THE CASE FOR ECONOMIC RATIONALISM
by Des Moore
( ECONOMIC PAPERS, ECONOMIC SOCIETY OF AUSTRALIA, Volume 20 No.4 December 2001).
Economic rationalists are often criticized for putting too much focus on maximizing material wealth to the detriment of other "real life" concerns such as looking after the poor or the environment. The attitudes of such critics are symbolized in the anti-globalisation protests and attacks on successful multi-national companies. However, the critics only rarely appear to understand what economic rationalism is about and the potential it has for improving community welfare both economic and social.
2 Some Benefits From Economic Rationalism
Because the 1990s produced a veritable onslaught on economic rationalism, it is pertinent to examine major economic developments in the decade, taking 1992-93 as the starting point and 2000-01 as the end point.
Starting with incomes per head of Australians, we see an average increase of 2.8 per cent a year after allowing for inflation. This may not sound much but it compares with only 1.4 per cent a year in the 1970s and 1980s. In fact, during the eight years Australian living standards actually increased by an astonishing 25 per cent.
Second, this was due almost entirely to faster productivity growth. But what caused that improvement in efficiency? Analysis (see Productivity Commission, 2000) suggests it mainly reflected reforms under economic rationalist policies rather than the strength of the business cycle or increased usage of more advanced information technology.
Third, notwithstanding the earlier reduction in tariffs driven by economic rationalist policies, there was no "blow out" in the current account deficit or, contrary to some predictions, external crisis. And the rate of unemployment fell.
Fourth, did these developments disadvantage wage earners and advantage nasty capitalists? Well "no", the increase in incomes was equally shared between wages and profits.
Fifth, it is true that amongst individual wage earners there was a widening in the distribution of earnings. However, the progressive income tax system paid out generous social welfare benefits and this prevented any increase in the inequality of total incomes.
Finally, what about the much-touted rural decline? Well, there was actually an increase in people living outside capital cities between 1995 and 2000 - and at a rate not much below the growth in capital cities. Real farm GDP increased by 35 per cent in the 1990s. Unfortunately for Hanrahan, the bush was not "ruined"!
This suggests, therefore, very strong evidence that in the 1990s economic rationalist policies produced large economic benefits for the great majority of Australians and that governments protected the less advantaged through the social welfare system. So, why has there has been so much criticism of economic rationalist policies and why have opinion surveys suggested that many think the quality of life has deteriorated? As has been pointed out (see Productivity Commission, 2000, p xvi), surveys show that around one-third consider the quality of life has deteriorated.
3 Some Reasons for Misunderstandings
One problem is that, as there is no "authorized text" explaining economic rationalism, common misconceptions develop (see, however, the exposure of critics factual and analytical errors in Coleman 2001, James 1993 and King 1993). The usual one is that advocates of such policies are only concerned to get the best economic results and have little regard to social consequences.
This reaction is quite mistaken. There is a failure to recognize that economic rationalism does not only have unfavourable initial effects. There are also usually second and third round effects that are favourable - and favourable from both an economic and social perspective.
Reductions in protection of manufacturing, for example, have initial unfavourable effects on some industries and some employees, and that is what most people perceive. But this also leads to expansions of other industries, even the industry most protected. Why? Because lower protection reduces costs for other industries or parts therof and it also reduces the prices that consumers have to pay, leaving them with more money to spend on other goods or services.
Accordingly, advocates of economic rationalism argue that reductions in protection are likely to have net favourable effects for the community as a whole. Lower protection in the 1980s, for example, has been followed by an increase in manufacturing production of 17 per cent and manufactured exports are now 24 per cent of total exports compared with only 16 per cent at the end of the 80s. Moreover, although employment in manufacturing industry has fallen by about 6 per cent, that reflects a shift from an inefficient industry to more efficient ones. Total Australian employment has increased by over 20 per cent.
It may seem "unfair" that lower protection eliminates or reduces some businesses and their employment. But isnt it unfair to ask the rest of the community to sacrifice their living standards to keep the protected sector going when there are more efficient alternative businesses and forms of employment? It is also surely more equitable and more socially healthy to have a community that consists of as many individuals as possible who are not dependent on others.
Another misconception arises from the economic rationalist policies of financial deregulation and reductions in protection adopted by Labor during the 1980s. Even some economists blame those policies for the major recession of the early 1990s.
I argue, however, that the underlying cause of that recession was not those policies but the opposite (see Moore, 1993). During the 1980s Labor tried to stimulate growth by pursuing highly interventionist monetary and budgetary policies. These policies were not consistent with economic rationalism. They kept up a high rate of inflation and demand, and this ended in a boom-bust situation. What did the policies leave Australia with? As Mr Keating acknowledged, "the recession we had to have" - but should not have had, of course.
4 Governments Have a Role But It Should be Minimal
A further misconception is that economic rationalism is the same as laissezfaire - the idea that there should be no intervention at all by the government in the free market. But it is not the same as laissez faire.
Economic rationalist proponents certainly favour allowing markets and competition to operate more freely than at present. But they also accept that governments should regulate both the economy and society provided the regulation is minimal.
Experience has shown that, when governments try to "manage" a business enterprise let alone fine-tune the economy, they run into intrinsic practical difficulties. Governments also tend to make decisions in the interests of lobby groups rather than the community as a whole.
This experience led about thirty years ago to the identification of a new phenomenon described as "government failure". The most striking example was the mess produced by the attempts at economic planning in Eastern Europe and the old Soviet Union - but Victorians also experienced government failure on a smaller scale in the 1980s.
The recognition that government manipulation of the economy is much harder than Keynes thought in the 1930s has had major repercussions. Most importantly, it has led to a radical modification of the notion that there is a fundamental flaw in capitalism and that governments need to intervene to prevent or smooth business cycles. In Australia today there is pretty much bipartisan agreement that government budgets should not be operated to try to anticipate and/or offset cyclical swings in the private sector.
True, the 2000-01 Budget stated "In the present situation of a temporary slow-down in economic growth, an easing in the fiscal position is appropriate as it helps to support demand growth in the economy". However, the strategy is presented as part of a "medium-term objective of budget balance over the course of the economic cycle" (see Commonwealth Treasurer, 2001pp 1-81-9). The additional measures included in the Budget were clearly mainly designed to impact politically before the Federal election and to leave limited scope for the Opposition to promise additional measures financed from the surplus.
Fine-tuning is also now widely rejected amongst overseas governments and international economic organisations. Even academic economists are changing. At the 1999 Conference of Economists at Latrobe University two prominent overseas economists, Professors David Hendry and John Taylor, told their audiences that Keynesian theory itself is outdated. It is also acknowledged amongst even today's apparently sophisticated economic modellers that it is difficult to identify major turning points in business cycles. But, if that cannot be done with confidence, it is difficult to justify government intervention to correct for the outcomes of such turnings. Such realisations have given economic rationalism a substantial credibility boost.
The support by economic rationalists for minimum government intervention also reflects a view that, in a modern society with relatively high degree of education, individuals should be relatively free to pursue their own interests and should be better able to look after themselves. A better balance is needed between the equity of assisting those on low incomes and the equity of rewarding individuals for their economic contribution.
5 Drawing the Line Between Private and Public Sectors
So, where do economic rationalists draw the line between allowing free play of market forces and individual decision-making, and having the government intervene? In reality, there is no clearly defined line.
6 Redistribution of Incomes
The most contentious issue is how far to go in reducing inequalities of income. The perception that the "fairness" of society would be improved by reducing inequalities is part of the supposed Australian culture of egalitarianism the idea of giving everyone a "fair go".
This is even reflected in theorizing by academic and other economists. A 1999 survey of Canberra Economic Society members, for example, showed that a majority of the economists surveyed strongly disagreed with the proposition that government outlays should be reduced as a percentage of GDP and agreed that governments need to be concerned about distribution of incomes and should "seek to reduce existing levels of inequality or at least stop further increases" (see Argy, 2001, p6).
Leaving aside the fact that the inequality of income appears to have been decreasing (see Productivity Commission, 2000, pp77-80), the policy conclusions drawn from such theorizing find little support amongst economic rationalists. Interventionists argue that there is a theoretical basis for greater redistribution because those on low incomes get more satisfaction from spending an extra dollar than do those on high incomes. However, adoption of such theory would justify attempts to equalise all incomes - a sure recipe for revolution!
Of course, economic rationalists do agree that governments should assist those on low incomes and that higher income earners should be net contributors. But they are also concerned to minimise the many adverse effects from government involvement in redistributing incomes.
One major problem is the growth in welfare dependency. Since the last economic expansion ending in the 1980s the proportion of the working age population on income support has jumped from 15 to 22 per cent and now covers an incredible 3.2 million people. The principal reason is not increased need. It is action by political parties to make it easier to obtain benefits and for politicians to obtain votes! If we count in education and health benefits, the top 40 per cent of incomes receive over 30 per cent of government benefits and allowances (see Moore, 2001). It is little short of astonishing that more attention is not drawn to the adverse effects of such "middle class" welfare.
Economic rationalists also reject arguments for greater redistribution based on calculations purporting to show up to 20 per cent living below the poverty line. The problem here is that the line is constantly being raised at about the same rate as national income. This means that the standard of "poverty" becomes ever-higher and that, while the population increases, there will always be growing numbers of "poor".
That does not provide a sound basis for intervention by governments, particularly as most who were poor at some earlier time would by now have moved up the income scale. A UK Government report on Households Below Average Income 1994/95 - 1997/98, for example, apparently showed that only 4 per cent of households were stuck in the bottom income quintile for the whole of the period covered by the report (see The Economist, 23 October 1999).
Economic rationalists also oppose the high degree of regulation of employer-employee relations imposed by Australian Governments and the industrial tribunals. The perception that fairness requires such regulation is quite wrong. It reflects the belief that, unless the government regulates the operation of the labour market, there will be a bargaining imbalance between employers and employees that will lead to exploitation of employees and a greater inequality in earnings.
However, this idea is based on a widespread failure to understand that, with over 1,000,000 employers competing for the services of over 9,000,000 employees, there is little scope for employers to impose conditions on workers. The basic problem is that the regulatory system seriously inhibits employers from adding to employment, particularly of low skilled workers. For example, by setting the minimum wage at a high level relative to the average wage, the Australian Industrial Relations Commission has almost certainly kept out of employment many with low skills and earning capacity, convicting them to reliance on social security.
In any event, the existing regulatory system has been unsuccessful in preventing a widening in the inequality of earnings. Moreover, it is nonsensical to try to protect the low-paid by adjusting wages. Why should the majority of low wage earners have their wages protected when they live in households in the upper half of the income scale? It is Government social security, not Commission wage decisions, that makes incomes more equal.
It is relevant that the proportion of Australias working age population employed has been lower than in countries with broadly similar political and legal institutions, but with less regulated labour markets. If, for example, we had the same proportion employed as in the USA our employment levels would be higher by an amount about equivalent to our unemployed. Yet, as those countries have larger proportions that are more difficult to employ, Australia should have even better rates of employment than them.
7 Privatisation, Competition and Monopolies
Ensuring competition is another area where economic rationalists have no in principle difficulty in supporting government regulation and intervention. Preventing monopolies or at least regulating them helps to protect consumers and to level the playing field for those who want to be competitors.
This of course leads economic rationalists to support the privatization of monopolistic public sector enterprises. Such action will expose the enterprises to competition of various kinds and is most likely to produce a more efficient use of resources that provides a better quality service. Critics need to ask themselves why there has been no significant reversal of the over 15,000 privatisations world-wide in recent years, including under Labour in the UK. Indeed, the Blair Government is extending privatization into the public health and education sectors.
If politicians want low income groups to have direct access to certain services at a reasonable price, this can be achieved by providing the enterprises or the consumer with subsidies. However, as governments nowadays rightly play little or no role in ensuring direct access to "basic" services such as food or clothes, the case for subsidizing other services directly is weak. Moreover, those on low incomes are provided through the social security system with the purchasing power needed to allow the basics to be obtained.
8 Environment and Education
The environment and education areas provide further examples of the ready in-principle acceptance by economic rationalists of government intervention. The basic logic here is that, while such intervention imposes costs on individuals or impinges on their individual freedom, it produces more-than-offsetting benefits for the community at large.
For example, government intervention to regulate and control the level of pollution is usually appropriate because individual factory or car owners have no economic incentive to limit the extent to which they emit pollutants and there would otherwise be excessive pollution. Similarly, government intervention is justified to ensure free and compulsory primary and secondary education because there are net "spin-off" benefits both economically and socially from having an educated community.
However, economic rationalists argue on both economic and equity grounds for limits to government assistance for higher education. The logic here is that qualified individuals have ample incentive to invest in educating themselves as graduates generally earn higher salaries. Economic rationalists also favour having privately run universities and do not accept that this would result in a lowering of standards.
9 Quality of Life
Finally, can economic rationalism be blamed for the view that the quality of life has declined? There is little evidence to support this view. It probably reflects concern at the increase in competition and the associated perception of increased stress. Yet Australians have continued to become healthier during the 1990s. Indeed, life expectancy has increased steadily over the past twenty years and the death rate from almost all diseases (including cancer) is less than at end 1980s. External causes of death have also declined, although there has been a slight increase in suicide rates.
Hopefully, the foregoing has at least made some things clearer about economic rationalism. First, it is not the same as a free-for-all laissez-faire system. Second, while government intervention and regulation is needed, that needs to be reduced: Australia is a considerable way from adopting economic rationalism. Third, such a reduction would improve economic efficiency and living standards. Fourth, there would be an improvement in equity resulting from the elimination of government assistance to particular groups that have no needs basis for it.
Supporters of government intervention are often either pushing their own barrows or some barrow that reflects their own interventionist view of how the world should be organised. History tells us that we should be extremely cautious of jumping on to such barrows.
F.Argy (2001) "Economic Rationalism in Australia Survey of Members of the Economic Society of Australia, ACT Branch" Economic Papers, Economic Society of Australia, Victoria,,20 No 1, pp1-14.
W.Coleman and A. Hagger (2001) Exasperating Calculators, The Rage Over Economic Rationalism and the Campaign Against Australian Economists (Paddington, NSW: Macleay Press).
Commonwealth Treasurer and Minister for Finance (2001) Budget Strategy and Outlook 2001-02, Budget Paper No1 (Canberra).
C.James,C. Jones and A. Norton (eds) (1993) A Defence of Economic Rationalism (St Leonards, NSW: Allen and Unwin).
S.King. and P.Lloyd (1993) Economic Rationalism Dead End or Way Forward? St Leonards, NSW: Allen and Unwin).
R.Mathews (14 November 1991) "Free Market Policies Have Been Disastrous", Canberra Times.
Productivity Commission Staff Research Paper (2000) Distribution of the Economic Gains of the 1990s (Canberra).
D.Moore (1993) "Condemning the cure: the recession and economic rationalism" in C.James,C Jones and A.Norton (eds) op cit.
D.Moore (19 June 2001) Why we need to reduce health "welfare", Presentation to Bristol-Myers Squibb Seminar on Health Policy, Melbourne, www.ipe.net.au.
The Economist, (23 October 1999) "Poverty A Mobile Society".