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Ineffective policy intruments

Recently a new website dealing exclusively with the so-called Real Incomes Approach to economics was initiated. It contains a tutorial on the Real Incomes Approach and it is addressing economic questions of relevance to today's economic crises as well, it would seem, offering pathways to useful solutions.

The tutorial is written by Hector McNeill, Director of SEEL, who has worked on the Real Incomes Approach since 1975. In a recent interview he explained that his interest in this alternative approach arose when he, like many other economists, could not identify satisfactory solutions for slumpflation (stagflation) in terms of Keynesian policy solutions. Even at that time, when Monetarism was gaining ground as an alternative to Keynesianism, he advised that Monetraism suffered from the same limitations as Keynesianism in that they were both "fine weather" policies but unable to provide effective solutions to severe shocks to the system. McNeill considers KM (Keynesian-Monetarist) policies to be particularly perverse in how they can impose significant differential impacts on different economic units largely through monopoly market interventions by governmental or regulatory agency actions acting to sustain government policy target directives. In constitutional terms, as well as economic terms, McNeill considers KM policies to be unsatisfactory and arbitrary.

In Section 2 of the tutorial, entitled "Is there a problem?" the review of the recent history of policy is provided. This tutotial section provides an explanation of some of the key reasons for policy failure.

Unruly indicators

In a paper written in 1981 ¹ McNeill set out an explanation of why Keynesianism had failed as well as why Monetraism was likely to fail. He wrote that although aggregate demand is considered to be the “governor” of the economy, at any particular time in the policy cycle different indicators will rise to dominate the current attention of policy makers. Thus unemployment might become something of concern, or attention might be deflected by rising inflation. On the other hand declining investment might be tied to interest rates having been set at too high a level. Things can get out of hand when several indicators rear up simultaneously as issues for current attention. Thus our experience with slumpflation is a good example of a combination of everything going “the wrong way”, that is falling demand, employment and output with rising inflation.

Stop blaming the "international market".....

Next week, a paper will be released on the fundamental weaknesses of Keynesianism, Monetarism and Supply Side economics. This paper, by Hector McNeill, is entitled "Leading Issues in the British Economy" (Charter House Essays in Political Economy, HPC) is an assessment of why the current macroeconomic policy options are so limited in the face of the current credit and commodity price rises; a condition predicted in a paper by McNeill in 1976.

McNeill is critical of the common attempt by both politicians and economists to blame the current crisis on "the international markets" rather than correcting obvious and fundamental shortcomings in the macroeconomic theory and practice we continue to apply in Britain.

In this paper, McNeill explains why Supply Side economics has had such a limited impact and he analyses some fundamental questions such as what drives the economy and how preferences can be built into policies so as to gain effective legitimacy and popular support and therefore traction. He makes use of an analytical measure known as the Price Performance Ratio (PPR)² to explain how inflation is generated and also how this analysis can point to ways to control inflation through a more appropriate macroeconomic policy approach.

This paper will be released by HPC around 15th August, 2008.

The quest for a common cause

To secure predictability for policy outcomes it is necessary to identify an economic measurement, or a prime index, which is acknowledged to represent the state of affairs facing everyone in the economy before a policy decision is implemented. Such a prime index needs to be comprehensive enough to remain the priority objective no matter what the outcome of the policy implemented. There is a need to get rid of the mixed bag of unruly indicators which quite naturally jostle for priority position in attracting the attention of policy-makers. This diversionary impact on policy needs to be overcome somehow. There is a need to select a prime index which accommodates all such possible sub-indices of significance. The objective of sound policy should then become the effort to sustain or move the prime index in the desired direction. The challenge is to avoid the KM problems of indices "moving the wrong way" or “moving too far” or even "not at all" in spite of policy implementation. McNeill explains that before identifying such a prime index it is necessary to clarify what is meant by policy traction. He thinks that macroeconomic policy needs to be designed in such a way as to gain more predictability of outcomes and, in particular in difficult circumstances such as commodity price shocks or failures of significant financial intermediaries. In order to gain more predictability policy needs to have a more direct control over the direction and extent of policy target movements. Put another way, conventional policy instruments do not gain enough traction over the decisions of companies and individuals within an economy to shift activities towards a mutually beneficial state.

The end to monopoly interventions?

However, a transition to this state of affairs should not be accompanied by the current assumptions that macroeconomic policy can continue to operate on the basis of the expensive luxury of monopoly interventions in markets. For any policy to gain the level of traction necessary to secure a direct control over a prime index (target variable), it needs to be acknowledged as one which represents a common objective of everyone in the policy constituency, that is all economic units and the population, that is the economy and the electorate of the United Kingdom.

Having explained the concept of traction the necessary characteristics of the prime index become more evident. McNeill identifies a relevanr measure as well as how this can gain policy traction. He writes that a target variable which should find unanimous acceptance as a prime-index is real income levels in place of aggregate nominal incomes or aggregate nominal demand. In terms of profits, real profits can substitute nominal profits.

But what in fact, are real incomes?

McNeill cautions the reader against a presumption that we know what real incomes measures are. The common measure of real incomes is the purchasing power of nominal incomes. Therefore if unit prices rise, real incomes for people on a fixed nominal income will fall. If unit prices fall then real incomes rise. However, a large proportion of utility that people and companies gain from income does not depend upon traded goods and services and therefore the determination of any unit prices associated with these is not possible. In economic terms it is possible to calculate the opportunity cost in terms of income lost by a person dedicating time to pursuits which do not rely upon marketed products and services. However, opportunity cost calculations are redundant in this case because what time is spent on constitutes a component of real income and contains a large measure of personal preference and choice. A person, having opted for a choice has made a decision and is no longer interested in the subsequent opportunity cost calculations because the choice, as far as that person is concerned, has been made in the direction desired and this is a preference as to what constitutes a contribution to their real income.

McNeill says that, at first, this appears to create an unfathomable issue of determining how to measure real incomes. Therefore the use of real incomes within which people can find and develop what they want to do, be this using market exchanged economic resources or non-marketed resources, is not something which adds confusion but rather something which can be used to make policy more relevant to all. Policy makers should remain content as long as nominal incomes with respect to the prices of a range of basic necessities can be identified and quantified then the rest of the calculation rests very much on how each individual sets values and responds to their own preferences. As long as unit prices (inflation) and interest rates (rental of money) remain steady or fall then if there are no differential effects in nominal incomes, in the sense of those of some participant's proportion falling, then all economic participants benefit.

He suggested that we should be able to agree then that although real incomes turn out to be an odd animal it does hold out the enormous benefit of providing degrees of freedom for economic participants to manage their preferences and choices, without affecting others in a negative fashion. This condition is facilitated as long as all real incomes remain stable or increase.

Given that real incomes would appear to be an economic objective that would find common support amongst all economic units, then policy traction can be established by making real incomes the objective of and basis for measuring the performance of activities in serving the ends of firms and people.

Untangling fiscal and macroeconomic policy

McNeill goes on to show that fiscal policy has always been in a direct conflict with macroenconomic management because it sets the public benefits derived from normal public services against the shorter-term "general good" as perceived by macroeconomic policy managers. He expands this under a section entitled, "An outstanding issue". This is the odd confusion, or even antagonism, between taxation and spending as macroeconomic policy instruments and taxation as raising revenues to support essential public services and spending as part of the normal process of implementing and sustaining them. This is explained as follows:

Achieving coherence between macroeconomic policy and fiscal policy

"The blaming of 'international factors' for our plight and the failure political parties, government and economists to come up with productive policy solutions is an unfortunate reflection of the poverty of economic theory to address realities in a practical and useful fashion..."

One of the peculiarities of macroeconomic policy is that there is a built-in conflict between what government tries to achieve in terms of responding to public needs in the field of essential goods, services and welfare in general and what the government wishes to achieve through intervention in markets to manipulate specific target variables such as interest rates or even inflation. Money-raising by governments through levies and taxation was originally perceived to be the raising of funds to carry out the governmental mandates for such things as national defence, provision of a judicial system, police and other services deemed essential to the functioning of a democratic society. Thus taxation and public expenditure was not originally conceived to be a process of macroeconomic management directed at general efficiency. With Keynesianism this all changed with tax and expenditure being part of the armoury of aggregate demand control running alongside market intervention measures largely directed at the setting of interest rates. In reality this was always a very poorly conceived basis for delivering on the public good as defined by mandates to satisfy the provision of a range of public services since these can be seriously compromised if interest rate setting turns out to be an insufficient condition to guide the economy in a desired direction. Thus the outcome is invariably a compromise between the ability of government to uphold the quality of public services or indeed, to maintain some level of taxation and levies. As can be seen, the very macroeconomic relationships described by Keynes, as a basis for designing macroeconomic policy, are also the relationships which can compromise the effectiveness of governance, not only in terms of macroeconomic policy but also in terms of provision of “normal services”. Thus is can be seen that the perversity of KM policies is not just limited to impacts on independent economic units but also on those economic activities which make up part of the so-called “public sector” and which remains the responsiblity of government.

There is therefore a very apparent incoherence between macroeconomic policy and fiscal policy because at times they will compete or nullify each other. This does not seem to be a very logical basis for managing the economy. The outcome is contradictory policy which, by its very design, also lacks adequate traction.

In order to gain traction there is a need to achieve a better coherence between macroeconomic policy and fiscal policy so as to prevent contention between them. It would be possible to promote the fiscal regime to the status of the central macroeconomic management process. The fiscal regime should be designed to promote the quality of economic performance by establishing real incomes as the universal macroeconomic objective. By merging the objective of policy identical to microeconomic and personal objectives then it is possible to achieve the necessary coherence between macroeconomic and microeconomic objectives. As a direct outcome of having agreed upon a clearly defined common objective then the economic participant activities will determine the progress of the macroeconomic objective simply by following their own preferences. Such diverse preferences provide the motivation for all, following their own, often diverse, interests, to sustain or increase their own real income levels.

Thus by establishing the achievable aim of stable or enhanced real incomes, policy could gain sufficient traction because this is also the objective shared by all participants in the economy. If, at the end of the process, all economic participants end up with enhanced real income net of tax then fiscal policy would be less of an imposition and more of a stable foundation for economic growth and development. Such a policy would prove to be superior to KM policies if, in spite of the differentiation between companies, policy should not give rise to any differential negative impacts on real income levels anywhere. Significantly, this analysis also applies to public services because the perverse compromises observable between KM macroeconomic policies and fiscal policies is removed. Most negative events would be exclusively related to genuinely market competitive effects and redundancies created by advances in technology, poor management and poor decision-making on the part of some economic participants. Such a system would also be free from the devastating market environmental impacts of monopoly policy interventions.

McNeill explains that much remains to be explained. For example how would the use of real incomes, as the prime index, operate in a fiscal system and what would be the impact upon inflation and interest rates? He says that these important issues will be addressed in subsequent sections of the tutorial.

¹ "Notes on Real Incomes Policy", McNeill, H.W., Charter House Essays in Political Economy, Real Incomes Series, December, 1981, HPC, ISBN:978-0-907833-05-5

² The PPR was first proposed as a means of analysing inflation in "Inflation, Its Control through Price Performance Fiscal Policy," McNeill H.W., Rio de Janeiro, 1976 and in the monograph "Price Performance Fiscal Policy - A Real Incomes Approach", Hambrook Publishing Company (HPC), ISBN: 978-0-907833-00-4

Posted: 10th May, 2008.
Updated on 22nd June, 2008 and 4th August, 2008 (adding box announcement - left hand side);
Updated: 6th August, 2008 (correction of Essay title citted in box announcement from "Some Leading Issues in the Economy" to "Leading Issues in the British Economy").