employment protection 154–5
economic development English, John 27
and democracy 48 Enron 78, 84n6
and East Asia 9–10 equilibrium, and capitalism 81
and education 238 Erler, Fritz 57
and militarism 48–9 Eschenburg, Theodor 57
and the state 199 European Bank for Reconstruction and
economic growth Development 219
and European Union 142–3 European Central Bank (ECB) 6, 127
and growth regimes 147–8 and changes required in 134–5
and institutional change 6–7 and commenting outside its remit
economic organization, and The New 131–2
Industrial State 2, 18–19 and exchange rates 133–4
244 Index
European Central Bank (ECB) – continued firm management, and economic

and finance capitalism 198 bias 74
and justification for 129–30 First World War 27
and lack of accountability 132 fiscal policy
and monetary policy 128, 129–35 and crowding-out 109–12
and neo-liberal agenda of 131–2 and ‘deficit bias’ 117
and one-size-fits-all problem 132–3 and economic development
and responsibilities of 128, 143 level 118
European Commission, and competition and eurozone 127, 136–7, 139–40
policy 143, 156 and institutional aspects of 115–18
European Constitution 127 and model uncertainty 115–16
European Convention 127 and need for reinstatement of 6,
European Monetary System 100, 101 105, 120
European Monetary Union (EMU) 6 and ‘new consensus’ in
European Union 60 macroeconomics 106–9
and budget of 128, 140–1 and pro-cyclical nature of 116
and competition policy 156–9 and quantitative effects of 118–20
and coordination failures 144, 148, and Ricardian equivalence theorem
150–1, 160–1 112–15
and economic performance of 142–4 and Stability and Growth Pact 128
and economic transformation 151–2 and supply-side inefficiencies 117–18
and growth regimes 147–8 Fischer, Stanley 165
and impact of country size 160 Fisher, Irving 30, 111
and improving job creation 145–6 Fitoussi, J.-P. 148, 149
and inappropriate economic foreign direct investment 198
policy 148 and concentration of 235
and institutional failures 145 and outward FDI 206–7, 211
and labour market 146–7, 154–5 foreign policy 43, 53, 54
and monetary policy 148, 152–3 Frankfurter, Felix 35
and need for coordination 144 fraud
and post-war economic development and control fraud 20–1
144–5 and financial panics 2, 17
and structural instability 148 and innocent 78, 81
and structural reforms 146–7 free trade
eurozone and bias in favour of 70–1
and budget deficits 126–7 and exclusions from 236
and coordination of fiscal policy and new mercantilism 231
136–7, 139–40 Fridman, Mickhail 185
and economic performance of 126–7 Friedman, Milton 37, 38, 66–7, 69,
and exchange rate volatility 133 74, 115
and fiscal policy 127 Friedmann, Georges 57
and ‘new consensus’ in Fukayama, Francis 32, 40
macroeconomics 128–9 full employment, and definition of 88
and policy framework for 128–9 Furner, Mary 30
Fama, Eugene 74 Gaffard, J.-L. 148, 149, 150, 152,

Fazzari, S.M. 109, 110, 120 153, 161
finance capitalism, and ascendancy Galbraith, Archie 27–9
of 9, 197–8 Galbraith, John Kenneth
financial panics 2, 16–17 and approach to economics 1, 52–3
Index 245
Galbraith, John Kenneth – continued see also accumulation, global legal

and disarmament 40, 48 framework of
and economic development 237–8 Goldfield, S. 67
and education 238 Goldwater, Barry 83
and financial panics 16–17 Goodhart, C.A.E. 141
and foreign policy 43, 53, 54 Gorbachev, Mikhail 57, 58, 180
and honesty of 35 Gordon, D. 110
and industrial society 52, 56–7 governance, and World Bank 237
and influences on 1, 3, 32: and governing the market, and industrial
agricultural policy 30–1; and policy 205, 209–12
early years 26–9, 53–4; and government, and relative capitalism
Howard Tolley 30–1; and John 81–2
D. Black 31–2; and Keynesianism Gramsci, Antonio 77, 83
26, 32; and Leo Rogin 29; and Great Society 59
pre-Keynesian academic Grether, Ewald 29, 30
economics 29–30 growth theory, and economic bias 73
and intellectual courage of 65
and Journal of Post Keynesian Hansen, Alvin 32, 36
Economics 38 Hemming, R. 106, 110, 115, 117,
and Keynesianism 3, 34–6 118, 119
and militarism 41–4, 45–6, 48–9 Hicks, John 168
and military expenditure 44–5, Highly Indebted Poor Countries (HIPC)
47–8, 54 initiatives 216, 219
and Post Keynesianism 3, 38–9 hoarding 85n8
and Third World debt 214, 216, 221 and pseudo-capitalists 81
as transforming figure 16 Hochfeld, Julian 57
and writings of: The Affluent Society Hong Kong 201
(1958) 2, 17–18, 32–3, 56;
American Capitalism (1952) 18, imperialism, and United States 53, 54,
56; Capitalism, Communism and 55–6
Coexistence (1988) 8, 180; The India, and Galbraith 54, 60
Culture of Contentment (1993) industrial capitalism, and subordination
41–2, 43, 44; Economics and the to financial capitalism 9
Public Purpose (1973) 36, 41, 43, Industrial Development Bureau (Taiwan)
44; The Great Crash (1955) 2, 204, 206, 211
16–17; A Life in our Times (1981) industrial policy
34; Modern Competition and and East Asia 199–200, 202–3: and
Business Policy (1938) 35; The low-level intervention 204–5
Nature of Mass Poverty (1980) and governing the market 205,
214; The New Industrial State 209–12
(1967) 2, 18–19, 41, 56 and role of state 205–9
Galbraith, Kate 27, 28 and sectoral policies 204
Galbraith, Kitty 35, 37 and spillovers 203
Gazprom 185 and types of 203–4
Germany industrial society 4, 52, 56–7
and sovereign debt 217 and state socialism 57–9
and United States 56 and Third World 60
globalization and western social democracy 59–60
and corporate global strategy 232 Industrial Technology Research Institute
and neo-liberalism 230 (Taiwan) 206
246 Index
inequality and loan loss provisions 218–19

and research programme for and ‘preferred creditor’ claims 218
economics 20 and rewarded for failure 220
and Russia 188 and Third World debt 215–17
and unemployment 20 international financial system
inflation and fundamental flaws of 166–8
and aggregate demand policies 91 and global reserve system 168–9
and labour power 90 and IMF loans 169
and measurement of 71–2 and international clearing union
and monetarism 67–9 proposal 170–6
innocent fraud 78, 81 and Keynes on 170
innovation 6–7, 142 and need for new architecture of
and labour market flexibility 154, 169–70
155–6 and problems with 8, 165
and requirements for 145–6 and reform proposals 165
insider operations 2, 17 and special drawing rights 169
institutionalism, and international and Washington Consensus 165–6
revival of 237 International Monetary Fund 8, 9,
institutionalists 3, 29 60, 165
institutions and institutional self-interest 219
and definition of 102n3 and loan loss provisions 218
as determinant of aggregate demand and ‘preferred creditor’ claim 218
5, 93–4 and Sovereign Debt Restructuring
and development 238–9 Mechanism 216, 219, 220–1
and economic outcomes 95, 97–9, and Third World debt 215
100–1 and Washington Consensus 169
and economic performance 5, 87, international relations, and ‘trade, not
101–2 aid’ 234
intellectual property rights 238 Intriligator, Michael 40
International Bank for Reconstruction investment, and economic
and Development (IBRD) 215 performance 202
and failure to grant debt relief 219
and insolvency 221 Japan 144, 148, 207
and loan loss provisions 218 and economic performance of 150
international clearing union, and and monetary policy 153
proposals for 170–6 Jensen, Michael 74
International Development Johnson, Lyndon Baines 53, 59
Association (IDA), and Third World Jost, John T. 84
debt 215 Journal of Post Keynesian Economics
international development community, 37–8
and Washington Consensus
196–7 Kahn, Richard 35, 36
international financial institutions Kahneman, Daniel 83
(IFIs) Kalecki, Michael 35
and failure to grant debt relief 219 Kasyanov 185
and inefficiency of programmes Kennedy, John F. 52, 54, 55, 57
219–20 Kerry, John F. 82
and institutional self-interest 219, Keynes, Maynard 21, 35, 61, 78, 232
220, 221 and international financial
and interference by 226 system 170
Index 247
Keynesianism and political economy theory of

and Galbraith 3, 26, 32, 34–6 aggregate demand 92–4: and
and Golden Age of capitalist formal model 95–9; and test
development 90 results 99–101
Khodorkovsky, Mikhail 191 and radical shift in 90–2
King, Mervyn 130 and unemployment 88–90
Kirkland, Lane 55 MaCurdy, T. 117
Klein, Lawrence 40 Madrick, Jeff 83
Klein, Michael W. 71 Magee, Stephen 71
Korea (South) 201 Marcuse, Herbert 60
and role of state 207–9 market size, and growth theory 73
and telecommunications Marrakech Agreement (1994) 236
liberalization 208–9 Marshall, Alfred 29, 79
Korea Mobile Telecom 208 and definition of economics 1
Korea Telecom 208 Marshall, T.H. 57
Krueger, A. 221, 222, 223 Martin, P. 159
Krueger, Ivar 17 Marx, Karl 21, 231
Krugman, P. 159, 234 Mayer, M. 172
Kuhn, Thomas 77 Mazzucato, M. 157
MDM Bank 183
labour market Means, G.C. 18
and European Union 146–7 Meany, George 55
and flexibility 154–6 media, and cretinization by 61
Lafollette, Robert 30 Meltzer, Alan 67
Lakoff, George 84 Menshikov, S. 8
Landreth, H. 36 mercantilism see neo-mercantilism
Lane, T. D. 118 Merriman, Robert 30
Lasch, Christopher 57 meso-economics 20
Laurier, Sir Wilfred 27 metacultural frames
least cost rule 79–80 and conventional wisdom 78
Lebedev, Platon 191 and neo-liberalism 77, 83
Lewin, Leonard C. 46 Mexico 198
liberalization and automobile production 210
and competitive 239–40 Mezhprombank group (Russia) 185
and economic performance middle-income countries
200, 202 and finance capitalism 197–8
see also neo-liberalism and Washington Consensus 198
lifestyles 79 militarism 3–4, 41–2
Lindert, Peter 73 and Cold War 42–3
Lisbon process 142 and economic development 48–9
LUKOIL 183 and lack of democratic control 43–4
military expenditure 54
MacDougall Report (1977) 139–40 and call for reduction in 40
macroeconomics and impact of 3–4
and Keynesianism 90 and Marxist theory of 45
and ‘new consensus’ in 106–7, and stabilizing effect of 44–5
128–9: and fiscal policy 107–9 and wastefulness of 47–8
and New Keynesianism 91–2 Miller, Alexey 185
and party control theory of economic Miller, William 67
policy 93 Minsky, H.P. 111
248 Index
Mirowski, Philip 18 Nishimura, K. 158

Miyazawa-Brady Initiative 216 Nordhaus, William 73
model uncertainty, and fiscal policy Norilsk Nickel 183
115–16 North, Douglas 40
Modigliani, Franco 40, 74
monetarism 66–7 objectivity, and illusion of 53
and inflation 67–8 organizations, and power 2, 18
and money supply 67 Orwell, George 60
and recession 68–9 Ottaviano, G. 159
monetary policy 21
and credit controls 134 Pack, Howard 199–200, 203
and European Central Bank 128, Paris Club 225–6
129–35 Parker, Richard 23
and European Union 148, 152–3 Pearl Harbor 25
and impact on real economy 130 Pearson Report 215
and interest rate volatility 117 Perotti, R. 117
and model uncertainty 115–16 Perry, George 69, 75
and one-size-fits-all problem 132–3 Philips 204
and prominence of 5–6, 105 Pizzorno, Alessandro 57
and Russia 187 Poland 58
moral politics 84 Popper, Karl 77
motivated social cognition 84 Porter, Michael 77
Mussa, Michael 67 Post Autistic Economics movement
Muth, John 74 19–20
Myrdal, Alva 57 Post Keynesianism 36
Myrdal, Gunnar 57 and Galbraith 3, 38–9
power
Nadiri, Ishaq 72–3 and definition of 102n3
nationalism, and Russia 58 as determinant of aggregate demand
Nelson, Richard 73 5, 92–3
neo-liberalism and economic outcomes 95, 97–9,
and challenges to 77, 83–4 100–1
and deconstruction of 5, 78 and economic performance 5, 87,
and decreasing relevancy of 78 101–2
and equilibrium 81 and organizations 2, 18
and globalization 230 Prebisch-Singer thesis 215
and metacultural frame 77, 83 production, and consumption’s
and US presidential election (2004) dependence on 18
82–3 productivity 7
and pseudo-capitalists 78–9 and labour market flexibility 154
and self-interest 82 pseudo-capitalists 78
neo-mercantilism and hoarding 81
and debtor impoverishment 232 and non-productive behaviours
and free trade 231 78–9
and global legal framework of and roots of 79–80
accumulation 231–4, 237 public interest groups 4
Netherlands, and economic performance public investment, and economic
of 148–9 bias 72–3
New Deal 59 Punzo, L.F. 147, 148, 149, 150, 161
New Keynesianism 91–2 Putin, Vladimir 184, 185, 190
Index 249
Raffer, K. 220, 222 and inequality 188

rational expectations 70 and inertial economic system 181–9
and Washington Consensus 168 and manufacturing 186–7, 192
Reagan, Ronald 18, 168 and maximalist approach to reform
recession, and monetarism 68–9 189–90
regulation policy 158–9 and minimalist approach to
and international revival of 237 reform 190
Rein, Martin 77, 83 and monetary policy, absence of 187
Republican Party and nationalism 58
and neo-liberalism 83 and neo-liberalism 8, 185
and US presidential election and oil and raw materials imbalance
(2004) 82 185–6, 190–1
Ricardian equivalence theorem (RET) 6, and oil/mineral rent 186, 191, 192
112–15 and oligarchic capitalism 8–9, 58
Ricardo, David 79 and oligarchic groups 182–4, 186,
Rice, Condoleeza 55 187, 190
Richta, Radovan 57 and profit maximization by
Robertson, D. H. 35 price 181
Robinson, Austin 36 and property tax 192
Robinson, Joan 35, 231 and reform proposals 195
Rocard, Michel 57 and reluctance to invest 182
Rodrik, Dani 75, 202, 218 and shock therapy 73–4
Rogin, Leo 3, 29, 30
Rogoff, K. 130 Sachs, Jeffrey 40
Romer, C. D. 149 Sakharov, Andrei 57
Rosneft 191 Samsung 207
Ross, Dorothy 30 Samuelson, Paul 3, 23, 36
Rostow, Walt 20 sanctions, and questionable
Rusal 183 effectiveness of 49
Rusk, Dean 37 Sapir, A. 145
Russia Sargent, T.J. 70
and absence of product innovation Sawyer, M. 105, 130, 135
182 Say’s tautology, and capitalism 81
and banking industry 183–4, 192 Schelsky, Helmut 57
and business/government relationship Schön, Donald 77, 83
184–5 Schuh, Scott 71
and capital gains tax 191, 192 Schultze, Charles 67, 70, 72
and capital market 192 Schumpeter, Joseph 18, 21, 231
and dividend taxation 191–2 Schwartz, A. 67
and economic development, self-interest
future of 189 and capitalism 78, 82
and economic policy, and the common good 78, 80
weakness of 187 and pseudo-capitalists 78, 80
and economic reform 9 Sen, Amartya 32–3, 75
and features of economy 181 Sharpe, William 74
and gross profit/labour income Shiller, R.J. 75
imbalance 187–9, 193 Sibneft 183, 191
and impact of devaluation 181–2 Silvermaster, Gregory 30
and incomes policy 194 Silvos-Labini, Paolo 57
and industrial policy 187 Simon, Herbert A. 18
250 Index
Singapore 201, 207 and relationship with business 184

Single Market Programme 142 and role of 1–2, 56
Slavneft 185 state intervention 4
Slemrod, Joel 73 state socialism 57–9
Smith, Adam 17, 21, 61, 222 Stein, Herbert 70, 212
social bargains 94 Stiglitz, J.E. 75, 165, 236, 238
and economic performance 101 and international financial system
social democracy, western 4, 59–60 166–7, 168–9
social-historical school 3, 29 and special drawing rights 169
socialism, and social control of elites 4 stock options 74
socio-linguistics 84 Strachey, John 57
solidarity, and systematic decomposition structural adjustment, and Third World
of 59 debt 215
Solidarnosc 58 SUAL 183
Solow, R. 116 Summers, L. 111
South Africa, and automobile Sun Yat-Sen 58
production 210–11 supranational rules, and developing
sovereign debt countries 10–11
and insolvency 222–3 Surgutneftegaz 183
and international Chapter 9 proposal Sweeney, John 55
222: and debtor protection 224; Sweezy, Paul 29, 45, 60
and democratic representation Szecpanski, Jan 57
224–5; and fairness 225–7; and
human rights 223; and neutral Taiwan 201, 202
arbitration 222–3; and and achievement of 205
sovereignty 223–4 as developmental state 206–7
and market solutions 217 and industrial policy 204–5
Soviet Academy of Sciences 57 and outward FDI 206–7
Soviet Union 57–8 Taylor, J.B. 105, 116
and collapse of 47, 180 Taylor, Lance 75
see also Russia Taylor, Paul 30
special drawing rights (SDR) 169 technostructure 18
spillovers, and industrial policy 203 and industrial society 56
Sraffa, Piero 35 and military sector 3, 40, 41
Stability and Growth Pact (SGP) 6, 126, and state socialism 57–9
135–40, 143 and Third World 60
and argument for 135–6 and western social democracy 59–60
and budget deficits 128, 136–8 terrorism, and war on 26, 55
and coordination of fiscal policy Thatcher, Margaret 192
136–7, 139–40 Third International 57
and criticism of 137 Third World debt 10, 214, 227–8
and fiscal policy 128 and absence of debtor protection
and operational difficulties 127, 128 217, 221
stagflation 69, 91, 92, 148 and changing structure of 215–16
state, the and debt management 216–17, 221
and economic development 199 and enforcement of policy
and governing the market 205, changes 218
209–12 and failure to grant debt relief 219
and industrial policy 205–9 and Highly Indebted Poor Countries
and reduced role of 234–5 initiatives 216, 219
Index 251
Third World debt – continued United Kingdom

and institutional self-interest 219, and economic performance of 149
220, 221 and United States 56
and international Chapter 9 proposal United States
222: and debtor protection 224; and bilateralism 239
and democratic representation and competition policy 156
224–5; and fairness 225–7; and and competitive liberalization
human rights 223; and neutral 239–40
arbitration 222–3; and and economic performance of 142–3,
sovereignty 223–4 149–50
and international financial and growth regimes 148
institutions 215–17, and imperialism 53, 54, 55–6
219–21, 226 and monetary policy 153
and loan loss provisions 218–19 and post-war economic policy 193–4
and structural disequilibria 215 and presidential election (2004) 82–3
Thurbon, Elizabeth 205, 211 and social democracy 59
Tinbergen, Jan 180 and subsidies 236
Tobin, James 69, 111, 165 as superpower 25–6
Tobin tax 82, 165 US Treasury 8, 165, 197
Tolley, Howard 3, 29, 30–1
Touraine, Alain 57 Veblen, Thorstein 16, 19, 21, 42
trade regimes, and economic Vekselberg, Viktor 185
performance 200–3 Venables, A.J. 159
trade unions 4, 55, 194 Viakhirev, Rem 185
Treaty establishing a Constitution for Vietnam War 37, 43, 53, 54
Europe 127 Vilasuso, J. 109, 110, 136
Triest, Robert K. 71 Volcker, Paul 68
Turner, Frederick Jackson 55 voting patterns, and economic outcomes
97–8, 100
unemployment
and causes of 34–5 wages, and unemployment 91
and definition of full war 3
employment 88 and functions of 46
and inequality 20 warfare-welfare state 55
and Keynesianism 90 Washington Consensus 8, 165–6,
and market power strategy 93–4 196–7, 230
and natural rate of 66, 69, 91 and currency crises 167
and New Keynesianism 91 and developing countries 198–9
and non-accelerating inflation rate of and features of 233–4
69–70, 91 and finance capitalism 9, 197–8
and party control theory of economic and IMF loans 169
policy 93 and lack of credible evidence for 197
and political economy theory of and rational expectations 168
aggregate demand 92–4: and Wassenaar agreement (Netherlands,
formal model 95–9; and test 1982) 149
results 99–101 Waugh, Evelyn 21
and rational expectationists 70 Weber, Max 18
and social bargains 94 Weintraub, Sidney 36, 37, 38
and trends in 88–90 Weiss, Linda 205, 211
United Farmers of Ontario 27–8 Wicksteed, P.H. 80
252 Index
Williams, William Appleman 55 World Development 165

Williamson, John 165–6, 167, 196, 230 world economy, and character
Wisconsin School of economics 30 of 230
Wojnilower, Albert 68 World Trade Organization 9, 236, 238
Wolfensohn, James 216 WorldCom 78
World Bank 8, 9, 165, 199, 236 Wright, Gavin 73
and East Asian Miracle study (1993) Wright Mills, C. 60
202–3 Wyplosz, C. 136
and good governance 237
and trade regimes and economic Yeltsin, Boris 58, 184
performance 200–2 YUKOS 183, 185, 186, 191, 192

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John Kenneth Galbraith

and the Future of

LA FIRME ET L’INFORMATION, INNOVER POUR CONQUÉRIR

Also by Dimitri Uzunidis

COMMENT ONT-ILS RÉUSSI? L’HISTOIRE DES ENTREPRENEURS DU XVIIIE SIÈCLE

List of Figures vii

List of Tables viii

Preface by James K. Galbraith xi

Part I Back to John Kenneth Galbraith

Part II The Trouble with Economists and Policies

Part III Economies in a Global Context: a Programme

8.1 Optimizing political preferences 96

8.1 Annual average standardized unemployment rates and

Philip Arestis is University Director of Research, Centre of Economic and

These papers from the International Symposium honouring John Kenneth

Galbraith’s economics centred on the American experience in the post-war

J.K. Galbraith often refers in his writings to Alfred Marshall’s definition of

Galbraith and the spirit of economics

Coming back to Galbraith’s works is useful to modern economists because

Back to J.K. Galbraith

a short-term positive influence, in the long run, it represents an economic

The trouble with economists and policies

The contributions in Part I illustrate J.K. Galbraith’s critical thinking, which

therapy in Russia or in the theory of corporate management in the 1990s.

downgraded. Monetary policy has focused on the setting of interest rates as

balanced public budgets as a preliminary step – once the economy is

Economies in a global context: a programme of action

Is it possible to correlate the entropy which exists in economics with the

suited to the vested interests of an extremely narrow group of oligarchic

sophisticated calculations and a highly skilled bureaucracy; and (c) other

the introduction of supranational rules in developing economies. Then, the

Let me first read a message from my father:

To all attending: Age and medical restraint firmly prevent my attendance

It is obvious, after such a greeting, that I am not going to be able to restrict

For there is an element of the personal in such tributes that tends to be a

denatured maximizing abstraction homo economicus to the flesh-and-blood

To the economist embezzlement is the most interesting of crimes. Alone

Though the essential precedent for this approach – generalization from

2. The Affluent Society is best remembered for its endearing, enduring

3. Then we have the theory of economic organization in The New Industrial

● We have the essentially clientelist character of decision-making, unable to

All of these characteristics have analogues in the corporation of The New

And that, my friends, brings me to my principal message for the morning. If

movement in recent years – of changing the way economics conducts its

corporate behaviour which combines the institutional decision-analysis of

They are noteworthy as efforts to reconcile neoclassical ideas and policy

I have no desire to dictate a specific course of action. Pluralism can and

much a part of our understanding of contemporary capitalism that we forget

Shortly after he published his wonderfully interesting memoir A Life in our

of technical controversy surrounding Keynes’s work and became one of the

One incident stands out in my mind. On 27 November 1970, Kitty

by some pessimism as to the capacity of Western systems, and particularly of

The denunciation of an excessive militarism

Galbraith’s analysis of the technostructure within the capitalist economic

Militarism, technostructure and policy of contentment

leads to dogmatic emphasis on profit maximization and to the neglect of the

The use of the foreign threat by the military establishment

military establishment allowed the maintenance of a high level of military

The autonomy of military power and the lack of

The stabilizing effect of military expenditures in

exercising an inertia effect in capitalist economies: less flexible downwards

The economic and political implications

A founder member of the ECAAR, Galbraith has warned in numerous works

It d3 d4Et(Yt1) [Rt Et(pt1)] (9.5)

d4 Et (Yt1) [Rt Et( pt1)] (9.6)

(Yt Y) (d1 d3) G [d2(1 t) (d4 1)]Y

[d2(1 t)](Yt1 Y) d4Et(Yt1) Y)