Theoretical Approaches to Economic Growth and Development: An Interdisciplinary Perspective [1st ed. 2020] 3030500675, 9783030500672

https://www.palgrave.com/gp/book/9783030500672 This book provides the theoretical and analytical background critical to

1,159 85 9MB

English Pages 579 [561] Year 2020

Report DMCA / Copyright

DOWNLOAD FILE

Polecaj historie

Theoretical Approaches to Economic Growth and Development: An Interdisciplinary Perspective [1st ed. 2020]
 3030500675, 9783030500672

Table of contents :
Acknowledgments
Introduction
Contents
Abbreviations
List of Figures
List of Tables
Part I Methodology and Introduction
1 The Methodological Puzzle
1.1 Introduction
1.2 Navigating Between Theories
1.2.1 Theory Construction
1.2.2 Positivism Versus Normativism in Economic Theory
1.2.3 Expanded Approaches in Economic Methodology
1.2.4 Models and Theories: The Role of Mathematics
1.2.5 Criteria for Choosing Theory and Hypothesis
1.2.6 Predictionism and Operationalism
1.3 Time and Spatial Dimensions of Economic Development
1.4 Concluding Thoughts: Methodological Pluralism
References
2 Introduction to General and Integrated Development and Growth
2.1 Introduction
2.2 The Key Questions for Growth
2.3 Growth and Prosperity
2.4 Output Gap and Potential Growth
2.5 Growth and Development
2.6 The Relationship Between the Part and the Aggregate
2.7 Stocks and Flows Analysis
2.8 Towards a General and Integrated Concept of Economic Development and Growth
References
Part II Important Concepts of Economic Behavior
3 Economic Action, Cultural Background, and Institutions
3.1 Introduction
3.2 Decision-Making and Alternative Rules of Economic Action
3.2.1 Decision-Making Process
3.2.2 The Birth of Culture and Institutions: Coordination
3.2.3 Formation of Stereotypes and Development of Personal Traits
3.2.4 Humans in Economic Action: Behaviors and Preferences
3.2.5 The Role of Goals, Targets, and Motives
3.2.6 Types of Institutions
3.2.7 Institution Selection Processes
3.2.8 The Behavior of Business
3.3 Time and Space in Institutions and Preferences
3.4 The Global Overview of Cultural Background and Institutions
References
4 Complex Economic Systems, Information and Forms of Capitalism
4.1 Introduction
4.2 Simple Versus Complex Economic Systems
4.3 Complexity in Economic Theory
4.4 “Tableau Économique” and Complex Circular Flow of Economic Activity
4.5 The Analysis of Complexity
4.6 Measuring Complexity
4.7 Information and Economics
4.8 Information Effectiveness
4.9 Complexity and Forms of Capitalism
References
5 Politics and Governance
5.1 Introduction
5.2 Politics, Economics and Growth
5.2.1 The Link Between Politics and Economics
5.2.2 Politics and Economic Results
5.2.3 Strong/Powerless State and Economic Outcomes
5.3 Policy and Distribution of Income and Wealth
5.4 Political Costs and Structural Reforms
5.5 Politics and Representation
5.5.1 Democracy and the Economic System
5.5.2 Elites and Pressure Groups
5.5.3 Politics and Cultural Background
5.5.4 Politics and Media
5.6 Politics and Economic Change
5.6.1 Resilience of Society and the State
5.6.2 Society and de-Industrialization
5.6.3 Social Change and the Middle Class
5.6.4 Economic Crisis and Populism
References
6 Uncertainty
6.1 Introduction
6.2 Risks and Uncertainty
6.3 The Global Outlook on Risk and Uncertainty
6.4 The Economic Outcome of Uncertainty
References
7 Expectations
7.1 Introduction
7.2 Foresight and Forecasts
7.3 Forecasts and Expectations
7.4 Adam Smith and Expectations
7.5 Adaptive Expectations
7.6 Rational Expectations
7.7 The Simplicity of the Rules of Thumb
7.8 The Role of Knowledge and Learning
7.9 Achieving Equilibrium: History Versus Expectations
References
8 Entrepreneurship
8.1 Introduction
8.2 Entrepreneurship as a Basic Concept of Human Economic Activity
8.3 Entrepreneurship and Entrepreneurial Opportunity
8.4 Entrepreneurial Failure
8.5 Opportunity and Necessity Entrepreneurship
8.6 Institutions and Entrepreneurship
8.7 Cultural Values and Entrepreneurship
8.8 Organizational Culture
8.9 Entrepreneurial Decisions Under Conditions of Uncertainty
8.10 Entrepreneurship and Creativity
8.11 Entrepreneurship and Innovation
References
Part III Growth Sources in Economic Thought
9 The Evolution of Economy and Economic Thought
9.1 Introduction
9.2 Economy and Evolution of Economic Thought
9.3 From the Birth of Economics to the Great Global Economic Depression (1720–1940)
9.4 The Outburst of Economic Thought: After the Great Depression and Until the Period of High Growth and Low Inflation (1940–1970)
9.5 Economy with Increasing Prices (1970–1980)
9.6 The Economy from the Period of Great Moderation to the Period of Great Recession (1980–2008)
9.7 Structural Changes in Global Economy in the Aftermath of the Great Recession (2008 to Date)
References
10 The Sources of Growth from the Birth of Economics to the Rise of the New Era
10.1 Introduction
10.2 Division of Labor, Population Change, and the Fundamental Laws of Capitalism
10.2.1 Adam Smith (1723–1790)
10.2.2 Thomas Robert Malthus (1766–1834)
10.2.3 Jeremy Bentham (1748–1832)
10.2.4 David Ricardo (1772–1823)
10.2.5 John Stuart Mill (1806–1873)
10.2.6 Edwin Chadwick (1800–1890)
10.2.7 Karl Marx (1818–1883)
10.2.8 Charles Darwin (1809–1882)
10.3 Absolute and Comparative Advantage
10.4 Factor Endowment Theory
References
11 The Sources of Growth from the Beginning of Economics to the Emergence of the New Era: Equilibrium, Evolutionary Development, Schumpeter and Keynes
11.1 Introduction
11.2 Innovation, Diminishing Returns, and General Equilibrium in the Neoclassical Economists
11.3 The Growth Approach According to Veblen
11.4 Relative Prices and the Entrepreneurs for Austrians and Schumpeter
11.5 Demand, Expectations, and Uncertainty in General Theory
References
12 Neoclassical Synthesis and Keynesian Development
12.1 Introduction
12.2 The Neoclassical Synthesis
12.2.1 The Contribution of Hicks
12.2.2 The Contribution of F. Modigliani
12.2.3 The Contribution of J. Tobin
12.2.4 The Contribution of P. Samuelson and R. Solow and the Phillips Curve
12.3 Keynesians, Real Demand, Capital Allocation, and Accumulation
12.4 Effective Institutions and Reducing Uncertainty in the Theory of Evolutionism
12.5 Balanced Dualism and Unbalanced Structural Development
12.5.1 Unbalanced and Balanced Growth
12.6 Catching Up Effects and Developmental Stages
12.7 Development Theories and Sources of Growth
References
13 Solowian Growth and AK Models
13.1 Introduction
13.2 Exogenous Growth: Savings, Exogenous Technology, Preferences, and Expectations
13.3 Overlapping Generation Models
13.4 Learning by Doing in AK Models
References
14 International Trade Relations, Optimum Currency Areas, Externalities, and Public Choice
14.1 Introduction
14.2 Optimum Currency Areas
14.3 Leverage, Risk Diversification, and Effective Markets
14.4 Monetarism and Neutrality of Money
14.5 Public Choice, Regulation, and Rent-Seeking
14.6 Externalities and Institutions
14.7 Industrial Organization and Uncertainty in Perfect and Imperfect Markets
14.8 Game Theory and Human Interaction
14.9 Nash’s Non-rational Equilibrium
References
15 The Era of Low Growth and High Inflation: Contemporary International Trade Theories, New Classics, New Keynesian, Human Capital, Contractization Theories, and Behavioral Economics Under Uncertainty
15.1 Introduction
15.2 The New Classical Economics: Flexible Prices, Market Clearing, and Rational Expectations
15.3 New Keynesian Economics: Market Imperfections
15.4 Human Capital as Intangible Capital
15.5 Theories of Cotractization, Agency Cost, Adverse Selection, Moral Hazard, and Signaling
15.6 Trading Theories Based on Business and New Trade Theory: Product Life Cycle, Porter’s Advantage, Barriers to Entry
15.7 Behavioral Economics and Decision-Making Under Conditions of Uncertainty
References
16 The Great Moderation, Real Business Cycles, and Dynamic General Equilibrium Models
16.1 Introduction
16.2 The Evolution of the New Keynesians: Microfoundation of Growth Economics
16.3 Real Business Cycles and Growth: Supply Shocks
16.4 Dynamic Stochastic General Equilibrium Models (DSGE): Technological Shocks
16.5 Great Moderation and Central Banks Coordination
16.6 Post-Keynesian Economic Theory and the Financial Instability Hypothesis
References
17 Endogenous Growth, Convergence, and Evolutionism
17.1 Introduction
17.2 Endogenous Growth: Summary
17.2.1 P. Romer’s Product Variety Model
17.2.2 Luca’s Model Based on the Deepening of Knowledge
17.2.3 Τhe Schumpeterian Model
17.3 The Convergence of Economies
17.4 Evolutionism: Neo-Darwinism
References
18 The Macroeconomic and Development Debate After the Great Recession: The European Crisis, Deleveraging, and Secular Stagnation
18.1 Introduction
18.2 The Nature of the Great Recession
18.2.1 The 2008 Crisis in the United States, and Globally
18.2.2 The European Crisis
18.3 The Macroeconomic Debate
18.3.1 Deleveraging, Balance Sheets Recession and Weak Demand
18.3.2 Managing the European Crisis During the Great Recession
18.3.3 The Hypothesis of the Secular Stagnation
18.4 The Hysteresis Issue
18.5 Monetary Policy: Zero Lower Bound, Quantitative Easing, Forward Guidance, and “Helicopter Money”
References
19 The Macroeconomic and Development Debate After the Great Recession: Fiscal Space, Multipliers and GDP, Debt Supercycle and Supply-Side Economics
19.1 Introduction
19.2 Fiscal Space and Fiscal Multipliers
19.3 Multiple Equilibrium Points in Public Debt Costs and Confidence
19.4 Over-Indebtedness and the Debt Supercycle Hypothesis
19.5 Increasing Supply Opportunities, Structural Changes, Ordoliberals and Neo-Mercantilism
References
20 Growth and Development Implications of Covid-19
20.1 Introduction
20.2 Pandemics and Economy in the Human History
20.3 Covid-19 Infects the Economy
20.4 Pandemic and Economic Recession Interactions
20.5 Finances of Covid-19
20.5.1 The Economic Situation Under Pressure
20.5.2 State Finances
20.5.3 Corporate Finances
20.5.4 International Finances
20.6 The Covid Moment, Monetization of Debt, Helicopter Money and Modern Money Theory
20.7 Economic Policies in the Time of Covid-19
20.8 The Long-Term Effects of Covid-19
References
Part IV International Financial Architecture and the Consolidated Financial Transaction Framework
21 The International Economic Architecture
21.1 Introduction
21.2 International Economic Architecture
21.3 International Economic Institutions
21.3.1 Established Organizations
21.3.2 Councils and Cooperative Models
21.4 Global Trade Institutions
21.4.1 Recognized Organizations
21.4.2 International Trade Agreements
21.5 International Governance Bodies
21.6 International Transnational Partnerships
References
22 Central Banks, Reserve Currencies, International Chains, and International Interactions
22.1 Introduction
22.2 Central Banks and Cooperation
22.3 Reserve Currencies
22.4 Currency Management and Manipulation
22.5 Extension of Global Supply Chains
22.6 Spillovers and Contagion Effect
22.7 The Shortage of Safe Assets
References
Appendix: The Integrated Framework of International Financial Markets and Transactions
References
Index

Citation preview

Panagiotis E. Petrakis

Theoretical Approaches to Economic Growth and Development An Interdisciplinary Perspective

Theoretical Approaches to Economic Growth and Development

Panagiotis E. Petrakis

Theoretical Approaches to Economic Growth and Development An Interdisciplinary Perspective

Panagiotis E. Petrakis Department of Economics National and Kapodistrian University of Athens Athens, Greece

ISBN 978-3-030-50067-2 ISBN 978-3-030-50068-9 (eBook) https://doi.org/10.1007/978-3-030-50068-9 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2020 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Acknowledgments

I wish to warmly thank the following people who contributed to the completion of this book: a special thank you to my scientific research team, Dr. K. Kafka, Dr. P. Kostis, and Researcher Mr. D. Valsamis whose cooperation were invaluable and Mr. M. Skotoris and Mr. G. Vasilis who untiringly contributed to the entire project. The mathematical formulations of economic theories and models were done by Dr. K. Stratis and Dr. I. Kostarakos. The language editing was done by Mr. K. Matsoukas. The final responsibility for the presentation of this book lies with the author. My scientific work would not have been completed without the help of my colleagues at the National and Kapodistrian University of Athens and, in particular, Mrs. E. Gkiouli, who contributed significantly to the development of this project.

v

Introduction

The purpose of this book is to provide the reader with the theoretical and analytical background needed to understand the process of development and growth as it is conceptualized at the beginning of the twentyfirst century having now taken into account the effect of the Covid-19 outbreak that occurred in early 2020. To this end, we present the theoretical knowledge about development and growth up to and beyond the 2008 crisis until early 2017. Since the beginning of economic thought, the focus has been on the process of development and growth, regardless of whether individual theoretical constructs were often more specifically targeted. Thus, in almost all major scientific contributions to the economic science, conclusions are drawn concerning this process. Such contributions cover a range of scientific areas and subfields, shaping the modern version of the scientific field of development and growth. Sometimes, their significance was such that they were perfectly identified with the concept of growth (e.g., the neoclassical theory of endogenous growth). Most of the time, however, partial identifications did not stand the test of time. In addition, it is extremely common for older theoretical contributions to reclaim power while newer ones fail to be widely accepted. Thus, the need for a pluralistic perspective that subsumes key points of view is more urgent than ever. Shortly before and especially following World War II, there was a deepening of specialization in economic science, as in almost all other sciences,

vii

viii

INTRODUCTION

and scientific subfields appeared such as microeconomics, macroeconomics, international trade, economic history, growth, and development economics. Thus, the original character of political economy that developed as a comprehensive method of handling economic problems, was disrupted. At the same time, the field of economics became isolated from its neighboring sciences: As a result, politics, psychology, anthropology, and biology were not allowed to communicate with basic economic thought even though the grid of human and social interactions made such communication self-evident, especially when it comes to economic developmental growth. The dispersal in the use of analytical tools has tested the comprehensive view of the growth process and exacerbated the difficulty of drawing a deductive conclusion with strong diagnostic ability. Thus, when the crisis of 2008 appeared, there was no ready response by economists and the world community, even though the accumulated knowledge of dealing with major crises, such as the Great Depression of the 1930s, had armed them with a large amount of information and experience. At the same time, it may not have been only the extraordinary specialization and isolation of economic theory and thought that resulted in the absence of general theories with strong predictive power. This may also be due to fundamental weaknesses in the theoretical framework that may not be known at present. Besides, the negative consequences of the fragmented way of scientific thinking extend to the researcher’s ability to grasp the issues of development and growth in a wide range of sciences (psychology, anthropology, sociology…) beyond economic theory. For the foregoing reasons, this book adopts a general and comprehensive understanding of development and growth. In this context, scientific subfields are allowed to communicate with the core of economic theory and policy as well as with neighboring sciences. This allows for a more in-depth treatment of the issues under discussion. The book consists of four parts. This approach was justified when the Covid-19 crisis broke out, which, being exogenous in terms of economy and health, caused, like the older great pandemics (such as Influenza of 1918), a very acute economic crisis that is almost touching all sectors of economic activity and the global economy. Part I consists of two introductory chapters that outline some essential methodology elements and an introduction to general and integrated growth. More specifically, the first chapter covers issues that are critical

INTRODUCTION

ix

to the structure and to how the book and economic thinking are organized. Thus, it endeavors to illustrate the expanded and selective view that underpins the methodological scientific structure of this book, while at the same time looking at the feasibility of extending this particular approach to issues of political growth. The second chapter presents basic questions of growth, then describes how the study of the subject is organized by specifying in particular the relationship between growth and prosperity, along with a series of basic analytic concepts: the relationship between the part and the aggregate, an analysis of stock against flow, and relevant concepts that need to be clarified for the reader first. In addition, through the issue of output gap and potential growth, it is clarified that the phase of the economy under analysis determines the characteristics of economic theory and policy that ought to be used, to make the study of the subject more effective. If the economy is at the point where it has not exhausted the available room of economic productivity, we are in areas where theories of macroeconomics are applicable. On the contrary, if it has exhausted the available room of economic capacity and the question of capacity building is raised, we are in areas where growth theories are relevant. This clarifies why this book favors the synthesis of macroeconomic thinking and growth thinking, as the discussion of enhancing growth prospects makes no sense without taking into account the starting point of the economy, i.e., whether it is below or above the thresholds of its capabilities. Part II analyzes concepts that play a particular role in mobilizing the economic activity of the individual and, hence, of society. These concepts are not primarily economic but come from a range of sciences. The following are analyzed: The cultural background, institutions, complex systems, and the role of information, politics, uncertainty, expectations, and entrepreneurship. The acceptance of the broader set of social and economic interactions established in Part I requires a clearer reference to these concepts. In their analysis, theoretical pursuits are broadened mainly toward the field of psychology, social psychology, anthropology, etc. In Part III, an overview of the most important theoretical contributions is made, in order to highlight the sources of growth identified in economic thought to date. The scientific subfields where sources of growth have been sought and identified include development theories, economic history, macroeconomic theories, microeconomic theories, finance, and international finance. Neighboring sciences also include

x

INTRODUCTION

history, psychology, sociology, social psychology, biology, and anthropology. When searching for and identifying sources of growth and crisis (Covid-19), we have chosen to consider the simultaneous evolution of economic reality and that of economic development and growth in the last two centuries. Thus, the reader becomes a partner in the dialectical relationship of economic reality and theoretical analysis, which makes it easy for them to follow in a cognitively creative manner economic developmental thought. Part IV analyzes the international economic architecture and the integrated framework of financial transactions. This is how global economic relations evolve in a globalized environment and a multidimensional world. The institutions, organizations, and international transnational relations that define global economic relations are presented. The role of central banks is made clear, while concepts directly related to the global governance of the world are clarified as an outcome of globalization and of the open financial system. Finally, in the annex to this part, the analysis concludes with the presentation of the consolidated financial transaction framework, describing concepts such as covered and uncovered interest rate parity, the International Fisher Effect, purchasing power parity, and the real exchange rate.

Contents

Part I 1

2

Methodology and Introduction

The Methodological Puzzle 1.1 Introduction 1.2 Navigating Between Theories 1.2.1 Theory Construction 1.2.2 Positivism Versus Normativism in Economic Theory 1.2.3 Expanded Approaches in Economic Methodology 1.2.4 Models and Theories: The Role of Mathematics 1.2.5 Criteria for Choosing Theory and Hypothesis 1.2.6 Predictionism and Operationalism 1.3 Time and Spatial Dimensions of Economic Development 1.4 Concluding Thoughts: Methodological Pluralism References Introduction to General and Integrated Development and Growth 2.1 Introduction 2.2 The Key Questions for Growth

3 3 4 4 7 9 10 12 14 17 20 26

29 29 29 xi

xii

CONTENTS

2.3 2.4 2.5 2.6

Growth and Prosperity Output Gap and Potential Growth Growth and Development The Relationship Between the Part and the Aggregate 2.7 Stocks and Flows Analysis 2.8 Towards a General and Integrated Concept of Economic Development and Growth References

31 36 38 39 42 43 50

Part II Important Concepts of Economic Behavior 3

4

Economic Action, Cultural Background, and Institutions 3.1 Introduction 3.2 Decision-Making and Alternative Rules of Economic Action 3.2.1 Decision-Making Process 3.2.2 The Birth of Culture and Institutions: Coordination 3.2.3 Formation of Stereotypes and Development of Personal Traits 3.2.4 Humans in Economic Action: Behaviors and Preferences 3.2.5 The Role of Goals, Targets, and Motives 3.2.6 Types of Institutions 3.2.7 Institution Selection Processes 3.2.8 The Behavior of Business 3.3 Time and Space in Institutions and Preferences 3.4 The Global Overview of Cultural Background and Institutions References Complex Economic Systems, Information and Forms of Capitalism 4.1 Introduction 4.2 Simple Versus Complex Economic Systems

55 55 56 56 58 59 63 72 75 77 81 84 86 95

101 101 102

CONTENTS

4.3 4.4

Complexity in Economic Theory “Tableau Économique” and Complex Circular Flow of Economic Activity 4.5 The Analysis of Complexity 4.6 Measuring Complexity 4.7 Information and Economics 4.8 Information Effectiveness 4.9 Complexity and Forms of Capitalism References 5

6

xiii

103 104 106 108 110 113 114 116

Politics and Governance 5.1 Introduction 5.2 Politics, Economics and Growth 5.2.1 The Link Between Politics and Economics 5.2.2 Politics and Economic Results 5.2.3 Strong/Powerless State and Economic Outcomes 5.3 Policy and Distribution of Income and Wealth 5.4 Political Costs and Structural Reforms 5.5 Politics and Representation 5.5.1 Democracy and the Economic System 5.5.2 Elites and Pressure Groups 5.5.3 Politics and Cultural Background 5.5.4 Politics and Media 5.6 Politics and Economic Change 5.6.1 Resilience of Society and the State 5.6.2 Society and de-Industrialization 5.6.3 Social Change and the Middle Class 5.6.4 Economic Crisis and Populism References

119 119 120 120 122

Uncertainty 6.1 Introduction 6.2 Risks and Uncertainty 6.3 The Global Outlook on Risk and Uncertainty 6.4 The Economic Outcome of Uncertainty References

153 153 154 162 168 170

125 126 129 130 131 132 135 137 138 139 140 142 143 148

xiv

CONTENTS

7

Expectations 7.1 Introduction 7.2 Foresight and Forecasts 7.3 Forecasts and Expectations 7.4 Adam Smith and Expectations 7.5 Adaptive Expectations 7.6 Rational Expectations 7.7 The Simplicity of the Rules of Thumb 7.8 The Role of Knowledge and Learning 7.9 Achieving Equilibrium: History Versus Expectations References

173 173 174 176 177 179 181 183 184 187 190

8

Entrepreneurship 8.1 Introduction 8.2 Entrepreneurship as a Basic Concept of Human Economic Activity 8.3 Entrepreneurship and Entrepreneurial Opportunity 8.4 Entrepreneurial Failure 8.5 Opportunity and Necessity Entrepreneurship 8.6 Institutions and Entrepreneurship 8.7 Cultural Values and Entrepreneurship 8.8 Organizational Culture 8.9 Entrepreneurial Decisions Under Conditions of Uncertainty 8.10 Entrepreneurship and Creativity 8.11 Entrepreneurship and Innovation References

193 193

Part III 9

194 197 200 202 203 205 207 209 210 212 219

Growth Sources in Economic Thought

The Evolution of Economy and Economic Thought 9.1 Introduction 9.2 Economy and Evolution of Economic Thought 9.3 From the Birth of Economics to the Great Global Economic Depression (1720–1940)

227 227 228 231

CONTENTS

The Outburst of Economic Thought: After the Great Depression and Until the Period of High Growth and Low Inflation (1940–1970) 9.5 Economy with Increasing Prices (1970–1980) 9.6 The Economy from the Period of Great Moderation to the Period of Great Recession (1980–2008) 9.7 Structural Changes in Global Economy in the Aftermath of the Great Recession (2008 to Date) References

xv

9.4

10

11

The Sources of Growth from the Birth of Economics to the Rise of the New Era 10.1 Introduction 10.2 Division of Labor, Population Change, and the Fundamental Laws of Capitalism 10.2.1 Adam Smith (1723–1790) 10.2.2 Thomas Robert Malthus (1766–1834) 10.2.3 Jeremy Bentham (1748–1832) 10.2.4 David Ricardo (1772–1823) 10.2.5 John Stuart Mill (1806–1873) 10.2.6 Edwin Chadwick (1800–1890) 10.2.7 Karl Marx (1818–1883) 10.2.8 Charles Darwin (1809–1882) 10.3 Absolute and Comparative Advantage 10.4 Factor Endowment Theory References The Sources of Growth from the Beginning of Economics to the Emergence of the New Era: Equilibrium, Evolutionary Development, Schumpeter and Keynes 11.1 Introduction 11.2 Innovation, Diminishing Returns, and General Equilibrium in the Neoclassical Economists 11.3 The Growth Approach According to Veblen 11.4 Relative Prices and the Entrepreneurs for Austrians and Schumpeter

235 239 241

243 248

255 255 256 256 257 257 257 258 258 258 259 260 264 267

269 269 269 274 276

xvi

CONTENTS

11.5

Demand, Expectations, and Uncertainty in General Theory References 12

13

14

Neoclassical Synthesis and Keynesian Development 12.1 Introduction 12.2 The Neoclassical Synthesis 12.2.1 The Contribution of Hicks 12.2.2 The Contribution of F. Modigliani 12.2.3 The Contribution of J. Tobin 12.2.4 The Contribution of P. Samuelson and R. Solow and the Phillips Curve 12.3 Keynesians, Real Demand, Capital Allocation, and Accumulation 12.4 Effective Institutions and Reducing Uncertainty in the Theory of Evolutionism 12.5 Balanced Dualism and Unbalanced Structural Development 12.5.1 Unbalanced and Balanced Growth 12.6 Catching Up Effects and Developmental Stages 12.7 Development Theories and Sources of Growth References

279 286 289 289 290 291 295 297 298 299 303 304 308 310 312 316 319 319

Solowian Growth and AK Models 13.1 Introduction 13.2 Exogenous Growth: Savings, Exogenous Technology, Preferences, and Expectations 13.3 Overlapping Generation Models 13.4 Learning by Doing in AK Models References

319 324 328 330

International Trade Relations, Optimum Currency Areas, Externalities, and Public Choice 14.1 Introduction 14.2 Optimum Currency Areas 14.3 Leverage, Risk Diversification, and Effective Markets 14.4 Monetarism and Neutrality of Money 14.5 Public Choice, Regulation, and Rent-Seeking

333 333 333 334 336 338

CONTENTS

14.6 14.7

Externalities and Institutions Industrial Organization and Uncertainty in Perfect and Imperfect Markets 14.8 Game Theory and Human Interaction 14.9 Nash’s Non-rational Equilibrium References 15

16

The Era of Low Growth and High Inflation: Contemporary International Trade Theories, New Classics, New Keynesian, Human Capital, Contractization Theories, and Behavioral Economics Under Uncertainty 15.1 Introduction 15.2 The New Classical Economics: Flexible Prices, Market Clearing, and Rational Expectations 15.3 New Keynesian Economics: Market Imperfections 15.4 Human Capital as Intangible Capital 15.5 Theories of Cotractization, Agency Cost, Adverse Selection, Moral Hazard, and Signaling 15.6 Trading Theories Based on Business and New Trade Theory: Product Life Cycle, Porter’s Advantage, Barriers to Entry 15.7 Behavioral Economics and Decision-Making Under Conditions of Uncertainty References The Great Moderation, Real Business Cycles, and Dynamic General Equilibrium Models 16.1 Introduction 16.2 The Evolution of the New Keynesians: Microfoundation of Growth Economics 16.3 Real Business Cycles and Growth: Supply Shocks 16.4 Dynamic Stochastic General Equilibrium Models (DSGE): Technological Shocks 16.5 Great Moderation and Central Banks Coordination 16.6 Post-Keynesian Economic Theory and the Financial Instability Hypothesis References

xvii

339 340 341 342 343

347 347 348 350 352 353

355 356 362

365 365 365 367 372 373 375 379

xviii

17

18

19

CONTENTS

Endogenous Growth, Convergence, and Evolutionism 17.1 Introduction 17.2 Endogenous Growth: Summary 17.2.1 P. Romer’s Product Variety Model 17.2.2 Luca’s Model Based on the Deepening of Knowledge 17.2.3 The Schumpeterian Model 17.3 The Convergence of Economies 17.4 Evolutionism: Neo-Darwinism References The Macroeconomic and Development Debate After the Great Recession: The European Crisis, Deleveraging, and Secular Stagnation 18.1 Introduction 18.2 The Nature of the Great Recession 18.2.1 The 2008 Crisis in the United States, and Globally 18.2.2 The European Crisis 18.3 The Macroeconomic Debate 18.3.1 Deleveraging, Balance Sheets Recession and Weak Demand 18.3.2 Managing the European Crisis During the Great Recession 18.3.3 The Hypothesis of the Secular Stagnation 18.4 The Hysteresis Issue 18.5 Monet ary Policy: Zero Lower Bound, Quantitative Easing, Forward Guidance, and “Helicopter Money” References The Macroeconomic and Development Debate After the Great Recession: Fiscal Space, Multipliers and GDP, Debt Supercycle and Supply-Side Economics 19.1 Introduction 19.2 Fiscal Space and Fiscal Multipliers 19.3 Multiple Equilibrium Points in Public Debt Costs and Confidence

383 383 383 384 386 387 391 393 396

399 399 400 400 403 408 409 414 416 422 423 429

433 433 433 436

CONTENTS

Over-Indebtedness and the Debt Supercycle Hypothesis 19.5 Increasing Supply Opportunities, Structural Changes, Ordoliberals and Neo-Mercantilism References

xix

19.4

20

Growth and Development Implications of Covid-19 20.1 Introduction 20.2 Pandemics and Economy in the Human History 20.3 Covid-19 Infects the Economy 20.4 Pandemic and Economic Recession Interactions 20.5 Finances of Covid-19 20.5.1 The Economic Situation Under Pressure 20.5.2 State Finances 20.5.3 Corporate Finances 20.5.4 International Finances 20.6 The Covid Moment, Monetization of Debt, Helicopter Money and Modern Money Theory 20.7 Economic Policies in the Time of Covid-19 20.8 The Long-Term Effects of Covid-19 References

Part IV

21

441 445 452 457 457 458 459 466 467 467 469 470 472 473 475 479 480

International Financial Architecture and the Consolidated Financial Transaction Framework

The International Economic Architecture 21.1 Introduction 21.2 International Economic Architecture 21.3 International Economic Institutions 21.3.1 Established Organizations 21.3.2 Councils and Cooperative Models 21.4 Global Trade Institutions 21.4.1 Recognized Organizations 21.4.2 International Trade Agreements 21.5 International Governance Bodies 21.6 International Transnational Partnerships References

487 487 488 489 490 495 497 498 498 501 504 513

xx

CONTENTS

22

Central Banks, Reserve Currencies, International Chains, and International Interactions 22.1 Introduction 22.2 Central Banks and Cooperation 22.3 Reserve Currencies 22.4 Currency Management and Manipulation 22.5 Extension of Global Supply Chains 22.6 Spillovers and Contagion Effect 22.7 The Shortage of Safe Assets References

515 515 515 523 525 528 529 531 533

Appendix: The Integrated Framework of International Financial Markets and Transactions

535

Index

545

Abbreviations

BIS BoJ CMEs CSPP DSGEs ECB ECI EEC EMH EMS EPU Index ERM FIH FOMC FSB FSF GATT GVCs HDI H–O model IBRD ICSID IDA IFC IMF

Bank for International Settlements Bank of Japan Coordinated Market Economies Corporate Sector Purchase Programme Dynamic Stochastic General Equilibrium Models European Central Bank Economic Complexity Index European Economic Community Efficiency Market Hypothesis European Monetary System Economic Policy Uncertainty Exchange Rate Mechanism The Financial Instability Hypothesis Federal Open Market Committee Financial Stability Board Financial Stability Forum General Agreement on Tariffs and Trade Global Value Chains Human Development Index Heckscher–Ohlin Model Bank for Reconstruction and Development International Centre for Settlement of Investment Disputes International Development Association International Finance Corporation International Monetary Fund xxi

xxii

ABBREVIATIONS

LMEs MIGA MMEs MMT Model “2×2×2” MPT NAIRU NLI OCA OECD OLG Models PEPP PIP PPP QE RBC RCEP R&D REH SDRs SSM TPP TTIP UNDP VIX VoC WB WTO ZLB

Liberal Market Economies Multilateral Investment Guarantee Agency Mixed Market Economies Modern Money Theory 2 Countries, 2 commodities, 2 coefficients Modern Portfolio Theory Natural Rate of Unemployment Non-Labor Income Optimal Currency Areas Organization for Economic Cooperation and Development Overlapping Generation Models Pandemic Emergency Purchase Programme Policy Ineffectiveness Proposition Purchase Power Parity Quantitative Easing Real Business Cycle Regional Comprehensive Economic Partnership Research and Development Rational Expectations Hypothesis Special Drawing Rights Single Supervisory Mechanism Trans-Pacific Partnership Transatlantic Trade and Investment Partnership United Nations Development Program Volatility Index Varieties of Capitalism World Bank World Trade Organization Zero-Lower Bound

List of Figures

Fig. 1.1 Fig. 2.1

Fig. 2.2

Fig. 2.3

Fig. 2.4

The nature of economic research (1963–2011) (Source Hamermesh [2013] and author’s own creation) Evolution of GDP per capita in large economies (since 1870) (2011 international dollars) (Note The international dollar [also known as the Geary–Khamis dollar] is a currency unit for comparing the values of different currencies. International dollar-to-country relationships have been adjusted to reflect currency values, as well as to reflect purchase power parity [PPP] and average commodity prices for each country. Source Maddison Project Database, version 2018 and author’s own creation) Percentage of the world’s population in (absolute) poverty, 1820–2015 (Source 1820–1992: Bourguignon and Morrisson [2002], 1981–2015: World Bank PovcalNet and author’s own creation) Ranking by GDP per capita for large economies (Note The ranking is a sample of 39 countries based on data available from the Maddison Project Database. Source Maddison Project Database, version 2018 and author’s own creation) Change in happiness level in the US and European countries from 2005–2008 to 2016–2018 (Source Helliwell, Layard, and Sachs [2019] and author’s own creation)

21

30

31

32

35

xxiii

xxiv

LIST OF FIGURES

Fig. 2.5

Fig. 3.1 Fig. 3.2 Fig. 3.3 Fig. 4.1

Fig. 4.2

Fig. 4.3

Output gap in selected economies (1980–2025) (Note The vertical axis represents the extent to which the actual output is different from the potential output in percentage form. A positive value means that the actual product produced exceeds the potential output. A negative productivity gap means that the actual output produced is below the full potential of the economy for production. Source Oxford Economics-Global Economic Model [January 2020] and author’s own creation) From human needs to human action (Source Author’s own creation) Analysis of motives and incentives (Source Author’s own creation) Political and economic institutions (Source Petrakis [2011]) The simple circular flow of economic activity (Note Both economic activity and money follow a circular flow. The circular flow of money means that the money spent should continue to flow in order to maintain a certain level of economic activity and income. In the above figure, we can see the circular course of money as well as of goods from household to firms and the reverse. Then, as households receive wages, rents and dividends from firms, they use them to consume. Source Author’s own creation) Complex circular flow of economic activity (Note Consumers are classified according to their income criteria, which obviously affects the attractiveness of the products available, the production of the products [ones that meet consumer needs] and hence the sales of the firms. Each firm faces a multitude of internal flows that ultimately determine its market position—along with the position of each undertaking over its competitors. Of course, precisely because the system is so complex, not all possible flows which affect it can be recorded, especially those relating to the firm’s relationship with the other firms in the market. Source Author’s own creation) Global picture of complexity (2017) (Source The Growth Lab at Harvard University [2019] and author’s own creation)

37 57 75 76

105

105

109

LIST OF FIGURES

Fig. 4.4

Fig. 4.5

Fig. 5.1 Fig. 5.2

Fig. 6.1 Fig. 6.2 Fig. 6.3 Fig. 6.4

Fig. 6.5 Fig. 7.1

Fig. 8.1

Fig. 10.1 Fig. 10.2 Fig. 11.1 Fig. 12.1 Fig. 12.2 Fig. 12.3

Change in the Economic Complexity Index (ECI) from 1964 to 2010 (Note Higher values indicate greater complexity. Source The Growth Lab at Harvard University [2019] and author’s own creation) Evolution of information based on all data transmitted on the internet (in zettabyte) (Source Kleiner Perkins Caufield & Byers [KPCB] [2019] and author’s own creation) Factors that shape the level and distribution of political power (Source Author’s own creation) Income distribution in OECD countries (2018) (Note Zero represents perfect equal distribution. Source OECD [2020] and author’s own creation) Uncertainty sources and levels (Source Author’s own creation) Uncertainty levels (Source Author’s own creation) Global Index of Economic Policy Uncertainty (Source Davis 2016 and author’s own creation) Economic risk index by Oxford economics (Source Oxford Economics-Global Economic Model (January 2020) and author’s own creation. Note The index receives values from 1 to 10, where 1 = lower risk, 10 = higher risk) World Pandemic Uncertainty Index (WPUI) (Source Ahir et al. [2018] and author’s own creation) GDP growth rate and expected GDP growth rate in the Euro area (Source Oxford Economics, ECB-Survey of Professional Forecasters and author’s own creation) Entrepreneurship in the early stages and per capita GDP (2019) (Source IMF—World Economic Outlook Database, October 2019, GEM [2019] and author’s own creation) Ricardian model in a closed economy (Source Author’s own creation) Heckscher–Ohlin Model (Source Author’s own creation) Expectations and economic outcome (Source Author’s own creation) The IS-LM Model (Source Author’s own creation) The turning point hypothesis in the Lewis model (Source Author’s own creation) Marginal product and wage in the traditional sector (Source Author’s own creation)

xxv

110

111 122

128 158 159 163

164 165

177

196 263 266 283 294 307 307

xxvi

LIST OF FIGURES

Fig. 15.1 Fig. 16.1 Fig. 18.1

Fig. 18.2

Fig. 18.3 Fig. 18.4 Fig. 18.5 Fig. 18.6 Fig. 18.7 Fig. 18.8 Fig. 18.9 Fig. 18.10 Fig. 18.11

Fig. 19.1 Fig. 19.2

Loss a version by Kahneman and Tversky (Source Author’s own creation) Negative productivity shock and interest rates (Source Author’s own creation) Change in the unemployment rate from the year before the crisis broke out and for the next 25 years (indicator: 100 = unemployment rate in the year before the crisis broke out) (Source IMF data processing World Economic Outlook—October 2016 and author’s own calculation) The cycle of austerity, deleveraging and deflation (Source Comstock Partners Inc. [2012] and edited by the author) The European crisis: domestic and international factors (Source Petrakis, Kostis, and Valsamis [2013]) Depression, deleveraging and growth in Europe and US (Source McKinsey [2010] and author’s estimates) The low growth trap (Source UN [2013] and author’s own creation) Economic policy and interest rates (Source OECD [2020] and author’s own creation) Monetary policy and liquidity trap (Source Author’s own creation) Fiscal policy and liquidity trap (Source Author’s own creation) Fiscal policy and floating exchange rates (Source Author’s own creation) Policy mix and floating exchange rates (Source Author’s own creation) Eurozone GDP and potential GDP (Note It is noteworthy that the IMF estimations of 2016 for the year 2021 indicate that the Eurozone will be at 15% below potential GDP, relative to the trend before the 2008 crisis. This fact is common to all advanced economies [Ball, 2014; Fatás & Summers, 2016]. Source Oxford Economics-Global Economic Model [May 2020] and author’s own creation) Estimation of the fiscal space (Source Botev, Fournier, and Mourougane [2016] and author’s own creation) ECB’s operations (in billion e) (Source Bruegel—European liquidity database and author’s own creation)

360 370

402

405 407 411 415 417 419 420 420 421

422 434

439

LIST OF FIGURES

Fig. 19.3

Fig. 19.4

Fig. 19.5 Fig. 20.1 Fig. 20.2

Fig. 20.3

Fig. 21.1 Fig. 22.1

Fig. A.1

Advanced Economies: Debt to GDP, 1925–2021 (Source IMF Historical Public Debt Database and author’s own creation) The Phillips curve and macroeconomic adjustment (Source Goldman Sachs [2012b] and author’s own creation) Required adjustment (Source Author’s own creation) World GDP growth (Source Oxford Economics/Haver Analytics [May 2020] and author’s own calculation) Production losses in the medium-term could be much higher (Source Oxford Economics/Haver Analytics and author’s own calculation) The pandemic and recessionary curve (Source Baldwin and Weder di Mauro [2020], Gourinchas [2020] and author’s own creation) International economic architecture (Source Author’s own creation) Shares of global official foreign reserves (first quarter of 1999–fourth quarter of 2019) (%) (Source IMF Currency Composition of Official Foreign Exchange Reserves—COFER and author’s own creation) Presentation of the five fundamental relationship (Note The connection between the elements expresses equality. Source Author’s own creation)

xxvii

441

447 449 463

465

466 488

524

536

List of Tables

Table 1.1 Table 3.1 Table 3.2 Table 3.3 Table 3.4 Table 3.5 Table 8.1

Table 8.2 Table Table Table Table Table

8.3 9.1 18.1 19.1 20.1

Table 20.2 Table 21.1

Concepts of space and time in economic theories Rational and natural human behavior Optimal and idiosyncratic/stagnated institutional framework Optimal and idiosyncratic/stagnated cultural values framework Global overview of the cultural background Overview of institutions (2019) (ranking among 141 countries) Motivations for starting a business per country as a percentage of Total Early-stage Entrepreneurial Activity (TEA) (%) (2019) Behaviors that influence the modulation of the business cultural background The picture of innovation The key theoretical contributions to economics Map of deleveraging in the second quarter of 2009 Fiscal multipliers and business cycle The main epidemics and pandemics that have occurred in the period 1918–2020 Policy measures to stimulate households, businesses, and the financial sector List of national economies that have chosen to peg their currency to the United States dollar

18 73 84 85 88 90

203 206 216 230 410 437 458 478 505

xxix

PART I

Methodology and Introduction

CHAPTER 1

The Methodological Puzzle

1.1

Introduction

Theories of development and growth are part of the theories of economics. Therefore, the methodological issues concerning economics also relate to theories of development and growth. To understand how the methodological issues in economics evolve, we need to clarify some of the issues that emerge as dominant. These are: 1st—On what principles are new theoretical constructs developed? 2nd—What are the trends in the evolution of economic thought concerning theory and reality, that is, the relationship between theoretical constructs and empirical data? 3rd—On the basis of what principles do alternative theoretical constructs interpret the particular phenomena being studied? The first chapter attempts to answer these questions. It is essentially a panoramic view of the methodological background of economic science. Thus, the approach is illustrated that characterizes the structure and organization of the book, which follows a pluralistic methodology.

© The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_1

3

4

P. E. PETRAKIS

1.2

Navigating Between Theories

Navigating between the different theories requires five issues to be clarified. These are: 1. the basic elements of theory construction 2. the importance of positivism in economic thought 3. expanded approaches to economic methodology 4. the difference between models and theories and the role of mathematics in economic thought 5. the criteria for selecting theories and hypotheses and the role of predictionism as well as operationalism in economic thought. 1.2.1

Theory Construction

The scientific method should be distinguished from the aims and results of science, such as knowledge, predictions or control. The method is the means by which these are achieved. Explanation is a process of describing what caused an event. It encompasses the concepts of physical causation and rational influence. Physical causation is a physical process that takes place in reality, while rational influence is a mental process that takes place in rational thought. Rational influences shape the steps of scientific justification in the transition from theory (assuming something is true) to conclusions. Scientific reasoning sets out a set of criteria for evaluating causal theories. Justification may be inductive, abductive, or deductive. Other models of reasoning are more informal, such as intuitive reasoning and verbal reasoning. 1. Inductivism This is a form of logical reference which states that observation occurs first, followed by generalization, and thus the theory emerges. In Baconian model (Bacon, [1620] 2000) one observes nature, proposes a law to generalize observed behavior, confirms it through a multitude of observations, attempts to formulate a slightly broader law, and confirms it through many more observations, while rejecting unconfirmed laws.

1

THE METHODOLOGICAL PUZZLE

5

Speculation about an argument supports the conclusion but does not substantiate it. It is about attributing properties or configurations to metaphysical formulations, based on the observations of similar phenomena. 2. Abductionism This is a form of logical reference which from observation leads to a theory that applies to that observation. It is formulated in the process of seeking the most straightforward and most likely interpretation and is based on rationality in choosing the best explanation. The original assumptions do not validate the conclusion. This is the process of creating a set of justifications and selecting an instance from that set (proof by contradiction). 3. Deductivism This is the kind of reasoning in which the conclusion is a sub-case or a specialization of a hypothesis. Assumptions or theorems are posited, and empirical verification is sought. In order words, it refers to the creation of a theoretical hypothesis and its confirmation or rejection by observation. According to deductivism, certain interpretation hypotheses are first introduced and then, while some environmental conditions are taken into account, the ability of hypotheses to adequately interpret real data is empirically investigated. John Stuart Mill (1806–1873) was the main proponent of deductivism. As Hausman (1989) points out: “According to Mill ([1843] 2002) a complex object, such as political economy, can only be scientifically studied through the deductive method. Since so many causal factors affect economic phenomena and experimentation is not generally feasible, there is no way to apply the methods of inductivism directly. The only solution is first to inductively substantiate basic psychological or technical laws—such as “people seek more wealth” or the law of diminishing returns—and then formulate their economic implications given the specific parameters of the relevant circumstances. Empirical confirmation or verification plays an important role in determining whether deductive conclusions are applicable, both in checking the correctness of the deductions and in determining whether significant causal factors have been

6

P. E. PETRAKIS

omitted. Such control is not based on one’s unreasonable commitment to basic “laws.” These have already been documented by insight or experimentation. In this respect, civil economics is similar to science which adopts independently substantiated laws.” A crucial conflict has developed between deductivism and inductivism. In his work, The Logic of Scientific Discovery, Karl Popper ([1934] 1959) advocates deductivism and criticizes inductivism (Popperian Deductivism). His criticism was so intense that he proposed eliminating inductivism from the sciences and replacing it with the deductive method. As Popper argues: “The empirical basis of objective science, therefore, contains nothing absolute. Science is not based on a strong foundation. The structure of its theories rests on a marsh. It’s like a building erected on piles. The piles are driven from a height down in the marsh, though not on a natural or ‘given’ basis. And if we stop driving the piles deeper, this is not because we have reached solid ground. We simply stop when we are satisfied that the piles are strong enough to bear the construction, at least for the time being.” Popper’s contribution was so significant that positivism is often referred to as the Popperian view. Box 1.1 The Scientific Methodology in Social Sciences: Until John Stuart Mill The issues of scientific ethics had already been raised by the ancient Greek philosophers Plato (429–347 BC) and Aristotle (384–322 BC). The “Platonic Way” emphasized rationalization as a method, downplaying the importance of observation. Aristotle disagreed, focusing on “the natural world as the fundamental principle to be discovered through the search in nature” (Stanford Encyclopedia of Philosophy). Scientific thinking in the Middle Ages—Magnus (1200–1280), R. Bacon (1219–1292), Aquinas (1225–1274)—was centered on the phenomenon under investigation to discover their basic explanatory principles. However, it was Newton (1642–1727) who founded the principles of scientific deontology. The role of experiment and causation and explicit methodological rules were at the heart of his contribution. The methodological controversies went through the views of major intellectuals, such as David Hume (1711–1776) and Kant (1724–1804). Both influenced the methodological reflections of the following century, until Mill (1806– 1873) came into the forefront as the most influential philosopher of the

1

THE METHODOLOGICAL PUZZLE

7

English language in the nineteenth century with his System of Reason (1843).

1.2.2

Positivism Versus Normativism in Economic Theory

Comte (1798–1857) developed his thoughts on positivism1 in the process of setting out the organizing principles of the science of sociology (of which he is considered the “father”) based on empirical infrastructures. His approach was based on two main axes: Methodological monism and the assumption that reality is empirical in nature and relates to empirical data (that is, information perceived by the senses). Methodological monism holds that there is a single scientific method, independent of the kind of phenomena being analyzed, and, this scientific method is the one followed in the natural sciences. Positivism holds that a theoretical proposition is valid only when it is logically verifiable, either directly or indirectly through empirically verifiable conclusions. In this sense, we may accept that positivism is a stricter version of deductivism. Normative economics stands in contrast to positivistic economics, which includes policy choices from alternative proposals. So, what we “see happening” (positivism) is counterbalanced by “what should happen” (normativism) which is the fundamental conception of the ‘normative’ approach. Positivism developed in the nineteenth century and eventually replaced (in the 1960s and 1970s) the orthodox traditional view of Mill (which was based on deductivism) which had prevailed until then. Normativism’s views express value or normative judgments about what the outcome of economic policy should be. To the extent that normative judgments are linked to data or knowledge, they may be purely scientific or changes in variables. Admittedly, it is possible that positive reasoning leads to normative outcomes, but this is another story. Ceteris paribus clauses accompany the views of positivism. This is a society’s mode of operation following general laws (to the exclusion of instinctual or metaphysical concerns). According to positivism, knowledge is based on the “positive” contents of empirical verification and limits the purpose of the sciences to acknowledgement and recording rather than the interpretation of facts and phenomena. Thus, observation and measurement are at the core of any scientific endeavor. For these reasons,

8

P. E. PETRAKIS

according to the positivist doctrine of science, any scientific theory should be based on the same critical preconditions: 1. Rational documentation of a theory that purports to be scientific (including the principle of falsification) 2. Observation 3. Experimentation. Positivism received major support through the contributions of Popper ([1934] 1959) and Lakatos (1970). It proposed to economists a more verifiable methodology for evaluating the reliability of a theory. Popper moreover argued that a theory that aspires to be scientific must also include the principle of falsification (Popper, [1934] 1959). According to this principle, a scientific proposal is scientific if it can be refuted, that is, if it contains the criteria based on which its validity can be checked. This is a property of positivism which does not originally appear in deductivism but was later added by Popper. Where a scientific theory is rejected for this reason, it must be reformulated until it is compatible with the principle of falsification. Thus Popper rejects all metaphysical claims because he considers that neither verification nor falsification is possible. According to Popper, new empirical evidence never requires economists to change their beliefs and initial assumptions. That is to say, we should be able to prove the truth of scientific findings on the basis of empirical observation, unless they are purely logical or mathematical truths, in which case this is not necessary. At this point, the difference between positivism from deductivism becomes established. In positivism, empirical observation and verification, if they do not confirm the theoretical proposition, lead to a re-examination of the empirical evidence and possibly to the exploration of the original theoretical framework. In deductivism, the empirical rejection of a theoretical proposition leads to its debunking. Thus, although positivism is considered part of deductivism (a more general view), it does have specific peculiarities that are worth noting. In the context of the critique of positivism, emphasis is placed on the methodological principle of the validity of general laws, which ignores the primary characteristic of economics as a social science, i.e., one that studies human activity. However, social science should include particular references to reasons, motives, values and mistakes and more generally to complexity and not just to causes. In addition, positivism has been

1

THE METHODOLOGICAL PUZZLE

9

accused of ignoring the existence of uncertainty (Knight, 1940), which shapes alternative consequences rather than anticipated outcomes. 1.2.3

Expanded Approaches in Economic Methodology

In exploring the boundaries of conceptions about economic methodology, we may add three additional methodological concepts: the rhetorical approach, social constructivism, and eclecticism. The first two approaches, in addition to being very recent, dating only three decades back, have so far failed to be acknowledged as primary in the broader economic and social sciences. By contrast, eclecticism, as it does not, due to its nature, claim an exclusive methodological conception, constitutes, as we shall see, a more widely acceptable approach. Rhetoric is the approach that uses a non-scientific type of reasoning in economics and science in general. This is due to the fact that it is based on ideas related to science and knowledge that are not from economics but derive from the study of history, literature and culture. It is based on the work of McCloskey (1985), The Rhetoric of Economics, who argues that the tools of classical rhetoric and literary criticism are more appropriate for understanding the subject of economists. Modern Economics uses philosophical methods, such as metaphors, proportions and narrative speech, to convince about the correctness of economic theories. A functional theory is one that is convincing to other economists. She argues that economists should pay more attention to how they argue and endeavor to persuade one another about the correctness of the economic theories they use. To this end, McCloskey urges a careful study of economic reasoning and considers that the way economists use empirical research and, more specifically, the use of mathematics and statistics, should be reconsidered. McCloskey’s (1985) rhetoric approach criticizes positivism, believing that its rejection would contribute to a real understanding of the scientific practice of economists. Nevertheless, she does acknowledge its important role as she views it as the dominant approach to understanding economics. Social Constructivism is the theory that has gained recognition in the United States after the publication of The Social Construction of Reality by Berger and Luckmann (1966) who argued that all knowledge is derived from social interactions. Human experience is influenced by language and historical and cultural contexts and by the way we perceive and experience the environment. So, there are many different aspects of reality and,

10

P. E. PETRAKIS

therefore, knowledge. The interpretation of reality is primarily subjective. Preferences, priorities, and institutions are aspects of objective reality. For example, parents organize the rules by which their children will live. So, the reality of their children is socially constructed. Understanding reality by the researcher who undertakes to investigate it, entails the element of subjectivity. This element of subjectivity derives from the causal relationships through which the individual seeks to understand economic reality, in a context that links his or her evolving perception (of reality) with history, geography, institutions, culture and beliefs, the characteristics of the human personality and its motivations. Eclecticism is the method that accepts that “different economic methodologies must be fully evaluated on their own terms and nothing more should be required than internal cohesion” (Caldwell, 1982). The viewpoint of eclecticism is consistent with the economist’s ultimate goal of developing effective growth policies, since what matters is the change of reality, regardless of the theory used to design the policy program. The work of Rosenberg (1976) Microeconomic Laws: A Philosophical Analysis, is one of the most important works on which eclecticism is based. It is responsible for an ever-growing literature on economic methodology by the philosophers of science. However, perhaps the most critical research work on eclecticism is that of Caldwell (1982) although Hausman (1989) believes that his is not a clear philosophical position. Characteristic of eclecticism is the view that, before economists decide which of the different methodologies to choose, they must first make a serious effort to understand and evaluate them. 1.2.4

Models and Theories: The Role of Mathematics

There is a distinction in the literature between the concept of “economic theory” and that of “economic model” although for many years the two concepts were used without distinction. An economic model is a system of theoretical relationships, functions and conditions that produces results through theory. Models contain definitions for the variables they include. They are neither right nor wrong. Their validity remains to be proved. They are usually case-based. They revolve around conceptual determination and are evaluated through the use of mathematics or reasoning. On the other hand, theories, whether true or false, are concepts or systems assumptions which possess the

1

THE METHODOLOGICAL PUZZLE

11

force of rules. Their defining element is claims about the world and the verification of reality by empirical means. Gibbard and Varian (1978) note that models are used by theory to express what is to be described or explained. In the twentieth century, the simple mathematical system of maximizing specific equations under constraints (Samuelson, 1947) played a central role in modeling economics so as to find equilibrium points. However, the widespread use of mathematical equations and the fact that economic models are so comprehensive, are some of the major criticisms against them. On the other hand, their most serious support derives from a straightforward argument: mathematical models prove the essential conceptual relationships at the cost of moving away from reality, while incorporating into the analytical context many and complex elements makes the attainment of theory extremely difficult. So, obviously, an equilibrium is sought between the two (see Romer’s views below). General economic theories provide the wider framework for organizing thought and are not isolated explanatory frameworks, as models may be. However, it is argued that the long and timeless questions in social sciences require the formulation of significant and universal theories (Rodrik, 2015) rather than the use of limited models. Although economic models are usually extraordinarily simplified and do not fully reflect reality, economists do still trust and use them. The reason for this paradox is that economists believe that by using successful and sufficiently numerous hypotheses, there are increased chances of models closely approximating the real world in a way that is compatible with the capabilities of the human mind. It should be noted that mathematics can be used either in a model or a theoretical construct framework. It is accepted that the close connection between the words of human language and mathematical symbols, enhances their alternative use. The problem faced by economists today is that the non-use of mathematics may refer to heterodox economics, while their use is identified with Neoclassical Synthesis, with some Keynesians, Neoclassical theory, the New Classical Theory and the New Keynesian macroeconomic theory on growth. However, this contradistinction is misleading and should not be uncritically adopted as it is well accepted that heterodox economics, also, can and does use mathematics. The differences between the two views are not focused on the use of analytical tools but are much more extensive. The real question concerns

12

P. E. PETRAKIS

the extent of using mathematics as an auxiliary tool in understanding economics and the process of growth. If we do not use mathematics, do we lose anything from the value of theoretical thinking? Romer (2015) in his article “Mathiness in the Theory of Economic Growth” responds affirmatively and supports the use of mathematics: What would have happened if R. Solow (1956) had not developed his mathematical theory of growth, Robinson (1956) the function of aggregate production, and Becker ([1962] 1993) his mathematical theory of wages which gave rise to the concept of human capital? Given the observation that in the last two decades growth theorists have failed to agree on how to incorporate scale effects1 and spillovers into the production process through new products, Romer (2015) stresses the importance of achieving a “new balance in the mathematical economics market.” Otherwise, there is the risk of using a mixed, non-scientific methodology (mathiness), which merely uses cognitive symbols, as opposed to mathematical propositions and the use of empirical observations, contrary to non-theoretical approaches. In conclusion, the use of mathematics is productive when simple abstract concepts are created and when the combination of abstract concepts creates new conceptual compositions and illuminates findings that are not apparent at first glance. 1.2.5

Criteria for Choosing Theory and Hypothesis

A hypothesis is a suggested explanation for an observed phenomenon or a particular observation or a reasoned prediction of a possible causal relationship between multiple phenomena. A hypothesis is merely a recommended possible outcome and the implication is that there is insufficient evidence to provide more than a provisional explanation. A theory is a tested, well-documented, unifying explanation for a set of verified data. A theory is always supported by evidence. This is the documentation of a general principle that can be applied to several specific circumstances in time and space, implying the existence of a more extensive range of data as well as a high probability of truth. A law is when a hypothesis is widely accepted. This means that it is considered to be accurate and that it will predict the outcome of a particular condition or experiment. After hypotheses and laws are checked multiple times and the results are found to be accurate, they then become theories.

1

THE METHODOLOGICAL PUZZLE

13

The issue at hand in this part of the book concerns the criteria used to judge that one hypothesis provides a better explanation than another. “How does one choose between alternative frameworks in cases where two or more theories are offered as an explanation of the same phenomenon? In such matters is the choice entirely subjective or are there objective criteria for the comparison, evaluation and final classification of alternative theoretical constructs? In a word, is there a set of rules for the rational evaluation of theories in science?” (Tarascio & Caldwell, 1979). It should be clarified that the choice of theory is a different process than the process of justifying the theory (i.e., why the basic theoretical idea is formulated) and of the rationalization of the theory (i.e., the necessity of explaining). In addition, the choice of theory is not developed differently depending to the parameters (i.e., when the choice is based on regulatory criteria). Also, the question of choice is quite different from the philosophical question of the methodology by which a theory is developed. What concerns us here is the issue that arises when alternative models and theories have been developed, and we must choose between them in order to interpret a particular phenomenon in the real world. The criteria for selecting a theory can be of two types: empirical and logical (Tarascio & Caldwell, 1979). The empirical criteria are two: 1. examining the simulations of a theory for the sake of verifiability and realism; and 2. comparing the prediction of a theory with reality. The rational criteria relate to whether the theory being tested is characterized by: 1. Productivity and suggestiveness: theories that propose new fields or methods of research or new approaches to old problems that are considered useful. 2. Coherence and consistency in the internal structure: let it be noted that logical consistency requires that no axioms or relationships are expressed within a theoretical structure that contradict other relations or axioms of the same structure; also, that mutually incompatible theories cannot be deduced from the axioms and relationships which have been posited.

14

P. E. PETRAKIS

3. Simplicity: this states that a simple and parsimonious choice between two theories is preferred as is theoretical elegance which focuses on the beauty and aesthetic appeal of a theoretical structure. 4. Generality: this states that a theory which integrates an existing and well-documented body of knowledge into a single unified context, must be judged as superior; Expandability also states that a theory is preferred if it allows for expansion through abduction to other fields of research. 5. Operationality (see Sect. 1.2.6) It is doubtful whether there is a theory which satisfies all the above criteria simultaneously. That is why choosing a theory based on one or more of these criteria is particularly difficult. These criteria are used to test theories, and only if two theories share all of the same characteristics but one, can they prove useful tools for selecting theories. When it comes to theory selection, it is necessary to first determine the criteria based on which the choice will be made. Obviously, hoping that we will achieve a purely objective choice of theory for a particular economic phenomenon is too much to hope for. That is why it is extremely difficult to conclude what ultimately influenced the organization of the theories which have prevailed in economic science. In order to have process of theory selection, it is necessary to have adequate literature describing the particular theory. There should also be conditions for peer group-oriented, objective review. The body of knowledge created is to be independent of its natural creator. Of course, in the volume of literature there is a quantitative and qualitative choice, and this allows for the subjective evaluation factor. This is followed by the stage of evaluation of the sorting process. Central to the process is the requirement for the essential value of scientific clarity. We can thus avoid the case of “technically sound contributions” with no meaning, which is very common. 1.2.6

Predictionism and Operationalism

Two of the previous criteria for choosing theories, one of empirical (predictionism) and one of the rational criteria (operationalism) have played an essential role in economic science.

1

THE METHODOLOGICAL PUZZLE

15

1. Predictionism argues that when a theory is suitable for making reliable predictions, it is a “good theory”. Therefore, the selection of theories must be based on their predictive ability. This is a view mainly based on Friedman’s The Methodology of Positive Economics (1953). Friedman attempts to satisfy the need for the empirical investigation of theoretical hypotheses by checking the predictability of their conclusions. He argues that, since events are complex and dependent on social and individual behavior, the theory should be chosen on the basis on its ability to predict. Therefore, it is wrong to evaluate a theory on the basis of its assumptions alone. Economists should focus on the ability of a theory to make predictions. There is no reason to check all the assumptions of a theory, as they are usually too numerous and often vague. The only items to be checked ought to be those linked to predictions. In addition, Friedman (1953) argues that some researchers incorrectly attempt to evaluate the “assumptions” of neoclassical theory instead of its predictions, and emphasizes that theories can be reformulated using different assumptions that will bear the same results. So, all that matters is how well a theory predicts the phenomena economists are interested in. Therefore, rejecting assumptions or predictions is not important unless it reduces the performance of a theory in predicting the phenomena under investigation. According to Hausman (1989), Friedman’s (1953) view is not entirely solid and could reasonably be disputed. It ignores the role of randomness. Admittedly, hypothesis control (which generates predictions) is always necessary in order to transform the deficiencies of the theories to provide sufficient predictions to respond to new conditions and data. 2. Operationalism is based on the notion that we do not know the meaning of a concept unless we have a way of measuring it. In operationalism, attention is focused not on the phenomenon itself but on its function and our ability to measure it. This is done by constructing rules that match the abstract concepts of scientific theory with the empirical functions of physical measurements. Initially, operationalism was developed by Bridgman (1927) who emphasized that:

16

P. E. PETRAKIS

1. to understand the meaning of a term, the scientist must know the criteria of operationalism for its application, 2. in order to avoid dispute, each scientific term needs to be defined by a single operating criterion, and 3. scientific terms must have a solidly defined operational meaning. Operationalism is a positivist reformulation of economic theory, which owes a lot to the work of Samuelson (1947, 1963). Samuelson believes that economic science can evolve when economists try to discover “operational theorems of relevance” and stresses that such theorems do exist in economic science, though it is not easy to verify their relationship to reality. For this reason, through their operational dimension, their value should be checked by empirical verification (Samuelson, 1947). The views (compatible with operationalism) of the models must reflect the process in real terms. Samuelson’s revealed preference theory (1953) appeared to give a behavioral approach to preference and utility, with observable claims regarding the actions of individuals and businesses (Hausman, 1989). Samuelson’s scientific approach has also been described as descriptivism, as he considers that a theory is a description of things empirically observed. He stresses that all known theories include hypotheses and propositions that have an empirical dimension. He also argues that if abstract models include empirical inaccuracies, economists need to reject them rather than justify their shortcomings. As for comparison between similar theories, he stresses that a theory should not be rejected if it cannot explain one phenomenon, while it can explain some others, and among two equally simple and elegant theories the one which interprets more empirical phenomena should be chosen. In essence, then, Samuelson is a positivist (Caldwell, 1984) as he fully endorses Popper’s falsification criterion ([1934] 1959). That is why his views are considered akin to those of Popper (1934) and Hutchison (1938). In conclusion, he defines theory as the set of axioms, basic hypotheses or hypotheses that explicitly define something in observable reality. If the underlying hypotheses are empirically false and therefore the theory is unrealistic, then the propositions derived from the theory cannot be accepted. Samuelson ([1965] 1972) opposes predictionism by pointing out that predictions are quite risky, and the potential cost of a failed prediction may be high. Therefore, according to this view, economists should not only deal with predictions.

1

1.3

THE METHODOLOGICAL PUZZLE

17

Time and Spatial Dimensions of Economic Development

When in 1953–1954 Joan Robinson (1953) developed her critique of neoclassical economists in the development of economic growth theory, she highlighted the problem of time and, by extension, space, suggesting that both dimensions are missing from the analysis of neoclassical equilibrium. As a result, methodological errors occur that lead to the confusion of comparing imaginary equilibrium positions with the process of capital accumulation. The problem of time and space is absolutely critical in analyzing economic development and growth. When time and space come in, social and distributional conflicts are brought into the picture. These will inevitably occupy the center of the dynamics of economics, forming and perpetuating path dependence on the economy. Usually, concepts of time and space are not dealt with simultaneously, as we focus either only on the role of time in economics (Davidson, 1995; O’Driscoll & Rizzo, 1985) or the role of space (Crevoisier, 1996; Martin & Sunley, 1996). The various schools of thought adopt different approaches to the concepts of space and time. Without necessarily naming these concepts, how they are approached is a significant indication of the explanatory frameworks used to simulate reality and interpret theoretical frameworks. Table 1.1 summarizes the differences between the equilibrium and non-equilibrium approaches2 in terms of how they deal with concepts of space and time. General equilibrium approaches perceive the concepts of space and time as extrinsic, unchanging, and objective, while non-equilibrium approaches do not distinguish between exogenous and endogenous time and space and consider the two concepts to be endogenous, variable and subjective. Based on the above analysis, we could give a basic example of the importance of specific time and space in shaping theoretical models of the economy and production (Box 1.2). So, while the Walrasian model (an optimal model) could be described as “spaceless” and “timeless”, something that can only be found in books, the deviations from it can be found in the real world and real time.

18

P. E. PETRAKIS

Table 1.1 Concepts of space and time in economic theories The concepts of space and time

Equilibrium approaches

Non-equilibrium approaches

Exogenous or endogenous space and timea

– Exogenous. No impact on economic activity

Invariable or variable spaceb

– Unchanged. Space cannot be changed by human activity – Abstract concept – Objectivity

– There is no distinction between exogeneity and endogeneity – Variable. Space and time are human constructs

Abstract or specific spacec Objectivity or subjectivity space and timed

– Specific concept – Subjectivity

a The intrinsic nature of space and time refers to whether the theoretical approach has its own

separate processes in which space and time do not play a role or if their role is important in the conceptual context b Invariable or variable space refers to whether space is approached as a given and intangible concept that cannot be changed by human activity or if it is a social construct that can be changed c The use of an abstract concept of space offers the dimension of universality through the ability to construct theories that claim to be valid at all times and in all places. When the concept is specific, it means that the concepts of space and time can be explained d The notion of objectivity implies that space and time exist independently of observers and economic actors. The concept of subjectivity implies that space and time can be constructed through observation Source Corpataux and Crevoisier (2007) and author’s own creation

Box 1.2 The Walrasian Paradigm versus the Stagnated Growth Prototype Leon Walras (1874) developed a general equilibrium model concerning the microfoundation of price formation. The optimal prototype can be based on the basic assumptions of the Walrasian paradigm. According to Pareto, perfect competition combined with the optimal allocation of resources in the Walrasian paradigm, presupposes a specific optimal framework of behavior and preferences or their complete elimination, shaping the way economic institutions operate. The existence of an optimal structure of institutions linked to an optimal framework of cultural values can only exist at the theoretical level. In reality, institutions and the cultural background diverge from their optimum rate of development, leading to the emergence of various types of economic models that may promote growth or drive economies to a stagnant condition, etc.

1

THE METHODOLOGICAL PUZZLE

19

In the stagnated prototype, the dominant institutions and cultural background could be hostile to a long period of stagnation. Deviations from the optimal prototype to a counter-developmental behavior can occur when there are extractive institutions (Acemoglu & Robinson, 2012) with anti-development goals. This leads to the emergence of idiosyncratic institutions. These could include extractive institutions, high transaction costs, non-market allocation mechanisms, and rent-seeking modes of appropriation (Petrakis, Valsamis, & Kafka, 2016). This institutional ecology may be associated with behaviors characterized by uncertainty avoidance, group collectivism, high present orientation, and lack of trust. When a stagnated growth prototype dominates the economy, there may be long periods of stagnation or of near-stagnation. Growth is the result of the process of transition from the stagnant model to the optimal one.

The use of space and time in economic theories has critical implications, notably concerning the development of economic policy but also for the theoretical background. The issue is particularly important when it comes to: the relationship between theory and reality, the relationship between equilibrium and path dependence, and the effects of economic policy on different productive patterns and economies. In developing an example of how different productive and economic models (time and geographical dimension) play an important role in the economic policies applied, we may refer to European economies and, in particular, to the exit from the 2008 crisis (Box 1.3). The economic policies that came out of the crisis took quite different forms, depending on the country in which they were implemented, although they all shared a common theoretical background in their design. Box 1.3 The Great Recession of 2008 and the Implementation of Austerity Programs in the European Environment During the Great Recession, one of the crisis response measures in some of the EU-28 economies which found themselves in the midst of the economic crisis (Greece, Ireland, Spain, and Portugal) was to implement fiscal consolidation and internal devaluation measures. The primary purpose of the design of the fiscal adjustment and competitiveness improvement programs was to stimulate competitiveness and

20

P. E. PETRAKIS

reduce deficits. The purpose of these policies, which had a common design background, was to encourage the supply-side economy. The programs implemented in the over-indebted Eurozone countries were based on a common view, ignoring the particular circumstances of each economy (one-size-fits-all). Each country responded differently to programs designed in the same way. There were wide differences in the causes of the crisis and hence in the required economic policy prescriptions among the countries which implemented consolidation programs. Greece was facing a fiscal problem, deficits in the balance of payment and a lack of competitiveness. Ireland entered the crisis because of high private debt, etc. The Portuguese crisis was mainly due to a lack of competitiveness, large budget deficits and high private and public debt, etc. Finally, the causes of the crisis in the Baltic region (Estonia, Latvia, and Lithuania) were the rapid growth of credit, excessive capital inflows, etc. However, it has been found that, following the outbreak of the crisis, the countries concerned took a different route out of the crisis, mainly due to the different policy mixes and, of course, the different structural characteristics of the birth of the crisis. It should be noted that, unlike the decade of 2010, in the 2000s stability programs were successfully implemented in various European countries such as Belgium, Ireland, and Norway etc. One of the crucial factors of the success was the different economic climate prevailing during that period compared to the 2010 period (Eichengreen & Panizza, 2014). This is a clear example of where time and space played a unique role concerning the policies implemented.

In conclusion, time and space do matter. Nevertheless, the issue of introducing space and time into the analysis is directly related to whether equilibrium or non-equilibrium theories are used, since equilibrium models are “spaceless” and “timeless”.

1.4 Concluding Thoughts: Methodological Pluralism Hamermesh (2013), in his article Six Decades of Top Economics Publishing: Who and How? ascertained a growing tendency in economic science to build its views with particular emphasis on empirical observations. In addition, while at the beginning of the period under review, in 1963

1

21

THE METHODOLOGICAL PUZZLE

theory and empirical data on economic research prevailed, a mix of theoretical and empirical foundations seems to have been adopted since 1993 and especially since 2011 (Fig. 1.1). More specifically, in the first three years, the most important scientific journals3 published almost exclusively articles that were theoretical or contained empirical work based on ready-made data. Since then, the share of purely theoretical articles has declined enormously, with much of this decline due to increased empirical studies. Also responsible for the decline is the development of theory through simulation and experimentation. This trend may be due to technological developments and the widespread use of computers that have made it possible for researchers to access statistics. At the same time, theory, and especially macroeconomic theory, failed to interpret reality adequately. This has helped limit the use of theoretical constructs. With empirical observation, reality has become easier to interpret for economists and for non-economic analysts (politicians, journalists […]). But does the departure from economic theory and economic models, which are at the core of science, turn economists into mere managers of statistical data which, in their hands, become tools to explain their

2011

19.1

2003

8.8

29.9

28.9

1993

34

11.1

32.4

1983

38.5

7.3

0% Theory

10%

20%

1.5 30%

Theory with simulaƟon

35.2

4.2

50.7 40%

50%

3.7 8.8

4

54.6

1963

17.8

47.8

57.6

1973

8.2

2.4 0.8

37

4.20

39.1 60%

Empirical with borrowed data

70%

3.7

8.7 0 80%

Empirical with own data

90%

100%

Experiment

Fig. 1.1 The nature of economic research (1963–2011) (Source Hamermesh [2013] and author’s own creation)

22

P. E. PETRAKIS

perspective on reality? In this way, empirical observation about the interpretation of reality becomes an end in itself, and economists may be trapped in a path that takes them away from the theoretical substance of science. On the other hand, does their deep commitment to theory lead them away from reality? The very etymology of the word “Science” (meaning I know well/I oversee, in ancient Greek) involves deep knowledge, not mere observation. Still, a social science cannot remain detached from the empirical observation that will provide it with the means to contribute to society. Those who are interested in the methodology of economics and do not consider the subject closed, before taking a position (e.g., accepting neoclassical perception or Marxist rules of evolution) need to decide— using their judgment—which approach suits them best for formulating and defending their models. They will thus assess and improve the efficiency of their work, while at the same time being able to apply the basic theories more prudently and with a deeper understanding of the real problems and processes associated with the subject at hand. The real question is how methodologically pluralistic we need and can be. The pluralistic approach draws on a wide range of schools of economic thought, economic models, empirical, and theoretical methodology, to develop a more effective approach to economic analysis that will lead to better policy outcomes. There are two extremes as answers to this question: On the one hand, there are those who argue that we should only be defined by one methodological approach, the so-called monists, and on the other, there are the pluralists who support the legitimacy of using different methodological approaches. In the middle ground, there is a number of different methodological versions. The most well-known and traditional methodologies are the monistic methodologies. The most well-known versions of the monists are: Inductivism, which considers scientific theories to be based on inductive inference from observed data, and Popperian falsificationism, which treats the method of science as an attempt to disprove the hypotheses proposed by scientists to explain the observed phenomena. Recent methodological pluralists argue against the idea of a fixed method, in favor of a plurality of methodological rules governing the evaluation of theory. These methodological rules may vary from time to time, as well as from field to field, within the same science. New rules can be introduced, and old ones can be discarded. The rules may be modified as scientific practice evolves. They can be applied in different ways

1

THE METHODOLOGICAL PUZZLE

23

in different fields of science and the individual scientist can interpret the same rules in different ways. The most famous pluralists are Feyerabend (1975), Kuhn (1977), and Laudan (1984). In today’s ever-changing world, which is rife with uncertainty, a complex view of the existing reality is required in order to substantiate an integrated view of growth. Therefore, to identify sources of growth as they arise through navigation between models and theories and to subsequently develop policies for activating them, a pluralistic approach can be used to facilitate the multidimensional analysis required. Pluralismeclecticism makes it possible to focus on the methodology applied by economists, by utilizing whatever tools philosophers of science have to offer which seem appropriate for this purpose (Hausman, 1981). The pluralistic approach allows us to move away from the need to exclusively support the veracity of the neoclassical model of economic thought, which—despite its organized mathematical formulation and, hence, its internal consistency—reflects only certain aspects of reality and may have partial spatial (in specific developed economies) and temporal (short-term analysis) implementation. In this model, economic reality is captured by the creation of a utopian economy, based on concrete assumptions. These are the cases of full information, absence of uncertainty, rationality, rational expectations, inclusive institutions, variety of investment behavior, optimal allocation of resources, and lack of transaction costs. Such assumptions cannot be universally accepted on an ex-ante basis, as they are often not correct. Nevertheless, the neoclassical model remains a starting point for reflection, a valuable analytical tool, and an internal consistency benchmark for the development of alternative scientific perspectives. Yet it also distances us from the need to lend support to any other model of economic thinking. The same concern applies to the newer versions of neoclassical theory, monetarism, neo-classical macroeconomics and others, which maintain the same assumptions and move around the core of neoclassical theory. A pluralistic approach mainly frees the researcher from the methodological implications of a “positivist mantle” and from the search for the predictive ability of the theories used. At the same time, it enables him to utilize his organizational ability to classify abstract theoretical frameworks through induction. Accepting the pluralistic/expanded eclectic approach along with the principle of deductivism allows us to fulfill our core objective of formulating a theory of growth that “fits the facts.” This is because, if its results

24

P. E. PETRAKIS

are not empirically verified, then, instead of focusing on the original hypothetical principles on which the theoretical construct based, it will eventually lead us to seek a different theory. The eclectic view is consistent with the ultimate goal of developing effective theories for policy development, since what matters is changing reality—regardless of the theory used—into policy proposals. In this sense, it must be understood that both positivist operationalism and predictionism are important methodological tools for the development of scientifically established theories of economic development and growth. At this point, it should be noted that in real life, researchers’ thinking is often influenced by existing observations, which trigger the creation of certain hypotheses (inductivism) and possibly hypotheses with explanatory ability (abductionism). Indeed, as we have seen, deductivism (cases for which confirmation or refutation is sought) is the methodology that most certainly leads to scientific research. At all events, it is to be noted that sometimes empirical observation creates research stimuli. If, however, we seek to enhance due scientific process, the Popperian principle of falsification is a useful addition to the methodological armory. Thus, economic thought should be able to interpret the temporal and spatial evolution of production, inflows and prices. This has to be done based on the observations of reality and the critical questions that thus raised, since we are, of course, based on a set of assumptions which posit phenomena and basic hypothetical interpretations and assumptions. These interpretations result in suggestions that can be empirically tested. Based on empirical findings, the underlying hypotheses are improved, and the predictive ability is strengthened. In this manner, integrated theories are generated based on a pluralistic view. Consequently, theoretical infrastructure and reality are in a constant dialectical relationship of conflict and change. Can the pluralistic view be expanded to where, transcending methodological boundaries, we can accept that different theoretical approaches to the same subject can apply simultaneously to different temporal and geographical referents? What problems arise from the existence of a theoretical construction that ‘fits facts,’ the necessity of which many support? To answer these questions, one must first determine whether we have one or more different realities (or, to be more precise) more than one reading of the same reality (social constructivism). Consequently, the analyst’s ability to accurately recognize the essential features of reality plays a significant role. Then, the relationship between

1

THE METHODOLOGICAL PUZZLE

25

theory and reality will need to be addressed. The differentiation of models of reality is very likely to lead him to realize that in two different and conflicting theoretical constructs, each has its own interpretation of the corresponding, different reality models, which are only alike at a first, very general reading. In other words, the methodological problem lies not only in the problem of finding the most appropriate theoretical framework to interpret reality but in the search for the reality we want to interpret. This observation could lead a researcher to consider whether the problem itself (e.g., achieving a satisfactory growth rate) is the same everywhere or does it conform to features determined by geographical differentiation or, finally, does the problem change character in time. So, for a variety of reasons, the growth rate may have fallen for some during the past decade, while for others, it has fallen within this decade. So, then, the term pluralism is used to classify the theories used, not only on the basis of internal elements but based on their temporal and spatial dimensions. In other words, a theory in use which falls within the criteria of a pluralistic approach, could be applied to a real situation with specific spatial and temporal characteristics. However, the same actual spatial and temporal characteristics may not be compatible with a different reality. Thus, a pluralistic approach may offer a theoretical proposition for a particular economic system, while in a different time dimension, it may be incapable of interpreting the real data of the same economic system. In that case, a different theoretical structure might need to be developed. It should be noted that the differences between the pluralistic and the selective approach are not readily discernible, and we could argue that the two are virtually identical. We conclude that it is preferable for economists not to have a specific theory in mind for analyzing the real world, but rather a multitude of theoretical considerations, a synthesis of which will enable them to seek the solution to crucial issues. The researcher’s art is to clarify the problem he has to analyze, to know the theoretical infrastructure thoroughly, and then to analyze the relationship between theory and reality. Rodrik (2015) argues that criticisms of economics are misleading when they claim that science has suffered because economists have not yet reached a consensus on “correct” models and theories. It is better to devote our energy to becoming wiser about the choice of framework to be applied. After all, it is not so important what economists do but what they do not do or refuse to do (Hausman, 1992). The persuasiveness and “beauty” of economic thought should be sought in the exhaustiveness of the causal relationships posited with

26

P. E. PETRAKIS

interdisciplinary freedom and interaction, without any methodological dogmatism as regards theory.

Notes 1. One of the puzzles in the theory and experience of endogenous technological change is the scale effect. Specifically, models in which growth is driven by the accumulation of non-rival knowledge predict that larger economies (based on metrics that show larger size of labor force) are growing faster because they have more resources to allocate to knowledge increase and the greater the scale on which knowledge can be applied, the greater the returns on innovation (Peretto & Smulders, 2002). 2. Almost all theoretical approaches (imbalances, complexity theories, etc.) that are not centered on achieving equilibrium are included. 3. The scientific journals used by Hamermesh (2013) are: American Economic Review, Journal of Political Economy and Quarterly Review of Economics.

References Acemoglu, D., & Robinson, J. A. (2012). Why nations fail: The origins of power, prosperity and poverty. New York: Crown Publishing. Bacon, F. ([1620] 2000). The new organon (J. Lisa, Ed.). Cambridge: Cambridge University Press. Becker, G. ([1962] 1993). Human capital: A theoretical and empirical analysis, with special reference to education. Chicago: The University of Chicago Press. Berger, L. P., & Luckman, T. (1966). The social construction of reality: A treatise in the sociology of knowledge. London: Penguin Books. Bridgman, P. (1927). The logic of modern physics. New York: MacMillan. Caldwell, B. J. (1982). Beyond positivism: Economic methodology in the twentieth century. London: Routledge. Caldwell, B. J. (1984). Appraisal and criticism in economics: A book of readings. Boston: Allen & Unwin. Corpataux, J., & Crevoisier, O. (2007). Economic theories and spatial transformations clarifying the space-time premises and outcomes of economic theories. Journal of Economic Geography, 7, 285–309. Crevoisier, O. (1996). Proximity and territory versus space in regional science. Environment and Planning A, 28, 1683–1697. Davidson, P. (1995). Reality and economic theory. Journal of Post Keynesian Economics, 18, 479–508.

1

THE METHODOLOGICAL PUZZLE

27

Eichengreen, B., & Panizza, U. (2014). A surplus of ambition: Can Europe rely on large primary surplus to solve its debt problems? (CEPR Discussion Paper 10069). Feyerabend, P. (1975). Against method. London: Verso. Friedman, M. (1953). The methodology of positive economics. Essays in positive economics (pp. 3–43). Chicago: University of Chicago Press. Gibbard, A., & Varian, H. R. (1978). Economic models. The Journal of Philosophy, 75, 664–677. Hamermesh, D. S. (2013). Six decades of top economics publishing: Who and how? Journal of Economic Literature, 51(1), 61–72. Hausman, D. M. (1981). Capital, profits and prices: An essay in the philosophy of economics. New York: Columbia University Press. Hausman, D. M. (1989). Economic methodology in a nutshell. Journal of Economic Perspectives, 3(2), 115–127. Hausman, D. M. (1992). The inexact and separate science of economics. Cambridge: Cambridge University Press. Hutchison, T. W. (1938). The significance and basic postulates of economic theory. Augustus m Kelley Pubs. Knight, F. H. (1940). Risk, uncertainty, and profit, with an additional note. Series of Reprints of Scarce Tracts in Economics and Political Science. London: London School of Economics and Political Science, no. 16. Kuhn, T. S. (1977). The essential tension: Selected studies in scientific tradition and change. Chicago and London: University of Chicago Press. Lakatos, I. (1970). Falsification and the methodology of scientific research programmes. In L. Imre & A. Musgrave (Eds.), Criticism and the growth of knowledge (pp. 91–196). Cambridge: Cambridge University Press. Laudan, L. (1984). Science and values: The aims of science and their role in scientific debate. Berkeley and Los Angeles: University of California Press. Martin, R. L., & Sunley, P. (1996). Paul Krugman’s geographical economics and its implications for regional development theory: A critical assessment. Economic Geography, 72(3), 259–292. McCloskey, D. N. (1985). The rhetoric of economics. Journal of Economic Literature, 21(2), 481–517. Mill, J. S. ([1843] 2002). A system of logic: Ratiocinative and inductive. Stockton, CA: University Press of the Pacific. O’Driscoll, G. P., & Rizzo, M. J. (1985). The economics of time and ignorance. Oxford and New York: Basic Blackwell Ltd. Peretto, P., & Smulders, S. (2002). Technological distance, growth and scale effects. Economic Journal, 112(481), 603–624. Petrakis, P. E., Valsamis, D. G., & Kafka, K. I. (2016). From an optimal to a stagnated growth prototype: The role of institutions and culture. Journal of Innovation & Knowledge. https://doi.org/10.1016/j.jik.2016.01.011.

28

P. E. PETRAKIS

Popper, K. S. ([1934] 1959). The logic of scientific discovery. London: Hutchinson. Robinson, J. (1953). The production function and the theory of capital. The Review of Economic Studies, 21(2), 81–106. Robinson, J. (1956). The accumulation of capital. London, UK: Palgrave Macmillan, A division of Macmillan Publishers Limited. Rodrik, D. (2015). Economics rules: Why economics works, when it fails, and how to tell the difference. Oxford: Oxford University Press. Romer, P. M. (2015). Mathiness in the theory of economic growth. The American Economic Review, 105(5), 89–93. Rosenberg, A. (1976). Microeconomic law: A philosophical analysis. Pittsburgh: University of Pittsburgh Press. Samuelson, P. A. (1947). Foundations of economic analysis. Cambridge: Harvard University Press. Samuelson, P. A. (1953). Consumption theorems in terms of overcompensation rather than indifference comparisons. Economics, 20(77), 1–9. Samuelson, P. A. (1963). Problems of methodology—Discussion. American Economic Review, Papers and Proceedings, 53, 231–236. Samuelson, P. A. ([1965] 1972). Economic forecasting and science. Cambridge: MIT Press. Solow, R. M. (1956). A contribution to the theory of economic growth. Quarterly Journal of Economics, Oxford Journals, 76(1), 65–94. Tarascio, V. J., & Caldwell, B. (1979). Theory choice in economics: Philosophy and practice. Journal of Economic Issues, XII (4), 983–1006. Walras, L. (1874). Elements of pure economics, or the theory of social wealth (W. Jaffe, Trans., Homewood, 111, Irwin). London: Allen & Unwin.

CHAPTER 2

Introduction to General and Integrated Development and Growth

2.1

Introduction

This chapter introduces the concept of general and integrated growth as well as the relevant key questions that need to be answered. The relationship between development, growth, and prosperity is particularly complex, and it is therefore necessary to clarify how the part relates to the whole, especially as this was a turning point in the theoretical evolution of growth once it acquired micro-foundations. The distinction between stock or flow-based analysis and the resulting policies ultimately leads to the need for an approach to the economics of development and growth from an integrated perspective that takes multiple factors into account.

2.2

The Key Questions for Growth

As the literature on growth has evolved to date, its primary concern is with the determinants of the long-term growth of GDP per capita and, consequently, the issue of its distribution. There is also the question of the convergence of growth rates between economies and, in particular, between the more and less developed economies. Convergence can be defined in terms either of GDP growth rates or GDP levels. More specifically, there are three key questions for development and, it should be emphasized, they have not lost their validity over time:

© The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_2

29

30

P. E. PETRAKIS

60000

50000

40000

30000

20000

10000

1872 1876 1880 1884 1888 1892 1896 1900 1904 1908 1912 1916 1920 1924 1928 1932 1936 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016

0

France

Germany

U.K

USA

Japan

Fig. 2.1 Evolution of GDP per capita in large economies (since 1870) (2011 international dollars) (Note The international dollar [also known as the Geary–Khamis dollar] is a currency unit for comparing the values of different currencies. International dollar-to-country relationships have been adjusted to reflect currency values, as well as to reflect purchase power parity [PPP] and average commodity prices for each country. Source Maddison Project Database, version 2018 and author’s own creation)

1. What factors have shaped and are still shaping the levels of growth of individual economies? 2. What factors shape the rate of change in growth levels? 3. What factors influence the processes of convergence of the growth rates of economies? These questions were the basic material of the classic manuals on growth.1 It is striking how GDP per capita (Fig. 2.1) has changed as a function of time, especially in the last few years of the evolution of societies. This has resulted in a general prosperity, so that the population living in absolute poverty has shrunk dramatically (Fig. 2.2). These findings have bequeathed to today’s society a very heavy task which is to maintain these rates of improvement in the future. It is also striking that the relative position of economies in the global economy has changed dramatically. Countries that were very rich a

2

31

INTRODUCTION TO GENERAL …

90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1820

1840

1860

1880

1900

1920

1940

1960

1980

1990

2000

2010

2015

Percentage of the world's population in absolute poverty (less than $ 1 a day, Bourguignon and Morrisson) World poverty rate (less than $ 1.9 a day, World Bank)

Fig. 2.2 Percentage of the world’s population in (absolute) poverty, 1820– 2015 (Source 1820–1992: Bourguignon and Morrisson [2002], 1981–2015: World Bank PovcalNet and author’s own creation)

century ago, have seen their relative position deteriorate dramatically and countries that have had an extremely weak presence, have seen their position improve significantly (Fig. 2.3). As we will see in the next part, the trends of change in relevant positions in the world will continue in the future, possibly with different protagonists.

2.3

Growth and Prosperity

Economic Growth is calculated as the annual growth rate of an economy’s gross domestic product (GDP) and GDP per capita. It is usually expressed as a fixed price and not as current prices. When making currency comparisons, we typically use the purchase power parity (PPP)2 to avoid the problems of exchange rates. A similar definition of growth refers to the level of materiality of an economy. It is usually expressed as the price (usually adjusted for inflation) of all finished goods and services produced in a country within one year. It is, therefore, an approximate measurement of the standard of living. This definition refers to a static description of the

32

P. E. PETRAKIS

1900 Austria Switzerland United Kingdom New Zealand USA

2016

Switzerland USA Germany Austria

Germany Canada France ArgenƟna

Sweden Canada United Kingdom France

Chile

Sweden

New Zealand

Portugal Hungary

Romania Mexico Portugal Russia

Hungary Russia Chile Romania ArgenƟna Mexico ʊ Serbia

Serbia Colombia Colombia India India

Fig. 2.3 Ranking by GDP per capita for large economies (Note The ranking is a sample of 39 countries based on data available from the Maddison Project Database. Source Maddison Project Database, version 2018 and author’s own creation)

2

INTRODUCTION TO GENERAL …

33

present (or achievable) level of material development of a society, which is particularly useful when comparing economies. But how adequate is a definition of growth that only includes references to the material level of growth? The question is fundamental, as the essential elements of basic reasoning about growth refer to human prosperity. Man, as an entity, is characterized not only by their income and wealth but also by their personality, which includes their psychological well-being and physical health. Consequently, the relevant concern is expanded to include not only wealth and income, but also quality of life and psychological and physical health. This could be extended to include other dimensions of life, such as, for instance, security and uncertainty for the future at the beginning of the twenty-first century. So, then, alternative perceptions of valuing the effects of economic effort and prosperity are also included (happiness vs gross domestic product). In other words, a comprehensive understanding of human beings that provides for both their economic and social dimensions is the focus of attention. Essentially, we are talking about Homo holisticus. This is a combination of Homo sapiens (based on genetic variation of characteristics and Darwinian principles of evolution) with Homo economicus (based on individual emancipation) and Homo socialis (based on cultural and institutional empowerment). “An adequate approach to growth must go beyond the accumulation of wealth and increase in GDP and other income-related variables. Without ignoring the importance of economic growth, we must look beyond it. Growth should give priority to enhancing human life and enjoying freedom” (Sen, 1999). In other words, growth must be linked to happiness. On a similar, though not identical basis, the Human Development Index (HDI) was introduced in 1990 by the United Nations Development Program (UNDP). The goal was to measure the quality of life and standard of living in 177 countries. HDI is a composite index based on three sub-indicators: • life expectancy, • the level of education, and • the material standard of living expressed by GDP per capita.

34

P. E. PETRAKIS

The purpose of the index is to assess the degree of development of each country with a measure that has a broader base on income and to complement any shortage of indexes, such as per capita national income. The HDI seeks to address the weaknesses of the per capita GDP, while enabling economic policymakers, as well as all stakeholders, to apply a more comprehensive measure for comparing economies (Haq, 1995); this is the reason it enjoys an advantage over GDP per capita. However, the development of such complex indicators has received serious criticism. Part of the criticism relates to the extent to which a conceptually restricted composite index can measure the level of human development. Another point concerns the limitations in the calculation of HDI, due to the lack of qualitative and quantitative statistics (Murray, 1993; Srinivasan, 1994). Finally, others have doubts about the technical properties of the index calculation. The debate reaches what has been termed the “Easterlin Paradox“ (Easterlin, 1995, 2005) which suggests that per capita output growth does not appear to be associated with improved quality of life, as average happiness has not shown a significant improvement over the last decades. Perhaps this paradox is related not only to GDP per capita but also to the HDI, especially given the criticism that it fails to take into account the qualitative dimensions of life. The OECD has developed the OECD Better Life Index, which includes quality-related issues: life satisfaction, job satisfaction, and crime and suicide rates. The calculation that expresses the level of happiness takes into account several individual variables: the production of a country in goods and services (i.e. GDP), social support, life expectancy, personal freedoms, charity and corruption. It also includes a range of positive emotions (joy, pride, etc.) and negative emotions (pain, anger, sadness, etc.). Figure 2.4 shows the change in countries’ level of happiness from 2005–2008 to 2016–2018. These two subperiods were chosen to present as an example of the use of these variables because they were separated by the Great Recession which caused significant changes in many economies. The Great Recession of 2008, among other issues that it raised, in terms of economic policy and growth policy implementation, has also given rise to the question of objectives, and therefore the way of measuring prosperity in today’s societies. Thus, in February 2008, French President Nicolas Sarkozy, dissatisfied with the state of final targeting for the economy and society, asked Stiglitz, Sen, and Fitoussi to create a

2

INTRODUCTION TO GENERAL …

35

1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5

Fig. 2.4 Change in happiness level in the US and European countries from 2005–2008 to 2016–2018 (Source Helliwell, Layard, and Sachs [2019] and author’s own creation)

committee that will be called “The Commission on the Measurement of Economic Performance and Social Progress” (2008). The Commission aimed to set the GDP thresholds as an indicator of economic performance and social progress. The Commission published its findings in the “Report by the Commission on the Measurement of Economic Performance and Social Progress.” The content of the report analyzed issues such as quality of life, sustainable development, environment, etc. One of its key proposals was that more attention should be paid to the emotional well-being of a nation than to its economic prosperity. The question is why, while accepting to focus on an expanded idea of human personality, we do not adopt a more complex indicator of human well-being (such as the UNDP Human Development Index, for example), but insist on the classic perception of GDP as an indicator of prosperity? The answer relates to the necessary compatibility of the theoretical infrastructures. In essence, few theoretical constructs have been developed to use growth indicators and targets other than the GDP. Moreover, empirical findings from the study of quantitative and qualitative indicators suggest that, even if we use only quantitative growth indicators, they evolve in the same direction as qualitative indicators (e.g., happiness, etc.). Therefore, an analysis that takes into account the evolution of GDP, indirectly takes into account the qualitative factors that are positively associated with it. In the end, that is, GDP growth is positively

36

P. E. PETRAKIS

associated with the enlargement of prosperity. But as Easterlin (1995, 2005) has shown, this relationship needs to be accepted with caution. The fact alone that growth can “finance” the increase in prosperity gives yet another strong argument for allowing GDP as a key indicator. However, the acceptance of GDP as an indicator of the efficiency of the economic system, is being increasingly criticized. This criticism is mainly linked to the major social upheavals of the post-Great Recession era and to the inability of GDP to incorporate the effects of rising income inequality. As a result, the mismatch increases between the real conditions of societies and the indicators of their effectiveness. In conclusion, we can say that the field of observation includes the quantitative and qualitative dimensions of human existence, but also the social dimension of human activity. It is, therefore, natural that our interest should extend to the basic manifestations of human collectivity, namely society, the economy (markets) and politics.

2.4

Output Gap and Potential Growth

During recessions, the economy’s GDP declines and during expansions, it increases. However, an economy has a specific productive capacity (resources, investments, human resources) that determines its maximum productive output. This is also the level of its potential output. Thus, the question is transformed into whether, at any given time, its GDP is above or below the potential GDP. The output gap (positive or negative) is a measure of the difference between the real output of an economy and its potential output. When an economy operates at its maximum output capacity, there is no pressure on prices to rise or fall. Therefore, output gap is a summary indicator of the relative supply and demand of an economy and the NAIRU3 is the unemployment rate that is consistent with a constant inflation rate (usually around 2%). The NAIRU can be estimated in the context of a more advanced form of the traditional Phillips Curve (wage inflation, cyclical unemployment and expected inflation). If the political objective is to maintain full employment, then the size of the output gap (which is zero in full employment) can be a useful guide for implementing monetary and fiscal policies. The progression of the output gap is illustrated by the indicator of the difference between the real output of an economy and the maximum potential output of the economy, expressed as a percentage of GDP (Fig. 2.5).

2

INTRODUCTION TO GENERAL …

37

4

2

0

-2

-4

-6

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

-8

USA

EZ

Japan

Fig. 2.5 Output gap in selected economies (1980–2025) (Note The vertical axis represents the extent to which the actual output is different from the potential output in percentage form. A positive value means that the actual product produced exceeds the potential output. A negative productivity gap means that the actual output produced is below the full potential of the economy for production. Source Oxford Economics-Global Economic Model [January 2020] and author’s own creation)

The concept of potential output relates to the concept of economic viability4 which in turn relates to inflation behavior. A significant disadvantage associated with productivity gaps (Barro & Grossman, 1971) relates to how they are measured. Ignoring the potential economic conditions that determine fluctuations in economic activity, may lead to less accurate estimates of the potential output. The phase in which an economy is located, determines the type of economic analysis that is applicable and the economic policy that must be followed in order to get the economy out of the production gap, whether it operates below or above its productive potential. As long as an economy is at the point where it has not exhausted the available margins of economic productivity, the theoretical and political analysis of growth will fall within the scope of macroeconomic analysis, while when it is above its potential, it will fall within the scope of development analysis

38

P. E. PETRAKIS

and policy. So, in essence, we accept a more general outlook developed before and after the Great Recession which argues that short-term problems cannot be addressed unless they are placed in a broader long-term context. However, the analysis should be diversified in its choices of theory and policy to be applied. The period after the Great Recession of 2008 is a good example wherein requirements for both macroeconomic analysis and growth analysis coexist, since economies have been operating below their potential for a long time. In conclusion, macroeconomic analysis should be used when the economy is operating at a level below its potential. Correspondingly, growth analysis and policies can be used when the economy produces at a level higher than its potential output.

2.5

Growth and Development

The concepts of growth and development were the two main subplots of economic thought in the period after World War II. Growth economics are more concerned with the macroeconomic dimension and the maintenance of full-time employment in developed economies. Development economics have a microeconomic orientation and are concerned mainly with the conditions shaping development and those accelerating it in less developed economies. Growth economists treat literature related to development economics as lacking in methodology and argue that it is burdened with useless organizational and behavioral issues. Development economists believe that the only useful contribution from those who deal with growth, are the right rates and prices. Development economies, when created, also took into account developments in sciences such as anthropology, sociology, and political science (Krugman, 1996). This comprised a set of ideas called high development theory (Krugman, 1993) and was very convincing in explaining, at least in part, what development was until the early 1940s and 1950s. However, although during the 1980s and 1990s, economists examined the theory of high development with a fresh glance, its methodological inability to express its ideas with “well-organized models” restricted it to the intellectual side-lines. By the mid-1980s, the theory of economic growth had gained ascendancy through the development of endogenous models. Today, the theory of growth does not disregard developments in its neighboring fields of thought.

2

INTRODUCTION TO GENERAL …

39

The real sources of growth resulting from efficiency gains, technological change, institutional reform, and planning, can only be studied at the individual and corporate level, where they produce the effects of growth imbalances (economies of scale, total output growth factor). Thus, in general, the economics of growth include economic development and other relevant scientific views.

2.6 The Relationship Between the Part and the Aggregate For many decades, for both theoretical and methodological reasons, there has been a serious “split” in economics with regard to the study of the part (reductionism) in relation to the aggregation. In the past, it was assumed that the study of the part led to conclusions concerning the aggregate. Conversely, total theoretical generalizations are based on assumptions about the relationships of aggregates (production, prices, consumption-investment decision). The question that arises is whether the assumptions governing the relationships of generic and aggregate volumes are compatible with the assumptions that govern the behavior of individual elements, that is, the behaviors of individual decision units, such as individuals, households, businesses, and vice versa. But as such a relationship does not always apply, the paradox called fallacy of composition was born.5 One version of the fallacy of composition is related to the observation that the properties observed at the individual level may disappear at the aggregate level. This may happen, not because the wrong method of generalization is applied, but because competing forces of interelimination operate, as the individual units may be different and heterogeneous and not behave in a manner that is representative. Another, serious finding associated with the issue of converting the part into the aggregate, is that, along the way, the characteristics of allocation and distribution (e.g., income distribution) are lost among the members that make up the aggregate. The tools that have been developed, e.g., the representative agent model, may be responsible for such problems. Samuelson and Nordhaus in 1992 showed the most well-known example of fallacy of composition: Individuals—operating rationally—save more during a recession, reducing the overall savings of a society. Thus, there is a contradiction that highlights the fallacy of composition and the need for internal consistency with the help of microeconomics.

40

P. E. PETRAKIS

The question of the relationship between the part and the aggregate is not only a matter of economics but of most sciences. Indeed, in the science of biology the micro-macro debate is particularly common (van den Bergh Jeroen & Gowdy, 2003). There is also the question of the relationship between individual psychology (part) and social psychology (aggregate) about economics. Typically, collective entities, national economies, or nations, are often described in a way that would fit the personality traits of individuals. In other words, the psychological concepts and attitudes that govern individual behavior are applied to a nation or a larger social group. Thus, classifications of a nation as “lean” or “wasteful,” “trustworthy,” or “irresponsible” are common and attribute individual characteristics to collective entities, while there is no proof of this being the case. The question of the relationship of the part to the aggregate, and in particular the conversion of the specific to general, has a parameter related to the particular period in question. Thus, for example, in a period of intense psychological stress, societies exhibit specific behaviors which, once experienced, gradually become the origins of inherited behavior (Petrakis, Kostis, & Valsamis, 2013). By contrast, a period of prosperity emphasizes the importance of a general framework of stability and creativity. Thus, we are faced with a peculiar transformation of the parts to the general that is carried out through the processes of social learning and transgenerational behavioral transfer. Another interesting aspect of the part-aggregate relation concerns the extent to which the conclusions of the analysis are applicable. There is a general perception that economics as a science seeks universal rules and laws with universal application, making it very difficult to tolerate the introduction of views on how to treat geographical or population units in a specific way. On the other hand, analyses that include cultural elements by their nature refer to individual population groups. As a consequence, general rules undergo a specific specialization with a geographical aspect. A relevant, though not identical, conceptual distinction, is that of the “microevolution” analysis approach as compared to the “macroevolution” approach. Microevolution refers to more or less uniform selection pressures, such as the operations of an industry. Macroevolution is the long-term transformation of a complex system of the evolution and branching of populations.

2

INTRODUCTION TO GENERAL …

41

The main reason we are taking up the issue of the compatibility between macro-analysis and micro-analysis, is the stability of the theoretical models used, either at the micro- or macro-level, and certainly the stability of the growth models. Attempting to extend a micro-analysis can lead to a very different macro-level analysis model than what is expected at the micro-level. The opposite can happen if we try to move from the general to the partial. This, however, can give rise to scientific weaknesses that cancel the inner discipline of science. Essentially, there is the need to develop methodological individualism in economies, with adequate justification, as there is no reason to assume that aggregate behavior needs to be commensurate with that of individuals. According to the theory of evolution, the procedure of aggregation has been a source of difficulties and the conversion of the analysis from the micro-level to macro-level has not been satisfactorily achieved. This has led to an intermediate solution with the incorporation of micro-analyses and macro-analyses into mesoeconomics (Dopfer, 2005). The literature has repeatedly been concerned with how individual traits are expressed as social behaviors, while the reverse question is also raised. There are, therefore, views, such as that of the Chicago School (Becker, 1976, 2000; Volkart, 1951), which argues that social behaviors are the result of cumulative individual behavior. Conversely, there are perspectives—which are widely supported in psychological science—claiming that individual behaviors are determined by social phenomena. Moreover, the confluence of the two views provides a third view, which recognizes both that the components of individual behaviors lead to the emergence of social models, and that the cultural background shapes individual behaviors. Altogether, there are at least three different viewpoints on to how to frame the microfoundation/macrofoundation relationship: 1. Individuals are behind the aggregated figures. 2. Individual behaviors affect the behavior of aggregates. 3. Aggregate figures are nothing more than summary statistics that reflect individual behaviors (Hoover, 2010). The microfoundations of macroeconomics have been the subject of controversy since the second half of the last century (Janssen, 2006) with two main competing approaches: the theoretical elaboration of the

42

P. E. PETRAKIS

general equilibrium of Walras (1874) and Arrow and Debreu (1954), and the neoclassical approach process of market clearing (Hicks, 1957). Flexible prices have been the essence of general equilibrium in the middle—and long-term. It is well known that the effects of rigid wages established the superiority of Keynesian macroeconomics. The issue of unemployment has introduced the discussion of micro-foundations in the middle space between the two approaches. Why aren’t people (as part of their economic behavior) actively involved in Walras’ process of clearing supply and demand in order to find new equilibrium wages? In attempting to provide an explanation, Clower (1965), Leijonhufvud (1968), and Barro and Grossman (1971) drew attention to the role of microfoundation in achieving price equilibrium. Admittedly, the idea of microfoundation for macroeconomics had been pursued in various ways since 1930, but it was only after the criticism of Lucas (1976) that macroeconomists formally began to insist that models without microfoundation, lacked scientifically sound support (Hoover, 2012). The contradictions between the micro-level and the macro-level can also be due to imperfect competition, information problems, or coordination failures. As Lucas (1987) pointed out: “The most important recent development in macroeconomic theory seems to be described as the reintegration of aggregation problems, such as inflation and business, with the general framework of microeconomic theory […] If these developments succeed, we will simply talk, like Smith, Ricardo, Marshall and Walras, about an economic ‘theory’.” At all events, we will return later in the book to the matter of the microfoundations of macroeconomics, as they has now been adopted as a basic methodological principle in both macro-analysis and theoretical analysis of growth. It is therefore understandable that the issues of growth should be treated as having individual origins, without disregarding the fact that aggregate sizes affect the component parts of the economic system.

2.7

Stocks and Flows Analysis

Another concept which is important to clarify is the reference to the stock variable and the flow variable. Stock variable is a volume that accumulates over time due to inputs, and decreases due to outputs. So, stocks can only be changed through flows. This issue is particularly important as the

2

INTRODUCTION TO GENERAL …

43

nature of the problem (stock versus flow) differentiates both the analytical tools required and the policies for tackling development and growth problems. As Klein (1950) notes, “[…] it would simply be misleading to equate flow analysis and stock analysis as interchangeable. There are certain simple dynamic models in which the choice between variable stocks and flows becomes necessary.” The accumulation of short-term consequences clearly has cumulative long-term effects, just as the accumulation of flow problems leads to stock problems. These observations are instrumental especially when describing the alternative policies for tackling them. Thus, if a policy is identified which addresses the stock problems but not the flow problems, it is apparent that it has limited effectiveness—even if that is in the long run. Also, when an analysis or policy targets stock issues but does not at the same time address flow issues, it is possible that it will not create the conditions necessary for it to be effective. By extension, the time span (short and long term) of an issue is of particular importance, as happened in the course of the 2008 European Crisis. It is reasonable, then, to realize that the wrong “diagnosis” of the nature of the issue at stake and the inability to define it as a stock or flow problem, can lead to an incorrect analysis and, possibly, the wrong policy for resolving it.

2.8 Towards a General and Integrated Concept of Economic Development and Growth The main objective of the theory of economic development and growth is to develop policies that can serve the issues of development and growth. But when considering a package of economic policy measures, it should be placed within the multidimensional real space of economic and social interactions. Only in this way is it possible to assess its significance and the possible effects it has on growth prospects. In the field of economics, the beginning of the twenty-first century was marked by the Great Recession of 2008. But its appearance was not the only major event. Equally severe was the inability of economists to predict its arrival, as noted by Krugman (2009) in How Did Economists Get It So Wrong? Yet, the problem was not just that very few economists had foreseen the coming crisis. The most serious issue was the general inability of economics to understand the failure of the market system’s effective functioning. Many attributed this failure to the analytical tools used in

44

P. E. PETRAKIS

the past, and still in use today, by economic theory and policy. “Did the profession of economists take the wrong way because economists confused (mathematical) beauty with the truth?” (Krugman, 2009). Eichengreen argued in 2009 that the problem was not so much the underlying theory as the selective reading of it. On 20 July 2010, Solow made a famous statement about “building a science of real-world economics” to the US Congress. According to it, modern macroeconomy has not merely failed to solve the present economic and financial problems, but, rather, it was destined to fail. He essentially argued that no satisfactory forecasts can be made by building dynamic, stochastic, general equilibrium models (DSGEs, which constituted the main approach to macroeconomics before and after the 2008 crisis), and, more generally, models based on a single agent, that is, a single worker-processor-consumer combination who plans the future and lives forever. Thus, economic science has become more focused on the inclusion and investigation of human behaviors such as, for example, the role played by the psychological behavior of economic decision-makers. An example is the “greed” of managers in the financial sector as a cause of the 2008 crisis. In 2009, in attempting to contribute to the interpretation of the Great Recession, Akerlof and Shiller put forward the question of the psychological background, namely “how human psychology directs the economy and why it matters.” Nobel laureate Roth in 2013, contributing with his predictions to Ignacio Palacios-Huerta’s book Leading Economists Predict the Future, noted about the work that economists will do in 100 years: “Economics will still be at the forefront of the social sciences, in part because they will continue to incorporate ideas and data that were once considered sociology and political science, just as they have already begun to assimilate elements derived from psychology, as well as biology.” In conclusion, the need for a general and comprehensive understanding of growth arises from: • the prevailing global conditions for the organization of economies and societies (globalization, changing international division of works, etc.) • the increasing demands for an understanding of economic and social phenomena that is based on our improved intellectual ability, and

2

INTRODUCTION TO GENERAL …

45

• the inability shown by linear and limited-range analytical tools to predict, interpret, and cure the major developmental problems of the early twenty-first century. Besides, the social sciences, and especially economics, at a very significant historical moment in their evolution, found support in conceptual loans from related scientific realms (expectations, animal instincts, animal spirits, economic behavior, etc.). Therefore, the areas of psychology, politics, social behavior, anthropology, biology etc., are critical fields that should be included in the areas that work together in order to identify growth phenomena. Consequently, the formulation of highly abstract, theoretical thinking is facilitated by loans from biology (at micro- and macro- level), psychology, social psychology, and anthropology. In each of the aforementioned sub-disciplines, those areas ought to be highlighted that may offer new analytical tools. Thus, complex approaches can emerge, such as macroeconomic psychology. Macroeconomic psychology can be linked to macroeconomic problems (taxation, saving, etc.) using psychological theories. The necessity is therefore ascertained of interdisciplinary research recognizing the diversity of interconnected forces operating at multiple levels. Nevertheless, the disadvantage of a general and integrated approach to growth is that it creates a complex field of reflection, where causality and effects are highly intertwined. Theoretical thinking must, on the one hand, respect the complex dimension of the issues it studies but, on the other, in needs to isolate the dominant causes that produce the main results. Assessing the background of the analysis and the collaboration of the sub-sciences come at a price, as it is very difficult for one scientist to possess the knowledge necessary to achieve a perfect synthesis. A comprehensive and integrated approach should therefore include influences from key economic sub-sciences: Microanalysis, Macroanalysis, International Economics, Economic History and Economics of Development and Growth. The starting point needs to be to analyse the behavior of individuals, businesses, and institutions (microanalysis) and then extend it to the macro-level. This covers the key areas of macroeconomic analysis related to growth, such as growth disruptions and business cycle analysis. The next sub-science of economics deals with international economics related to growth issues. This is a relationship of competitive advantage with offshoring and supply chains, as a way of organizing the international industrial structure. It also covers issues concerning exchange

46

P. E. PETRAKIS

rate management, cessation of acquiring an advantage through the price mechanism (non-price advantage), international capital movements and debt accumulation. Also, the issue of monetary unions and their implications for the small open economies which are their members is related to the coordination of international political governance and international co-operation. The attainment and progress of knowledge of historical evolution enriches the portfolio of theoretical and empirical observations. The blind spots as well as the progress of human knowledge about critical economic issues have played an essential role in advancing reflection on economic development and growth. Thus, on the one hand, the discovery of weaknesses in knowledge about key macroeconomic issues (such as monetary policy under zero interest rates, zero lower bound, and under structural rigidities) has strongly enhanced the relationship between development theory and macroeconomics analysis, since it was impossible for the latter alone to push the economy out of the productive gap. On the other hand, advancing knowledge, for instance, about the process of social learning and the formation of social stereotypes, has improved our ability to understand the relationship between growth and social behavior. But once we accept the need for an approach of general and integrated growth, it makes sense to look for theoretical constructs that can describe and interpret the general context in which different constituent elements and behaviors coexist. It is a fact that the structure of neoclassical thinking contains theoretically adequate references to the coexistence of all the constituent elements of the system in its entirety. These are the characteristics that govern human behavior, business and industry and, of course, the macroeconomic perception of the corresponding organization of the theory of development. We can hardly claim that there is an alternative proposal to neoclassical theory for an overall organization that exists in a comprehensive form today. However, complex perspectives can be developed and many of them could offer alternative theories. Some of them are extremely mature for an alternative conception of development (such as the theory of evolution). Their choice and utilization will depend on whether the researcher will distance himself from the intrinsic beauty of analytical tools in favour of the real analytical potential they offer. Besides, it is quite possible that the neoclassical view proves admirably adequate in analyzing certain economic phenomena that bear those characteristics found in the neoclassical paradigm (e.g., short-term analysis for

2

INTRODUCTION TO GENERAL …

47

economies close to full equilibrium). Alternatively, alternative considerations may interpret different types of economies (e.g., stagnant growth prototypes with rational behaviour, etc.). A general and comprehensive approach requires a thorough analysis of the economy of growth over time. So, we need to look at mediumand long-term growth, concentrations with or without endogenous technological changes, and the long-term evolution of growth of different economic systems, depending on the type of markets involved. Finally, very long-term growth issues are also present: the role of geography, genes and cultural backgrounds for the deep roots of growth, path dependence, uncertainty and the creation of alternative growth futures. The growth process is highly interconnected with a variety of factors given that random and unforeseen changes and interactions occur. But that does not mean that the process of growth is the result of the serendipity of an economy, even if coincidence is a necessity in an open world. It is clear that there are systems, models and long-term trends which are at work and which should be highlighted. Thus, on the one hand, dynamic trends in evolution must be identified and, on the other, the micro-processes need to be outlined that determine the paths which link points of equilibrium to one another within general trends. Related to the issue of micro-processes and the issue of aggregation, is the question of partial or general equilibrium analysis; that is, the effects of individual decisions on the system of all markets (and the corresponding effects on the individual) can be explicitly excluded or included. The question of the distinction between partial and general equilibrium approaches is critical when it comes to economic policy issues. Alfred Marshall in 1961 focused on the analysis of partial equilibrium by contrast to Walras (1874) who aimed at an image of interdependence among all individuals. The partial approach may be inconsistent with policies recommended by a policy framework of general equilibrium. One way to close the gap of analysis between partial and general equilibrium, is to create a representative subject whose actions will coincide with all market operations. Accordingly, Hicks’ basic IS-LM model (1937) depicts average behavior, although newer versions of macroeconomic and growth evolution, mainly in the Neo-Keynesian domain, introduce heterogeneous entities allowing for substantive behavioral elements. The introduction of heterogeneous entities is tantamount to incorporating behaviors as crucial analytical tools.

48

P. E. PETRAKIS

At a more complex level, theoretical constructs and models can and are being developed where the study of industrial dynamics is developed in an evolutionary context, through combining microeconomic and macroeconomic policies in the long run with short-term fluctuations. It is also possible for the incomplete coordination between heterogeneous interactive subjects to coexist with a post-Keynesian theoretical framework. In other words, the development of growth theories can take complex and highly sophisticated theoretical formulations. These, while benefiting from the possible satisfactory interpretation of reality, increase the theories’ complexity. Widening the theoretical boundaries of general and integrated growth, allows for the incorporation of views that are not underpinned by a hidden ideological bias in favor of a particular view (e.g., neoclassical economics), as is the case with prevailing views often focused exclusively on studying productivity and efficiency (Stiglitz, 2010). So, we are looking at a synthetic approach to growth that needs another dimension: that of the political field. Essentially, at a collective level in an economy there is action only when the political sector of social administration, which is to say, the government, is activated. How motives for political behavior are shaped, is therefore of particular importance. The concept of political economy was first studied by Plato when he raised questions about the nature of the state, the central ideas of its administration and the nature of its leaders (Ekelund & Herbert, 2014). It culminated during the classical period with Adam Smith, Thomas Malthus, David Ricardo, and Karl Marx, who developed an overall understanding of economic science as social, including references to human nature and to the general evolution of social phenomena. It is now widely accepted that when, in a society, the reality of taking responsibility for policymaking, including economic policy, is considered of higher importance, politics is placed at a higher level than the economy. Consequently, the political responsibility for undertaking social initiatives is considered much higher than the liability for economic analysis and recommendations on economic policy. Policy decisions are the result of a complex pooling of power and partnerships between the holders of political and economic influence (elites, major economic interests, etc.) in a society.

2

INTRODUCTION TO GENERAL …

49

In line with our approach, then, this book preserves the complexity of the sources influencing the development of the theory of growth, along with a classic view of the political economy of growth, while paying attention to the processes between the political and the economic field in the context of an integrated, overall conception of growth.

Notes 1. The reader has a wealth of teaching manuals through which to gain familiarity with the basic principles for answering these questions. One should pay particular attention to Schumpeter (1942) as his seminal work shapes knowledge by allowing in-depth exploration in one theoretical direction or another, and thoroughly covers the subject. The texts of Acemoglu (2008) and Aghion and Howitt (2009), provide a solid background on growth. Both of these books place great emphasis on the neoclassical conception of growth, although in many cases they broaden this thinking by introducing elements and concepts that come from the analysis of different theoretical approaches. 2. PPP relies on the utilization of exchange rates and links prices to it. The equivalence of purchasing power is a view of exchange rates based on the law of a price. According to this, one unit of any currency should buy the same quantity of goods in each country. In this way transnational and diachronic comparisons are possible. 3. NAIRU (Non-Accelerating Inflation Rate of Unemployment) is defined as the rate of unemployment that does not accelerate inflation. It is alternatively called natural unemployment rate or equilibrium unemployment. This is the result of defining a newer version of the Phillips Curve in conditions of open economy. NAIRU is an unemployment threshold below which inflation will inevitably accelerate. In this case, the government will not be able to use fiscal policy, or the central bank monetary policy, in order to reduce unemployment below a point of equilibrium, without rising inflation. It consists of classical unemployment resulting from rising wages, and structural unemployment related to the structural characteristics of the labor market, and in particular to the mismatch of jobs and of the knowledge and skills of the unemployed. 4. The term “economic viability” refers to the ability of an economy to support a certain level of output indefinitely. 5. The principle that the partial conclusion does not apply to the general level of analysis and vice versa.

50

P. E. PETRAKIS

References Acemoglu, D. (2008). Introduction to modern economic growth. Princeton: Princeton University Press.. Aghion, P., & Howitt, P. (2009). The economics of growth. Cambridge: MIT Press. Akerlof, G. A., & Shiller, R. J. (2009). Animal spirits: How human psychology drives the economy and why it matters for global capitalism. Princeton, NJ: Princeton University Press. Arrow, K. J., & Debreu, G. (1954). Existence of an equilibrium for a competitive economy. Econometrica, 22(3), 265–290. Barro, R. J., & Grossman, H. I. (1971). A general disequilibrium model of income and employment. American Economic Review, LXI, 82–93. Becker, G. S. (1976). The economic approach to human behavior. Chicago: University of Chicago Press. Becker, G. S. (2000). A comment on the conference on cost-benefit analysis. The Journal of Legal Studies, University of Chicago Press, 29(2), 1149–1152. Bourguignon, F., & Morrisson, C. (2002). Inequality among world citizens: 1820–1992. American Economic Review, 92(4), 727–744. Clower, R. W. (1965). The Keynesian counter-revolution: A theoretical appraisal. In F. H. Hahn & F. Brechling (Eds.), The theory of interest rates (pp. 103– 125). London: Macmillan. Dopfer, K. (2005). The evolutionary foundations of economics. London: Cambridge University Press. Easterlin, R. A. (1995). Will raising the incomes of all increase the happiness of all? Journal of Economic Behavior & Organization, 27 (1), 35–48. Easterlin, R. A. (2005). Feeding the illusion of growth and happiness: A reply to Hagerty and Veenhoven. Social Indicators Research, 74(3), 429–443. https:// doi.org/10.1007/s11205-004-6170-z. Ekelund, R. B., & Hebert R. F. (2014). A history of economic theory and method. Long Grove: Waveland Press. Eichengreen, B. (2009). The last temptation of risk. The National Interest, 10, 8–14. Haq, M. (1995). The birth of the human development index. Readings on human development. Oxford: Oxford University Press. Helliwell, J., Layard, R., & Sachs, J. (2019). World Happiness Report 2019. New York: Sustainable Development Solutions Network. Hicks, J. R. (1937). Mr. Keynes and the ‘classics’: A suggested interpretation. Econometrica, 5(2), 147–159. Hicks, J. R. (1957). A rehabilitation of “classical” economics? Economic Journal, 67, 278–289. Hoover, K. D. (2010). Idealizing reduction: The microfoundations of macroeconomics. Erkenntnis, 73(3), 329–347.

2

INTRODUCTION TO GENERAL …

51

Hoover, K. D. (2012). Microfoundational programs. In P. G. Duarte & G. T. Lima (Eds.), Microfoundations reconsidered: The relationship of micro and macroeconomics in historical perspective (pp. 19–61). Cheltenham: Edward Elgar. Janssen, M. C. W. (2006). Microfoundations (Tinbergen Institute Discussion Paper Series). Retrieved from http://hdl.handle.net/1765/7684. Klein, L. R. (1950). Economic fluctuations in the United States, 1921–1941. New York: Wiley. Krugman, P. R. (1993). Toward a counter-counterrevolution in development theory. Proceedings of the World Bank Annual Conference on Development Economics. Washington, DC: IBRD and The World Bank. Krugman, P. R. (1996). Development, geography and economic theory. Cambridge: MIT Press. Krugman, P. R. (2009). How did economists get it so wrong? New York: The New York Times Magazine. Leijonhufvud, A. (1968). On Keynesian economics and the economics of Keynes. Oxford: Oxford University Press. Lucas, R. E. (1976). Econometric policy evaluation: A critique. CarnegieRochester Conference Series on Public Policy, 1, 19–46. Lucas, R. E. (1987). Models of business cycles (p. 120). Oxford: Basil Blackwell. Marshall, A. (1961). Principles of economics. London: Macmillan. Murray, J. L. (1993). Development data constraints and the human development index. In D. G. Westerndorff & D. Ghai (Eds.), Monitoring social progress in the 1990s (pp. 40–64). Avebury: UNRISD. OECD. (2013). Health at a glance 2013: OECD indicators. OECD Publishing. Retrieved from http://dx.doi.org/10.1787/health_glance-2013-en. Petrakis, P. E., Kostis, P. C., & Valsamis, D. G. (2013). European economics and politics in the midst of the crisis, from the outbreak of the crisis to the fragmented European Federation. New York and Heidelberg: Springer. Samuelson, P. A., & Nordhaus, D. W. (1992). Economics. New York: McGrawHill. Schumpeter, J. (1942). Capitalism, socialism and democracy. New York: Harper & Row. Sen, A. (1999). Development as freedom. New York: Oxford University Press. Srinivasan, T. N. (1994). Human development: A new paradigm or reinvention of the wheel? American Economic Review, 84(2), 238–243. Stiglitz, E. J. (2010). Risk and global economic architecture: Why full financial integration may be undesirable. American Economic Review, American Economic Association, 100(2), 388–392. Van den Bergh Jeroen, C. J. M., & Gowdy, J. M. (2003). The microfoundations of macroeconomics: An evolutionary perspective. Cambridge Journal of Economics, 27 (1), 65–84.

52

P. E. PETRAKIS

Volkart, E. H. (1951). Social behavior and personality. New York: Social Science Research Council. Walras, L. (1874). Principe d’une théorie mathématique de l’échange. Journal des économistes, 34, 5–22.

PART II

Important Concepts of Economic Behavior

CHAPTER 3

Economic Action, Cultural Background, and Institutions

3.1

Introduction

Human action is the result of human behavior. The factors that determine it are central to the study of the economics of development and growth. Human action and behavior are critical elements of the decision-making process. Analyzing the decision-making process requires an understanding of the role of the cultural background and institutions. Since its emergence, the human species has shown signs of social organization and cooperation. The assembling of individuals in groups to meet their needs and ensure the proper functioning of the group is the primary reason for the formation of institutions. However, institutions seem to be evolving in a way that influences individual behaviors and, to a significant extent, the cultural background, and vice versa. The interaction of cultural background and institutions with the behavior of the individual and the group shapes economic action. Investigating the above relationships requires analyzing the factors activating individual human actions and decision-making, as well as analyzing the psychological motives that influence behavior. Investigating these issues is not easy, as it requires the analysis of various concepts of the social sciences—mainly of psychology and anthropology—and the integration of many levels of analysis that address social, economic, psychological, demographic, ecological, and biological issues.

© The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_3

55

56

P. E. PETRAKIS

3.2

Decision-Making and Alternative Rules of Economic Action

When Austrian Ludwig von Mises published his book Human Action: A Treatise on Economics ([1944] 2007), he drew attention of economic science and the social sciences in general, on the way human action is shaped. He thus provided economics and the other social sciences with a complete picture of their mission. The individual is a separate entity but if the aim is to present a complete description of human action, the person should also be considered as an expression of the society of which the individual is a member. In this case, we are talking about archetypes (C. G. Jung), social stereotypes or dimensions of the cultural background that characterize social behaviors. 3.2.1

Decision-Making Process

The decision-making process is directly related to the needs that motivate human action. Human action is a dynamic process based on causal relationships. Needs generate desires, desires generate motives, and motives generate targets. The content of our targets leads us closer to the analysis of needs. • In 1943, Maslow recorded human needs in evolution terms on five levels (from the bottom of the pyramid upwards): Safety, Belonging, Love, Self-Esteem, and Self-Actualization. Needs are prioritized by importance and the need for survival is the point of departure. • In 1968, Alderfer simplified the above analysis to only three levels: Existence, Relatedness, and Growth. They are perceived as a continuum rather than a hierarchical structure. • Max-Neef’s theory (1991) refers to universal needs that influence the formation of the individual’s character. Needs, except for urgent ones, are impossible to prioritize as they interact and interrelate. • In 1993, Ryan recognized three basic needs: Autonomy, Relatedness, and Competitiveness (otherwise, Theory of Self Determination). Needs are the same worldwide, but their main differentiation relates to the cultural context in which they are born, as culture influences how the individual will meet those needs. • In 1998, McClelland emphasized the differentiation of needs from person to person, as well as the fact that needs are diffused in

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

57

the social web through imitation: He posited three levels of needs: Achievement, Power, and Affiliation. Human action is developed to meet human needs. This definition of the concept of human action draws away from the concept of positivism, according to which there are general laws that—using specific empirical observations—shape the final social effects in a deterministic manner, similarly to the natural phenomenon of gravity, etc. In the decision-making process of positivism, natural forces are replaced by organized knowledge, while in non-positivistic decision making, individual knowledge and processes that are based on strong individual theoretical foundations are present (Fig. 3.1). Needs and goals relate within a logical sequence which starts with needs, passes through the cultural background of a society—consisting of the preferences of the individuals who from that particular society—as well as its institutions (where business also belongs), to arrive at organizing the goals and, finally, to activate human action. The individual as a member of a society is subject to endogenous and exogenous influences. External influences come from geography and institutions, both of which influence human action, while the reverse relation is also true. Endogenous factors, on the other hand, also influence cultural background and

Fig. 3.1 From human needs to human action (Source Author’s own creation)

58

P. E. PETRAKIS

beliefs and interact with human activity. Human personality traits are associated with preferences, either exogenously (through genes), or through addiction (from person to person through imitation), or through the interaction between generations. The preferences that feed on and are supplied by human action are formed by specific criteria and choices (rationality, bounded rationality, expected benefit, dynamic choices over time, evolutionism, and natural human behavior). Finally, the incentives thus formed, motivate human action. Note that when studying systems of activation of human action, it is evident that considerations that can be projected by analogy to how organisms of any form are propelled into activity. Naturally, such analogies are by no means linear. 3.2.2

The Birth of Culture and Institutions: Coordination

Humans have shown signs of social organization ever since their appearance on earth. According to Aristotle, humans are by nature social beings. Experimental studies demonstrate the importance of cooperation between individuals, which contributed to their social development (Fehr & Fischbacher, 2003). Early societies were small and kin based but with the development of learning ability through imitation, not only did the behavior of individuals but also the organization of societies changed. The rapid adaptation of individuals’ cultural characteristics led to persistent differences between groups and the competition between them contributed to the spread of behaviors that enhanced individuals’ competitiveness (Boyd & Richerson, 2009). Thus, not kinship, but the cooperation of individuals was the primary reason for the formation of societies. The cultural background reflects the individual’s behavior, which is influenced by other individuals through learning, imitation and other forms of social transmission. It is about the set of beliefs, preferences, skills, values, stereotypes, and rules that characterize and differentiate the members of society. Human behavior is mainly transmitted through two mechanisms, the mechanism of cultural transmission, and that of social learning and genetic information, transmitted from generation to generation (Darwin’s theory). Individuals’ tendency to cooperate evolved through group choice processes. Not only genes but also external influences, as well as the behavior of the group in which they live and develop, play a key role in determining individuals’ behavior. Leading thinkers

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

59

of psychology, such as Freud (1856–1939), Fromm (1900–1980) and others, have contributed to this direction in terms of social influence on the shaping of behavior. The role of team dynamics and their interplay on the individual shape and explain economic behavior, as well as the evolution of institutions. Institutions are the laws and constructs that create a viable structure in social interactions between members of a population for society to function properly. Individuals resorted to the formation of institutions to combat uncertainty. Cultural background and institutions interact and evolve in a complementary way and through mutual feedback (Alesina & Giuliano, 2015). The same institutions may function differently within different cultural backgrounds and, respectively, the cultural background may evolve differently depending on the type of institutions. Historical institutions form the cultural background which in turn leads to economic outcomes (Tabellini, 2010). When different cultural values and practices prevail within a society, then, different political institutions are developed. The cultural background primarily affects the political institutions which in turn shape the economic institutions through a continuous process of interplay (Petrakis, 2014). The latter consist of structures and human motives, but because the individual elements of economic theories have a direct influence on the cultural background, economic institutions shape the conditions for growth and distribution of income and wealth. 3.2.3

Formation of Stereotypes and Development of Personal Traits

It is the existence of shared cultural knowledge that creates the right conditions for the formation of stereotypes in a society. Stereotypes are normative beliefs shared by group members, which act to coordinate their behavior (McGarty, Yzerbyt, & Spears, 2002). At the same time, the cultural background creates stable and ordered perceptions that are spontaneously internalized, thus leading the individual to a predetermined opinion and judgment. There are many studies that have attempted to group together and formalize cultural background. Hofstede (1980, 1991, 2001) mentions six dimensions of cultural background that describe the basic aspects of social behavior. These dimensions are as follows: Power distance that indicates the extent to which society accepts the unequal distribution of power among its members. Uncertainty avoidance, which refers to

60

P. E. PETRAKIS

the lack of tolerance shown by a society toward uncertainty. Individualism/collectivism which reflects the extent to which the people of a country learn to act more as individuals rather than as members of a group. Masculinity/femininity which relates to the extent to which “masculine” values (e.g., competition) outweigh “feminine” values (e.g., care for the weak and solidarity). Confucian dynamism which distinguishes short-term oriented cultures (where personal stability, honor protection, respect for tradition, etc. dominate) from long-term oriented cultures (where persistence, classification of relationships according to social status, saving, feeling ashamed, etc. dominate). Life indulgence/restraint1 represents societies resilient to the freedom of the individual which allow for the fulfillment of the natural human needs for enjoyment and pleasure. A more recent study is that of House, Hanges, Javidan, Dorfman, and Gupta (2004) which works parallel to Hofstede’s cultural dimensions. The study examines the interactions between social culture, organizational culture, and organizational leadership. It resulted in nine dimensions of cultural background which are: Power distance (see above). Uncertainty Avoidance (see above). Institutional collectivism which reflects the extent to which business practices of organizations/societies encourage and reward collective action and the collective distribution of their members’ resources. In-group collectivism, which reflects the extent to which the members of a society express loyalty and commitment to the institution of the family or the organization to which they belong. Gender egalitarianism measures the extent to which an organization/society minimizes gender discrimination by promoting equality. Assertiveness refers to the extent to which individuals impose themselves, confront others and are aggressive in their relationships with others. Future orientation refers to the extent to which individuals in a society exhibit future-oriented behavior (e.g., planning, investing in the future). Performance orientation identifies the extent to which a society encourages and rewards its members for improving their performance and superiority. Human orientation refers to the extent to which individuals in a society encourage and reward other individuals for their fairness, truthfulness, friendliness, generosity, care, and kindness. At the same time, surveys focus on the geographical segregation of societies based on their cultural characteristics. In 2000, Inglehart created a map of cultural dimensions showing a detailed measurement of all the variables related to the themes around which human interest revolves

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

61

(religion, politics, economics, and sociability), grouping the countries under study into various sections. In 1994, Schwartz formulated the theory of cultural values to identify a relationship between cultural background and significant social phenomena. In 1995, the research Georgas and Berry attempted to record similarities and differences in psychologybased data, related to the ecological and social characteristics of particular populations and to the population as a whole. In addition, Georgas et al. in 2004, expanded the previous study by including psychological variables in a study of the relationship between grouped countries based on ecological and socio-political variables. Social behaviors may be the sum of individual behaviors within a society or it may be that social phenomena themselves can determine individual behaviors. A relative perception could combine the two views, recognizing that the composites of individual behaviors do lead to the adoption of social patterns, but also that cultural background shapes individual behaviors. To better understand the significance of the role of a specific period in the transition from the localized psychological background to the social psychological background, it is sufficient to consider that, in times of severe disruption, particular societies exhibit specific behaviors which, due to their dynamics, are embedded in the cultural background and influence future behaviors. By contrast, a period of prosperity emphasizes the importance of stability and creativity, thereby reducing the significance of individual cultural differences between segments of the population. The cultural background can influence personal comprehension ability mainly through three processes (Markman, Grimm, & Kyungil, 2009). • Through communication and language: These are concepts passed on to community members and play an important role in the development of causal constructs. • Through the way strategies for tackling problems are developed: This way younger generations process new stimuli from a more favorable position than previous ones. These stimuli are not only concepts but also ways of thinking and problem-solving processes. • Through the process of motivation and the presence of motives, as each cultural background can be characterized by different priorities.

62

P. E. PETRAKIS

The psychology of personality is dominated by the approach of traits (Hofstede & McCrae, 2004). There are several attempts in the literature to identify the personality traits of individuals and the elements shaping them (McDougall, 1932), such as Cattell’s System (1956), H. Eysenck’s System (1970), Guilford’s System (1975), H. Murray’s System of Needs (Borkenau & Ostendorf, 1989; Costa & McCrae, 1988), the Interpersonal Circle Model (Leary, 1957) and Linguistic Analyses (Goldberg, 1981; Osgood, Suci, & Tannenbaum, 1957). All these attempts result in five or six personality traits at most. As basic components of the human personality, five broader aspects of it have been identified which endeavor to describe human personality without being related among themselves. They satisfactorily describe traits observed in people, regardless of their age, cultural background or other particular circumstances. These five factors are: 1. Receptivity to experience: this refers to the degree to which individuals are characterized by curiosity, ingenuity, and how much they use their imagination, act independently and tend toward art, emotion and unusual ideas. There is a crucial distinction in this trait: tendency toward adventure that relates to how easily an individual accepts changes and new experiences, and trend toward liberalism, that is, to what extent an individual is conservative and prefers the safety and stability provided by tradition. There are some controversial aspects to this feature, as flexibility and creativity may be useful in some professions, but they may be an obstacle in others, where autonomy and unconventionality are penalized. 2. Conscientiousness: this refers to the extent to which an individual is characterized as responsible, obedient, disciplined, oriented toward reaching achievements and does not exhibit spontaneous behavior. It can be differentiated into self-confidence, that is, confidence in one’s ability to achieve their goals, or ambition-achievement, where a high score in this trait implies a high tendency toward achievements and a desire to be considered successful. By contrast, a low score signifies the intention to perform to the extent where one feels comfortable without necessarily seeking social recognition and cautiousness. Whereas a high score means that all possibilities and probabilities are analyzed before making a decision or taking action,

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

63

a low score in this trait implies that the individual acts spontaneously without any premeditation. 3. Extroversion: this refers to the extent to which an individual is characterized by a tendency for outward expression, dynamism, selfconfidence, positive emotions, warmth and talkativeness. It can be differentiated into sociability, which indicates the extent to which an individual can easily form interpersonal relationships, ability to coexist, which refers to how easily an individual joins groups, and activity level, i.e., the extent to which an individual undertakes many actions at the same time and lives a life at an intense pace. 4. Affability: this refers to the extent to which an individual is characterized as cooperative, conforms to rules, is modest, and likes to help people around him/her, toward whom he/she displays trust. It can be differentiated into trust, i.e., the extent to which an individual trusts his/her fellow humans and may rely on them, into altruism, which refers to the extent to which an individual is prone to helping others in order to maximize his/her benefit, and cooperativeness, which relates to the question of whether an individual could sacrifice part of his/her own benefit for the sake of a group to which he/she belongs to. 5. Neuroticism: this refers to the extent to which an individual is characterized by the ability to overcome difficult situations with relative ease and whether a person is characterized by emotional stability and does not indulge in impulsivity. All personality traits have two contrasting aspects and the individual is usually characterized by both. In this sense, each individual has a different combination of personality traits, and what distinguishes him/her from the rest, is the composition of these personality traits, the external influences one is subject to and, finally, the degree of convergence in one or the other of the two aspects of each trait. 3.2.4

Humans in Economic Action: Behaviors and Preferences

To date, economic theory has discussed five systems of human activation for human action, without, however, defining them exhaustively. In more detail, these are:

64

P. E. PETRAKIS

1. Rational Behavior and Utility Maximization Adam Smith (1723–1790) through his work The Wealth of Nations ([1776] 1977) is generally recognized as the forerunner of the modern theory of utilitarian individualism or the theory of rational choice, even if he did not give a clear definition of the concept of the theory of rational choice.2 Other social sciences where the theoretical approach to rational choice has been widely used include sociology, political science, anthropology etc. At the heart of the rational process (Box 3.1) is the individual, who acts rationally and makes decisions in the context of basic assumptions about the entire set of his/her beliefs and preferences. Rational choice is the process by which the available options are determined and, then, the preferred one is selected, according to a coherent criterion. The rational model is an optimization-based approach. Box 3.1 Rational Choice Theory: Basic Assumptions

– The basic theory of rational choice refers to a choice at a given moment—that is, the model is static, assuming that all the outcomes are known with certainty, i.e., that there is complete information. – It is a school of thought according to which individuals opt for choices and make decisions so as to achieve the goals they have set, based on rationality. – It is used to model the decision-making process of individuals and considers individuals to act rationally, which means that their choices are stable as they are based on their personal preferences. – A rational individual encounters a known set of alternatives. – For each pair of alternatives (e.g., A and B), the individual either chooses A instead of B or chooses B instead of A or is indifferent to both A and B. This is the completeness property. A rational individual always makes a decision when facing a set of alternatives. – The ranking of the preferences of a rational individual has the transitivity property. This means that if an individual prefers A to B and B to C, then he/she is going to prefer A to C. If he/she is indifferent toward both A and B, and indifferent toward both B and C, then he/she is necessarily indifferent toward both A and C as well.

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

65

– A rational individual’s alternatives are sorted, always according to he/she preferences, in such a way that one is either preferable to the other or leaves him/her indifferent or is less preferable to the other. – Among alternatives, a rational individual always chooses the one that is higher in the ranking list of his/her preferences, even if the level of uncertainty and risk is very high. – A rational individual always makes the same decision every time he/she encounters the same alternatives. – Individuals are characterized as rational when their preferences are complete (that is, if they reflect a relationship of superiority, inferiority or indifference among all pairs of choices) and rationally ranked (i.e., they do not have cyclical inconsistencies).

The modern expression of the “homo economicus” model is the theory of rationality, which is considered to be particularly important for modern neoclassical economics. Neoclassical economists, who write about rational choice, assume that actors make consumption choices to maximize their happiness or benefit. The analysis of rational consumer behavior is approached through Marginal Utility (MU) and is based on the assumption that utility is a measurable and regular concept. It provides a way of comparing the satisfaction an individual receives from different levels of consumption of different goods and derives from the capability of the potential utility of a good or service to satisfy a human need. It is due to some of the actual characteristics of the product but is also primarily influenced by subjective factors, such as each consumer’s preferences. The more an individual increases the consumption of a product, the higher the overall utility he/she receives. However, each additional unit of a product has a consistently smaller increase in the individual’s overall utility due to the law of diminishing marginal utility.3 So, a consumer who has: a certain budget constraint, clear preferences for different goods and services, behaves rationally, and knows that each good or service has its price, will have to decide on which goods and services to allocate his/her income so as to maximize overall utility through the rule of optimization. The optimal way to allocate his/her income is to ensure that the last unit of money spent on each of the products consumed, delivers the same utility. In other words, individuals decide to distribute their monetary income in such a way that the

66

P. E. PETRAKIS

last unit of money spent on each product purchased, delivers the same amount of additional marginal utility. If a good provides more utility per unit of money than another, the consumer will buy more of that good. However, as more of this good is purchased, its marginal utility diminishes until the amount of marginal utility per unit of money equals that of other products. MUY MU Z MU X = = = . . . = etc. PX PY PZ The analysis of rational consumer behavior may also be approached by the use of indifference curves, where, in order to explain consumer behavior, it is sufficient for it to be possible to compare and prioritize the utility of the various goods. Each indifference curve, as developed after the studies primarily of Edgeworth (1881), Fisher ([1892] 1925), and Pareto (1906), shows all the combinations of goods that are equivalent for the consumer in terms of the level of satisfaction they provide or, else, the equivalent overall utility they provide. The consumer pursues the highest possible satisfaction with his/her available income. Utility maximization is achieved where the slope of the line of budget constraint equals the slope of an indifference curve, or, in other words, when the budget constraint curve of the individual is tangent to his/her indifference curve. Rational behavior is the process whereby human beings act through a system of rewards and punishment. However, reality is a great deal more complex: • First, the theory of rational expectations does not reveal the nature of the individual on which these assumptions are based. (Moreover, the role of the cultural background4 is by implication absent in the neoclassical model, resulting individual behavior being a function of particular, individual preferences and restrictions). So, then, this approach seems to ignore essential factors shaping human activity, such as the psyche of the individual, the society in which they live, and the role of the society’s cultural and institutional background. For example, changes in values affect preferences and thus, human behavior. Possibly, a version of the rationalist choice approach, which will include elements of the cultural background, would improve its interpretative ability concerning human behavior. Culture, as a sociopsychological variable, forms attitudes and behaviors are shaped

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

67

through social interaction. So, decisions can be interpreted which, though made by rational individuals, often lead to the sacrifice of some of their expected benefit (Becker, [1957] 1971). The concept of altruism, as it is observed in societies, affects the way individuals act, since altruism, in terms of rational choices, is the extent to which the individual integrates part of the prosperity of other individuals or groups in his/her utility. Thus, the individual is willing to sacrifice part of his/her utility for the benefit of the group. A high sense of altruism and the team spirit it entails, fosters the establishment of cohesive bonds between group members. • In addition, rational choice—as it is typical viewed—leads to a static model of analysis, as it fails to take time into account, and so is unable to adequately explain the sum of economic problems. Because of the asymmetry of information, individuals do not always have the maximum information possible about the great many choices available to them. • Finally, cognitive abilities vary among people, resulting in individuals with limited cognitive ability not being able to act rationally. This creates anomalies associated with individuals’ indecisiveness, that is, the difficulty of making a rational decision among a multitude of choices, especially in environments where actors are required to make decisions which are fully interactive and of uncertain duration or whenever cooperation is necessary in order to achieve the best possible result outcome. Other anomalies, which exist in conventional theories, concern the inaccuracy between predicted and observed behavior. This is mainly found in situations of “social dilemma” where, while cooperation is mutually beneficial, individual interest contradicts the group interest, because of the individual reward. This is a different version of the fallacy of composition. The rational choice approach, which is a theory for the determination of human behavior, does not endeavor to identify with great accuracy all possible choices. The viewpoints presented above are not covered by the standard rational approach, thereby making it less widely accepted. However, these areas provide opportunities to improve the rational choice process, once the problems they engage with them are taken into account. Thus, by challenging the assumption that the individual, when making decisions, is fully informed, the theory of bounded rationality has emerged. Correspondingly, intertemporal-dynamic choice rejects the static concept

68

P. E. PETRAKIS

of rational choice theory (non-temporal), while the theory of expected benefit disputes the assumption of certainty when rational individuals make decisions. 2. Bounded Rationality Process The concept of bounded rationality refers to behaviors where the process of rationality is constrained by certain factors, resulting in behavioral deviations (abnormalities) as compared to optimal rational behavior. This is because an individual’s rationality is constrained by problem management abilities, relevant to decision-making, by cognitive limitations of the mind (cognitive and computational abilities) and the time available to make the decision. Thus, individuals cannot possess all the information available because of the asymmetry of information they are faced with in reality. Therefore, when they are required to make a decision, it is almost impossible to reach high levels of rationality, as they will have to choose from a multitude of alternatives without this being finite and without the outcomes being known in advance. According to this decision-making process, certain mechanisms are created to delimit the above weaknesses. Thus, for example, the individual singles out only a few from a set of alternatives and predicts a limited number of consequences for these solutions. Therefore, although bounded rationality exhibits all the features of rational choice theory, it differs from it because of the limitations it posits. As a result, humans do not always act rationally, as the dominant theory of rational choice assumes, and their rationality is bounded. 3. Intertemporal: Dynamic Choice In 1834, Rae formulated the notion of intertemporal choice, rejecting the condition of rational choice taking place in a static world. Intertemporal choice introduces the notion of time, as one’s decisions have consequences over multiple periods. According to Rae, temporal preferences are explained by the “effective desire of accumulation,” where desire is determined by motive, self-restraint, the uncertainty of human life and the excitement of immediate consumption.

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

69

Later on, models that study temporal preferences (dynamic models) were developed. These raise the question of maximizing utility in relation to consumption (Böhm-Bawerk, [1884] 1890; Fisher, 1930; Jevons, 1888). Other models based on intertemporal choice include the LifeCycle Income Hypothesi5 of Modigliani and Brumberg (1954), Ando and Modigliani (1963), and Friedman’s Permanent Income Hypothesis6 (1957). In dynamic/intertemporal models, utility maximization relates not only to the present, but extends to the future. These models describe how individuals’ current decisions affect their choices and become relevant in the future (saving or investing, working or resting, etc.). In addition, in most dynamic consumption-related models, the question of discounts arises, because individuals prefer a given level of consumption in the present, rather than a given level of consumption in the future. Dynamic models with a positive temporal preference— meaning that a given utility is worth less to an actor in the future than in the present—abound in the literature of rational choice. 4. Expected Utility The most widespread version of rational choice theory is the Theory of Expected Utility, where Von Neumann and Morgenstern ([1944] 1947) incorporate the terms of risk and uncertainty into decision-making for the first time. According to this theory, the criterion for rational choice is the maximization of expected utility. Uncertainty is characterized by a probability distribution that defines a probability for each possible outcome. The subject considered to maximize the expected benefit, which is the sum of the benefits resulting from each outcome, weighted by the probability of that outcome occurring. The mathematical expression of expected utility maximization is: TU = pU(x) + (1 − p) U(y) where x and y are two possible outcomes, p and (1−p) indicate the probability for outcome x and outcome y to occur, respectively, U(x) and U(y) are the subject’s benefits under outcome x and outcome y, respectively. At this point it should be noted that the theory of expected benefits is subject to particular criticism from behavioral economists. Behavioral economics, instead of explaining economics through a pervasive and prescriptive view of human rationality, try to study it without such prior

70

P. E. PETRAKIS

assumptions, with the help of other social sciences, such as psychology and sociology. In this context, Prospect Theory (Kahneman & Tverky, 1992), is a theory of behavioral economics that describes how people choose among possible alternatives which include the element of risk and where the probabilities of the outcomes are uncertain. According to it, people make decisions based on the potential value of the resultant losses and gains, since they evaluate their decisions on the basis on specific, heuristic psychological methods. The model is descriptive and tries to take into account psychological traits, values, feelings and experiences associated with the real world, avoiding optimal choices. 5. Generalized Darwinism and Evolutionary Theory In these theoretical areas, individuals’ choices are determined by cognitive mechanisms formed in evolutionary time through the process of natural selection (Hammerstein & Stevens, 2012). In order to explain how individuals make specific decisions, why they seek particular results, why they persist despite negative feedback, and why systematic errors often continue to lead to undesirable results, it is particularly important to understand how intentions are based on past habits and instincts. Charles Darwin (1809–1882) developed a theory of biological evolution in 1859 according to which, all kinds of organisms emerge and develop through the natural selection of small, hereditary variants that increase individuals’ ability to compete, survive and reproduce. Darwin’s theory, also known as Darwinism, initially included the general concepts of species conversion or evolution, but later referred to specific concepts of natural selection. Darwinism soon developed and set the background for a whole range of evolutionary philosophies related to biology and society. In recent decades, the need for a more evolutionary view of economics is visible in the literature, which may guide the thinking of scientists one step beyond the mere use of biological metaphors. An evolutionary perspective reveals how humans and other animals make decisions. And a rationale seems to be discernible behind decision-making that may not be in line with axioms of rationality. The main position of evolutionary theory is based on Darwinism and natural selection. The process of evolutionism also introduces the concept of cultural background in the above analysis. In 1898, Th. Veblen,

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

71

drawing from Darwin and others the necessity of explaining the causal origin of all evolutionary phenomena, sees the future evolution of society and economy as a result of collective change in society and its institutions, and not as a result of change at the individual level. He perceives the development process as ‘a process of cultural development’, stating that this development is not necessarily better in quality than what was the case beforehand. Evolutionary behavior appears when the whole system of rewards and punishments collapses and conditions are dominated by either addiction or biological factors, genes and homeostasis.7 So, there are three types of theories that can be considered evolutionary (Stoelhorst, 2008): • Those, which simply deal with change over time. • Those based on simple biological metaphors and proportions. • Those that go beyond the analogous use of evolutionary principles and start with recognizing ontological similarities between all complex open systems. These theories pertain to what is called Generalized Darwinism (also known as Universal Darwinism, Universal Selection Theory, or Darwinian metaphysics). It is based on a variety of approaches that extend the theory of Darwinism beyond mere biological evolution. Generalized Darwinists argue that the basic concepts of Darwin’s theory should extend beyond the field of biology to other sciences and levels of life. This means that the mechanisms of Darwin’s diversity, selection, and heredity must be generalized so that they can explain evolution in a wide variety of other fields, including biology, psychology, culture, and economics. These three principles can be understood as an evolutionary algorithm that explores the realm of potential forms for those that are best adapted. In this way, they can and should be used as the background for explaining evolutionary processes in the social and cultural fields. 6. Natural Human Behavior An individual’s preferences are not the result of a process that is fully conscious, specific, and deliberate but, rather, a process that progressively evolves throughout the person’s life. Thus, we can surmise a sixth approach that seeks to give a clearer picture of how an individual’s actions

72

P. E. PETRAKIS

are activated in real life. This view argues that this can happen on the basis of features derived from more than one human activation system. This understanding of human behavior significantly differs from the typical rational choice theory in that it is a model linking economic science to other sciences and in this sense, constitutes a more comprehensive analytical framework, which however, due to its complexity, is difficult to utilize. As can also be seen in Table 3.1, the differences between the two behavioral models are significant and essential in terms of individuals’ decision-making, rules of conduct, goals and motives that influence human action, individuals’ ability, information, and knowledge. So, since each individual’s behavior and preferences are not consciously shaped and are possibly changeable, the cultural and institutional background provides the individual with a set of information which has been created over centuries within each society and reflects knowledge of the past (Hodgson, 1988). Information directly affects the way individuals select and interpret their data. Even if individuals have access to the same information, depending on their inner world, each human being may interpret the data differently and extract information that reflects his/her own imagination and creativity (Loasby, 2001). Therefore, according to this approach, decisions are made every moment through a process that takes into account the cognitive background, which reflects the cultural and institutional environment in which each person lives, as well as his/her psyche. Based on this background, human beings are engaged in understanding and specifying their needs and desires. The above process is significantly influenced by the pervasive uncertainty about the future, which limits an individual’s cognitive and computational ability (Davidson, 1996; Dequech, 2000, 2006). 3.2.5

The Role of Goals, Targets, and Motives

A goal or target is considered a future situation which individuals seek to reach and is therefore the main guide to their activity. Goals trigger behavior and guide choices, so individuals differ from each other concerning the goals they set and the way they achieve them. Goals spring from the pursuit of individuals to cover their needs. As mentioned above, needs generate desires, desires generate motives and motives create goals. Motives are shaped by the pursuit of goals and drive human action, triggered by the urgency of needs. Moreover, they are not directly observable

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

73

Table 3.1 Rational and natural human behavior

Decision making

Rules of contact

Goals range motives

Ability

Information, knowledge

Rational human behavior/utility maximization

Natural human behavior

Decision-making is based on “substantive” or “decisive” rationality The prioritization of preferences is complete, constant, consistent, and independent for each individual. It has additional features such as transitivity, continuity, and saturation Rationality is associated with the process of utility maximization. Maximization is the main motive. The behavior of the individual is aimed at maximizing utility

Human rationality includes elements of procedural logic, creativity and emotional logic Other features of the prioritization of needs and desires include saturation and increase of the needs and goals which are set

All desires are comparable based on the individual’s ability to obtain utility. There is a prioritization of preferences. Preference prioritization is an exogenous process for each individual Individuals have a developed reasoning ability that enables them to process and take account of all the information they acquire. Individuals have sufficient cognitive ability to deal with the complexity of reality Knowledge includes the information that exists. The environment is known or can be known

Source Author’s own creation

Rationality is associated with the search for solutions and the idea of satisfaction. Motives are the search engine for a variety of needs and desires. Behavior aims to achieve a set of individual goals (needs and desires) There is a complex network of needs and desires with a basic set of priorities. Recognizing the hierarchical structure of needs and desires is the result of a cognitive process Individuals have bounded cognitive capacity, but they are creative. Their emotions can shape the decision-making process

Knowledge is a social form of action and requires some form of choice, organization, and interpretation of data. Knowledge is subject to uncertainty. This “opens” the door to the “uncertain knowledge” derived through the continuous thinking process

74

P. E. PETRAKIS

(we may only observe external manifestations of motives, not the motives themselves), they are not identical with satisfaction and do not appear as derivatives of consciousness. Motives may originate either in the human conscious or subconscious, as Freud notes (1915). Maslow (1943) is considered the ‘father’ of the motive theory. At this point, a clarification of terms is required: 1. Motives as ‘incentives’ motivate and encourage. They can be distinguished into: monetary and economic, which are triggered when for example a subject expects a particular work to be carried out and therefore, provides a primarily economic reward; moral incentives, which exist when the individuals acting expect moral satisfaction, an enhancement of their self-esteem or even the opposite, should they fail to act. Moral incentives motivate people to act on the basis of right and wrong; coercive incentives emphasize the consequences of not doing something rather than the benefits of doing something. For instance, blackmailing is a form of coercive incentive. Natural incentives include curiosity, fear, admiration, anger, and more generally whatever can motivate individuals, not for external reasons, but because to the action falls within their field of investigation. 2. Motives as “causes” are the reasons, leading an individual to act in a certain way and they relate to anything that leads to an action choice (Fig. 3.2). They can be divided into two types: • Endogenous: for these, there is no other type of reward but the activity itself. They generate creativity, wellness and spontaneity. • Exogenous: these are imposed motives, resulting from pressure and low self-esteem. However, there are also other distinctions of motives into biological, social, and personal. According to psychology, biological motives are essential for survival. A typical example of a biological motive is homeostasis. Social motives are the result of the interaction between individuals and the social groups to which they belong. They are considered one of the reasons for the differentiation between individuals. Personal motives are considered to satisfy pleasure and they also differentiate individuals.

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

75

Fig. 3.2 Analysis of motives and incentives (Source Author’s own creation)

3.2.6

Types of Institutions

We classify institutions as formal (legal system, market, political, and economic institutions) and informal (networks, rules and beliefs). Informal rules, according to North (1991), incorporate moral and ethical rules. As both types of institutions usually exist in every society or organization, they are likely to evolve together. Informal institutions play an even more important role in the shaping of formal institutions and the functioning of markets (Casson, Giusta, & Kambhampati, 2010). In developing countries, where the economic system has not developed the proper mechanisms of operation, informal institutions can substitute formal ones and, through social networks, become integral for relationships of good, moderate or poor functionality and trust at different levels. Institutions are usually divided into: 1. economic, which are related to concepts such as property rights, the rule of law, accountability, government effectiveness, labor and product markets, tax and social insurance systems, public infrastructure, financial system, companies and shadow economy.

76

P. E. PETRAKIS

2. political, which concern the parliament, the quality of democracy, national government (political circle), politicians and political parties, and local government. 3. social, including family, military, educational system, health care system, non-governmental organizations, public corporations and organizations, security forces, the judicial system, the legal system, mass media, religion, trade unions, and the Internet. The interconnection of economic and political institutions is presented in Fig. 3.3. The initial allocation of resources, the main cultural background, and the critical characteristics of transactions shape the cultural background and political institutions which influence the allocation of resources. These significant conditions of society have both de jure and de facto political power. Finally, the whole framework shapes economic institutions (property rights and contracting procedures). Economic institutions, in turn, have developed and shaped the relative prices in the economy and, consequently, the operating motives of its protagonists (individuals and businesses). How motives are formed, ultimately shapes the economic performance of the system as a whole, and it should be noted that the system is dynamic and the image of its performance is only an instant in the flow of time.

Fig. 3.3 Political and economic institutions (Source Petrakis [2011])

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

77

An additional distinction of institutions is into extractive, when they impede economic growth and inclusive, when they promote it (Acemoglu & Robinson, 2012). In societies with extractive institutions, there are barriers to doing business, the systematic risk is increased and the functioning and efficiency of markets are suppressed. When a recession occurs, existing production structures are discredited. This, coupled with the existence of extractive institutions which hinder the creation of new productive structures (e.g., failed bankruptcy procedures), leads to the preservation of failed production models. Thus, these problematic situations are perpetuated. In other words, failed businesses live longer and new businesses take long in appearing. So, innovation production is decelerated and the economy remains stagnated. On the contrary, if inclusive institutions exist, the process of creative destruction can be facilitated and the economy can recover more quickly. A similar distinction to that between extractive and inclusive institutions is that of predatory institutions, which allow groups of the population who have power to use the available resources of society for self-interest by creating disincentives for investment and development, and developmental institutions, which, on the contrary, encourage business actors to do business by providing them with incentives to invest (Evans, 1989; Shleifer & Vishny, 1994). 3.2.7

Institution Selection Processes

The way institutions are shaped relates to a process that is defined either in terms of institutions as rules or in terms of institutions as equilibrium points. In the end, however, the institutional background is shaped by specific characteristics. Thus, the existence of hierarchical structures in the productive model is a key way of shaping economies, in contrast to the form of structure based on the development of an institutional framework compatible with full and free competition. This form of institutional framework is often referred to as ‘markets’. The economic system also stresses the presence of social networks that may be an additional element of the institutional framework for developing confidence in human cooperation. Finally, the process of selecting institutions may be the result of a sequential dependency evolution.

78

P. E. PETRAKIS

Institutions as Rules and as Result of Equilibrium There are two perspectives on institutions: the perspective of institutions as rules (North, 1990) and the perspective of institutions as states of equilibrium (Greif & Kingston, 2011). According to the perspective of institutions as rules, institutions and rules either are the best possible answers to the institutional environment or, they are determined by the political actors who decide what those rules will be. Thus, because rules are exogenously determined, this approach is adequate in cases where effective and transparent enforcement institutions are observed and one can easily see how the rules guide human behavior. Thus, the approach to institutions as rules is appropriate for exploring how institutions are developed within an established structure that can impose rules. When these conditions do not apply, institutions are approached as an endogenous process. According to the perspective of institutions as equilibrium points, the motives provided by beliefs, rules and expectations are the result of strategic interaction between individuals, organizations, and political actors. Thus, the approach to the institutions as a point of equilibrium is considered appropriate for exploring institutional structures in which the enforcement of rules should be regarded as the endogenous outcome of a process. In this case, formal and informal rules operate together within a unified framework, shifting attention from the belief that rules define behaviors to the behaviors themselves. This approach is in general the concept of the “equilibrium perspective.” There can be a number of potential equilibrium points operating in the background. The perspective of institutions as equilibrium points sees formal and informal “rules” as the means for individuals to cooperate, helping them to form a set of common beliefs about each one’s behavior. According to Calvert (1995), “Institution is just a name we give to certain parts of certain kinds of equilibria.” Thus, in an equilibrium state, each subject is constrained by both exogenous natural constraints and endogenous institutional “rules of the game”, reflecting the strategies of the other players (summarized in the form of informal and formal “rules”). The Role of the Evolutionarily Sequential Dependency History plays a decisive role in a variety of everyday human phenomena, such as preferences, decisions, and institutional behaviors.

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

79

Consequently, an evolutionarily sequential dependency is created. That is, to the extent that preferences, behaviors, decisions, and institutions are shaped by initial experiences and constructs, they are sequentially dependent. The reasons why prior experiences can influence future preferences and constructs should be sought in the mechanisms which fuel anchoring and adaptation. Evolutionarily sequential dependency stresses the problem of economic science and especially, of mainstream economics as regards the efficient functioning of markets. Thus, real markets, precisely due to the process of sequential dependency, today have varying degrees of similarity to an ideal institutional model of their functioning. In most cases, institutions diverge to ensure property rights and effective economic governance. In fact, in the real world, property rights and the way the institutional framework of the economy functions are the result of a sequential dependency process with elements of historical heritage. Markets and Hierarchies Coase’s theory of the firm (1937), introduces the idea that both markets and hierarchical decision structures are two alternative institutional forms that govern transactions. Hierarchical structures which, in their simplest version take the form of a business or a complex system of subsidiaries, can replace markets when the transaction costs of the internal organization are lower than those resulting from the functioning of the market. That is, the existence of transaction costs adds inefficiencies to the market, which are healed by the hierarchical structure. Williamson (1985) defines transaction costs as the administrative costs of the economic system. In his book Markets and Hierarchies, Williamson (1973) argues that hierarchies exist mainly because of uncertainty and opportunism, although bounded rationality is also involved here. Hierarchies exist when the actual underlying conditions associated with the transaction or related set of transactions are known in one or more parties, but cannot be perceived by others at no cost. When hierarchies are dispersed throughout the range of economic activities, they increase uncertainty and systematic risk. On the other hand, the existence of transaction costs deprives the real economy of resources and consequently, the optimal allocation of resources is violated. High transaction costs lead to market failures

80

P. E. PETRAKIS

and, thus, to restricted efficient use of resources and to an increased likelihood of creating systematic risk. So, then, hierarchies and transaction costs distort the allocation of resources and increase systematic risk. After all, in a Walrasian-type free market, transaction costs are zero and market exchanges are conducted with competitive form. In general, any attempt to incorporate transaction costs into mainstream economics—based on the general equilibrium framework—is outside the equilibrium framework (Williamson, 1981). Factors that contribute to the formation of hierarchies and types of high transaction costs are coordination failures, information asymmetries, and evolutionary path dependence. Coordination failures occur when the actions of an individual (or a business) create externalizations for other members of the economic system. As a result, externalities, which have not been taken into account, entail costs in economic terms, leading the economy to the point of equilibrium that deviates from the optimal trend. Another crucial point is that the existence of information asymmetries also affects the allocation of the resources of the economy and, therefore, it is difficult to achieve market efficiency. As eliminating them requires contracting between the principal and the agent, there are additional costs involved in the functioning of the economy. The dominance of hierarchical structures in the production process creates barriers to the orientation of available resources to more productive destinations, resulting in economies not adapting or taking a long time to adapt to the process of creative destruction that is necessary for their regeneration. Social Networks Since the mid-1980s, social capital started to become an increasingly important concept in social theory and research. In general, the term refers to those benefits that are enhanced by participation and integration into social networks. Social networks are one of the critical components of social capital. The term social network refers to any group, club, organization, or other relationship that goes beyond family relationships and informal friendships. The social capital of bonding is in evidence in these networks. These networks by and large lack diversity in their members’ characteristics and are characterized by strong bonds among their

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

81

members. Adverse results, sometimes associated with strong “engagement” networks, include isolation of the group that may lead to the exclusion of non-members, excessive investment of group members’ time, restriction of individual freedoms and deviant rules of conduct. The social capital they integrate can exacerbate inequalities and act to the detriment of both society and the members of the network themselves. The main personal networks to which individuals belong are families and friendships. These relationships can vary in size. The social capital that exists in such personal networks can be significant when measured against the resources available to each member, especially in family networks. Private networks generally contain what R. Putnam (1995) named “bonding” social capital, characterized by strong bonds and dedication within the group. While benefits may be increased for individual members of such networks, their exclusivity may encourage competition with other groups. Participation in social networks provides benefits in the form of resources and support. Networks can thus be seen as the primary mediators of social capital between individuals, groups, and society. Social networks may contain many individuals or groups of individuals. The advantages of this coexistence depend on those involved and include increased access to valuable information and ideas, opportunities arising from the formation of new relationships and enhancing the efforts of individuals through joint action. The lack of an appropriate institutional framework in an economic system renders social networks a complementary element in the search for missing confidence. The higher the uncertainty in the prevailing institutional background, the more economic actors rely on social networks, rather than on business relationships at the production stage. 3.2.8

The Behavior of Business

The neoclassical theory of business based on the production function, assumes that the entrepreneur is the owner of the business. The sole purpose of the business is to maximize profit and the goal of profit maximization is achieved when the business equates its marginal costs with its marginal revenue, which in perfectly competitive markets equals price. Since a business operating in a competitive market cannot impose production input and output prices, but accepts the prices shaped in the markets of production factors and product, profit maximization entails decisions

82

P. E. PETRAKIS

about determining the amount of production. Profits are maximized at the amount of production at which the marginal revenue from the last unit of output is equal to the marginal cost of producing it. Because in the short run, the only factor of production that varies according to the amount of production is labor, then, the condition of profit maximization leads to a certain amount of employment for which the marginal revenue of the product of labor must be equal to its marginal cost. Therefore, the condition of profit maximization determines both the amount of production and the quantity of labor required by the business. The above behavior of entrepreneurs and, consequently, of businesses is based on the fact that entrepreneurs act rationally, that is, they actively try to maximize their advantage in every situation and therefore, consistently try to minimize their losses. Alchian (1950) developed an evolutionary approach to describe business behavior in which he incorporated the principles of biological evolution and natural selection. It rejects profit maximization and utility maximization as basic operating principles of businesses that are compatible with rational choice. Businesses do not seek to maximize their profits but, rather, they act in view of the fact that market forces sweep away businesses which fail to generate positive returns: businesses that rapidly copy successful businesses will increase their chances of survival, while businesses that fail to adapt have a higher chance of failure. Contrary to the perfect rationality which is often attributed to economic actors, Alchian (1950) notes that uncertainty makes the maximization of any objective function meaningless. Nelson and Winter (1982), drawing from Alchian (1950), and rejecting the concept of maximizing behavior, adopted by mainstream economics through rational choice theory, use the concept of natural choice to describe the behavior of businesses in the light of the evolutionary theory. Evolutionary theorists based their own theories of business on bounded rationality and routines. Evolutionary theory is based on learning and adaptation and therefore, may outperform other business theories. There are certain objections to the standard production theory which assumes that technology is accessible to every business and, thus, technological change is exogenous, while research and development are distinguished from production as such. Each business has different capabilities, which are established in its structure and determine its behavior. In their analysis, Nelson and Winter (1982), emphasizing the differences

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

83

between businesses, use the concept of “production knowledge,” which they regard as being stored in businesses as a set of routines and not easily transferable to other businesses. Production knowledge, further to the knowledge that is embedded in equipment and machinery, also includes tacit knowledge, abilities, skills, and problem-solving heuristics. By habit or routine, Nelson and Winter (1982) refer to the cognitive aspects of learning and knowledge, as well as the organizational aspects of motives, supervision and control in businesses (Hölzl, 2005). In addition, routines can be defined as the technological knowledge of a business and consist of the actions of the business, as a result of a set of behavioral patterns. They are the means by which businesses organize and standardize information production and processing and, thus, they describe the behavior and production techniques of businesses. Routines develop as the business strives to cope with the changes taking place in its external environment, they constitute learning through acting and are the result of past learning efforts. More generally, the evolutionary approach considers business as “a knowledge processor”—that is, the business is considered to be the core of the organization, construction, selection, use and development of knowledge—while traditional theories regard the business as “an information processor”—that is, the behavior of the business can be understood as an optimal response to the environmental signals identified by the business. This means that the evolutionary approach is more sensitive to the sharing and dissemination of knowledge than to the dissemination of information. In other words, a business focuses not on solving problems arising from information asymmetry but on coordinating and developing new knowledge. The operation of businesses depends on the skills of the employees, their personality traits, their way of decision-making and their technological capabilities. The accumulation of knowledge and thus, the production capabilities of a business depend on the skills of the staff and the routines in place at the organizational level. Organizational patterns are the memory imprint of an organization and, as a result, when an organization faces a problematic situation, it can recall various routines in order to identify the appropriate solution. Successful routines remain in the business’ decision-making strategy to address similar issues in the future. As such, routines play the role that genes play in biological evolutionary theory. In addition, routines have a dual nature, both as problem-solving skills and as governance mechanisms.

84

P. E. PETRAKIS

3.3 Time and Space in Institutions and Preferences A crucial issue, which concerns the applicable theoretical infrastructure about behaviors, preferences, and institutions arises from the fact that different theoretical foundations have very different consequences and conclusions. As regards institutions, the picture is more precise than that of the cultural background. From the moment one decides to take into account the concept of institutional framework, one enters an area where the simple neoclassical model, without functions, costs or rational behavior, certainly does not apply. So from that moment on, one has to decide what kind, what quality and how much to allow the concept of institutions to enter their analysis. Table 3.2 describes the optimal operating economic framework (Optimal Institutional Framework), compared to an Idiosyncratic/ Stagnated Institutional Framework. The description of the basic dimensions of the institutional framework, in terms of space and time, makes it evident that different institutional conditions may prevail at different times and places. It is therefore important to have an accurate picture of the current institutional framework in which we are going to analyze a problem of development and growth also in way that is applicable. In order to form a corresponding picture for the preferences framework, Table 3.3 presents the description of the Optimal Cultural Table 3.2 Optimal and idiosyncratic/stagnated institutional framework Optimal institutional framework

Idiosyncratic/stagnated institutional framework

• • • • • •

• Non-market allocation of resources • Coordination failures • Information asymmetry • Dependence on the past • Rent seeking activities • High systemic risk

Perfect market allocation of resources Effective coordination Full access to information History does not play a role Creating new wealth Non-systematic risk

Source Author’s own creation

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

85

Table 3.3 Optimal and idiosyncratic/stagnated cultural values framework Optimal cultural values framework

Idiosyncratic/stagnated framework of cultural values

• • • • • •

• • • • • •

Differentiated investment attitudes Moderate avoidance of uncertainty Individualism Moderate discounting of time High levels of confidence Desire to earn profits

Undifferentiated investment attitudes High uncertainty avoidance In-group collectivism High time discount Lack of confidence Loss aversion

Source Author’s own creation

Values Framework, compared to an Idiosyncratic/Stagnated Preferences Framework. The above distinction between the two models of organization of economies could correspond to the distinction of applying them to two different spatial production structures. Then again, they may also reflect the temporal evolution of the same production system. It should be understood that in reality, there are too many versions of the Idiosyncratic/Stagnated Framework of Institutions and Preferences. On the contrary, the Optimal Framework approximates what is quite typically described in a Walrasian system. Concerning the analysis of a developmental or growth problem, it should be noted that a scientific methodology is required which guarantees the validity of the results. Of course, the adoption of a specific methodological approach (e.g., positivism) is very likely to also highlight the accompanying assumptions that will be adopted regarding human action. If this is not the case, the question then arises of under which conditions the researcher will choose one of the aforementioned methodological approaches regarding the behavior of the subjects. In searching for a response, let us note two conditions: 1. Freedom of choice has certain limits. If, for example, an analysis refers to a productive model, which has certain specific characteristics, i.e., which includes a temporal and spatial dimensions in the analysis, then a particular behavioral hypothesis (e.g., the hypothesis of rationality) might have to be excluded because it does not correspond to reality. If, on the other hand, the research analysis

86

P. E. PETRAKIS

aims to study certain interactions between crucial economic variables—without reference to evolutionary characteristics—while at the same time the productive model which is being discussed is that of a highly developed economy and there is no temporal dimension, then, it is reasonable to accept that rationality—or bounded rationality—is a much more appropriate interpretative framework. 2. A long-term development problem involving long-term human behavior would be very difficult analyze in an optimal framework (e.g., a systematic social preference for working in parallel economy or for systematic tax evasion). So, by definition, we refer to anon optimal framework.

3.4

The Global Overview of Cultural Background and Institutions

As mentioned, various studies have tried to group cultural backgrounds in some way, such as by attempting to geographically distinguish between societies on the basis on their cultural characteristics. So, Inglehart (2000) illustrated on the map of his cultural dimensions a detailed measurement of the variables related to themes of significant human interest. Thus, he explored the contrast between societies in which tradition and religion are important and those in which they are not. Also, societies that place particular importance on the institution of the family, strongly respect the authorities and law and reject divorce, abortion, euthanasia, and suicide, as opposed to those who do not. At the same time, he explored the contrast between industrial and postindustrial societies. The accumulated wealth from previous generations, in developed/industrial societies, has resulted in a large proportion of the population, in these societies, taking its survival for granted. It seems that in almost all industrial societies behavior has changed from traditional values to secular-rational values. Values in a society do not change directly, but only across generations, because of the different experiences from one generation to the next. So, when a society has reached the stage of industrial development, it relies on new knowledge, focusing on values related to externalization (self-expression) rather than survival values (Petrakis, 2014).

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

87

Schwartz (1994) using seven cultural variables (harmony, egalitarianism/equality, intellectual autonomy, affective autonomy, mastery, hierarchy and embeddedness/integration into groups and multidimensional measurement) designed a value map for the countries concerned. The two-dimensional diagram he created shows the scores of all societies on the variable of successful integration into a group (embeddedness). Thus, he grouped the societies concerned into eight cultural regions. The survey shows that economic development promotes autonomy and equity, and suppresses hierarchy and group action. Also, that culture affects development as hierarchy and embeddedness repress individuals’ motives and creativity. The role of culture is significant as it guides the ideology according to which a competitive economic system will be selected or not. Regarding the relationship between culture and the prevailing political system, autonomy and equality are positively correlated with democracy, as opposed to embeddedness and hierarchy. Culture influences and is influenced by the size of the family. Autonomy and equality are supported by small families so that everyone can develop their abilities and interests, while women are encouraged to play a more constructive role. Finally, it was found that investments at the international level were more in low-scoring societies for the variables of embeddedness and equality, but also that harmony encourages international investments (Petrakis, 2014). At this point an attempt is made to present the current overview of cultural values and institutions in key economies of the world. The aim is to highlight the particular cultural and institutional characteristics that exist in particular geographical regions. There are many research studies trying to determine the dimensions of the cultural background in human society. Mostly, they have a national background, that is, they measure the cultural background manifestations in each country, according to available statistics. By 2009, 93 important research studies on intercultural organizational behavior had been counted (Tsui, Sushil, & Yi, 2009). Among the most important ones are those of Hofstede (1980, 1991), Hofstede, Hofstede, and Minkov (2010), Schwartz (1994), Georgas and Berry (1995), Inglehart (2000), Georgas, Vijver, and Berry (2004), and House et al. (2004). In general, there are some groupings of countries in terms of cultural background, mainly based on their geographical location, although the general level of economic development and the standard of living of the economies also seem to play an important role (Table 3.4).

88

P. E. PETRAKIS

Table 3.4 Global overview of the cultural background Countries

Power Individualism Masculinity Uncertainty LongIndulgence distance avoidance term orientation

North USA America Canada Europe Germany United Kingdom France Italy Spain Asia China and Japan Oceania India Korea Australia Latin Argentina America Brazil Africa Egypt South Africa

40 39 35 35

91 80 67 89

62 52 66 66

46 48 65 35

26 36 83 51

68 68 40 69

68 50 57 80 54 77 60 36 49 69 70 49

71 76 51 20 46 48 18 90 46 38 25 65

43 70 42 66 95 56 39 61 56 49 45 63

86 75 66 30 92 40 85 51 86 76 80 49

63 61 48 87 88 51 100 21 20 44 7 34

48 30 44 24 42 26 29 71 62 59 4 63

Note The scale ranges from 0 to 100 with 50 as the average. In general, if the score is below 50, the effect of the culture is generally low on the scale and if the score is above 50 the result of the culture is generally high on the scale Source Geert-Hofstede.com, the data was received in February 2020 and author’s own creation

In particular, in the societies of North America (USA and Canada) and Oceania (Australia), there is a strong aversion to social inequalities, relatively low uncertainty avoidance, and the main characteristics are individuality, masculinity, present orientation and enjoying life. In Europe, there is a significant differentiation between the countries belonging to the European South and the countries of the European North. The cultural model of the countries of the south (Italy, Spain, and France) is dominated by high levels of acceptance of inequalities, high levels of individual behavior and masculinity, and aversion to uncertainty which affects their choices, while there is a relatively low preference for values relating to enjoying life. On the contrary, the North European countries (Germany, United Kingdom) are very close to the characteristics of North American economies, nevertheless showing greater future orientation and higher aversion to uncertainty.

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

89

Asian countries (China, Japan, India, and Korea) have a high score in power distance, which is also evidence of the chronic existence of inequalities in these societies. Also, the level of in-group collectivism is particularly high, as well as masculinity, uncertainty avoidance and future orientation. Finally, these societies tend not to enjoy life and to control desires and impulses because of their way of upbringing. Latin American countries are very similar in their cultural characteristics to Asian countries, except that they are more present-oriented rather than future-oriented and have a tendency to enjoy life. Finally, there are significant differences between African countries, due either to the different levels of their economies’ development and their standard of living or, else, their different geographical location. Thus, societies such as that of Egypt show great acceptance of inequalities, collectivism, femininity, uncertainty avoidance, present orientation, and restrictions on personal freedom, and the joys of life. On the contrary, societies like that of South Africa show a mean score in accepting inequalities and avoiding uncertainty, as well as individuality, masculinity, a lower orientation to the present and a tendency to enjoy life. Regarding the institutional environment of a country, it depends on the efficiency and behavior of both public and private stakeholders. The legal and administrative framework within which individuals, businesses, and governments interact, determines the quality of a country’s public institutions and strongly influences competitiveness and development. It also influences investment decisions and production organization, while it plays a crucial role in how societies allocate benefits and bear the costs of development strategies and policies. The World Economic Forum (WEF, 2019) takes into account the pillar of institutions when forming the Global Competitiveness Index. Table 3.5 shows the pillar of institutions and the variables of which it consists for major world economies. The countries of North America are very high in world rankings of the organization of their institutional background. The main institutions for which they stand out are the legal framework’s adaptability to digital business models, the efficiency of the legal framework in settling conflicts, the degree of regulation of conflicts of interest, social capital and the state budget’s transparency. However, due to their high economic growth, they are also characterized by high business costs. Also, the lowest scores are recorded for institutions related to treaties in force for the protection of the environment.

Europe

13

12

24

37

24

23

6

38

27

17

26

11

8

11

8

14

5

23

15

97

22

11

20

41

34

18

Canada Germany

20

USA

North America

5

21

8

19

16

25

37

31

11

United Kingdom

15

138

68

132

126

126

51

87

48

Italy

5

114

47

63

74

92

7

25

28

13

65

68

26

23

32

35

28

22

Spain France

29

19

85

52

36

50

63

78

58

5

31

27

16

19

34

9

16

19

15

26

21

53

39

33

77

67

59

1

87

21

45

67

36

34

37

26

China Japan India Korea

Asia and Oceania

Overview of institutions (2019) (ranking among 141 countries)

Total Pillar: Institutions Strength of auditing and accounting standards Reliability of police services Government’s responsiveness to change Efficiency of legal framework in challenging regulations Efficiency of legal framework in settling disputes Conflict of interest regulation Burden of government regulation E-Participation

Table 3.5 Africa

5

80

53

30

38

40

15

14

17

84

125

97

118

107

86

104

100

88

12

141

68

120

115

122

117

71

99

100

75

106

66

47

23

54

50

82

Australia Argentina Brazil Egypt

Latin America

38

101

12

31

40

110

121

49

55

South Africa

90 P. E. PETRAKIS

Budget transparency Incidence of corruption Property Rights Judicial independence Freedom of the press Environment-related treaties in force Government ensuring policy stability Social capital Government long-term vision Organized Crime Shareholder governance

Europe

16 9

19 15

18

95

26

11 38

39 28

22 25

42

132

16

6 17

69 99

74 37

16 32

19

1

13

30 31

17 11

Canada Germany

7 22

USA

North America

70 37

8 61

39

7

30

25 26

10 11

United Kingdom

117 64

39 130

124

36

37

68 60

13 48

Italy

14 12

26 121

55

7

26

47 54

39 39

60 12

34 34

34

7

29

33 36

10 21

Spain France

71 37

119 37

45

36

140

58 47

85 75

13 89

90 28

21

17

55

5 5

27 18

91 2

93 31

42

17

114

65 51

51 66

45 17

72 39

76

26

36

39 69

27 42

China Japan India Korea

Asia and Oceania

Africa

24 64

2 81

36

36

20

9 10

10 13

100 17

69 85

118

56

46

112 112

45 73

132 17

75 129

130

26

84

103 94

7 91

128 37

31 78

108

36

28

89 33

1 62

South Africa

(continued)

35 28

128 30

64

79

132

34 34

63 91

Australia Argentina Brazil Egypt

Latin America

3 ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

91

Europe

60 27

24

2

10

95

96 1

12

12

49

129

111

1

6

29

33 9

38

Source WEF (2019) and author’s own creation

41

Canada Germany

58

USA

North America

(continued)

Quality of land administration Homicide rate Legal framework’s adaptability to digital business models Intellectual property protection Energy efficiency regulation Renewable energy regulation Terrorism incidence

Table 3.5

125

2

8

21

40 15

17

United Kingdom

86

6

1

48

20 101

11

Italy

100

38

28

37

20 64

34

121

5

25

14

44 42

25

Spain France

112

37

21

53

15 24

27

83

19

31

8

1 34

22

138

3

33

57

81 25

112

45

7

3

50

15 33

6

China Japan India Korea

Asia and Oceania

Africa

89

20

7

11

26 30

47

70

47

72

85

95 77

86

74

28

51

95

132 111

85

136

32

40

89

75 79

111

Australia Argentina Brazil Egypt

Latin America

109

21

15

46

135 73

74

South Africa

92 P. E. PETRAKIS

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

93

In Europe, there is significant variation between economies, as some countries appear to occupy particularly high positions in world rankings regarding energy efficiency regulations and the renewable energy regulations (such as the United Kingdom, Germany and Italy) while others appear in lower positions (such as Spain). The countries are ranked high in terms of environment-related treaties in force with the exception of Italy. By contrast, European countries rank last in terms of terrorismrelated institutions and the government long-term vision (mainly in Italy and Spain). Asian countries have high rates of e-participation and homicide rates (excluding India). On the other hand, they have a very low ranking in the terrorism and social capital index (excluding Korea) and the freedom of the press Index (excluding Japan and Korea. Australia holds a high position in the social capital index, e-participation index and in intellectual property protection. The lowest positions in the world rankings, in terms of institutions, are occupied by the countries of Latin America and South Africa. However, South Africa and Brazil stand out, ranking first in the world in terms of budget transparency.

Notes 1. Hofstede (1991) added the fifth dimension of culture, “Confucian Dynamism (Long-term Orientation),” based on the research of Michael Bond, who conducted an international study among students with the contribution of Chinese workers and administrative staff, applied in 23 countries. In 2010, he introduced the sixth dimension “Life Indulgence /Restraint” (Hofstede et al., 2010), based on Michael Minkov’s analysis of the World Values Survey (WVS), conducted in 93 countries. 2. The evident presence of the theory of rational choice in the social sciences was elucidated in the 1960s by Homans (1961). During the 1960s and 1970s. Blau (1964), Olson (1965), Coleman (1973), and Cook and Emerson (1978) expanded and broadened its scope, contributing to the development of standard mathematical models of rational action. A crucial step in further developing the example of rational choice in the social sciences was made by Coleman in 1990. 3. The total utility curve ascends at a declining growth rate due to the diminishing utility of additional units, reaches a peak where the consumer becomes saturated with the particular good and does not want other units, and then descends because the quantity of the product has increased so

94

P. E. PETRAKIS

much that it has begun to annoy the consumer who would prefer a smaller quantity. 4. The literature about cultural background as a determining factor of choice is limited. We will refer, for example, to Wildavsky’s (1987) analysis of the formulation of choices through social relations and the organization of society. Differences between institutions and technology determine differences in values between groups (Tabellini, 2008). The better organized the institutions are, the easier it is for them to be disseminated among members of a group, as well as from generation to generation. Some writers deviate from the prevalent trend by trying to identify how choices and values are formed. Where the cultural background enters the Neoclassical Model, this becomes a source of constraints on individual’s rational choices. In this case, we are referring to the New Institutional Economics. The basic idea of the New Institutional Economics is that individuals are not perfectly informed and therefore, face uncertainty in their choices. So, to deal with uncertainty, they form institutions. Through institutions, rules and individuals’ ways of acting are established, behaviors become more predictable and uncertainty is reduced. Thus, in addition to reducing uncertainty, institutions also constrain the range of choices available to individuals (North, 1990). In other words, they constrain individuals’ choices, and that is why culture is considered a source of constraints. By considering culture as a source of constraint and mutually linking it with institutions, the factor of time and, so, of any change observed, is now involved. 5. The Life Cycle Hypothesis is based on the fact that individuals’ income does not remain stable throughout their life that individuals form a particular consumer and saving behavior, and that individuals also take into account their future income,—in addition to the current income—in making decisions about consumption in the present. Consumer behavior is such that it ensures a smooth distribution of consumer expenditure throughout the life of an individual or household. Through savings and borrowing, individuals limit the fluctuations in their income. At the same time, through savings, they can allocate the income they receive in high-income periods of their lives to low-income periods. At the beginning of their life, individuals have a small income, which over time increases significantly and, then, when approaching old age, the income again starts to decrease. 6. Permanent Income Hypothesis is part of the life cycle philosophy. Its basic assumption is that rational consumers use permanent rather than current income to make a consumer decision. As a result, permanent consumption is determined by the level of permanent income, that is, individuals seek to normalize the amount of their planned expenditure even when their income fluctuates. Friedman’s theory is based on four assumptions: (a) there is no correlation between permanent income and temporary consumption,

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

95

(b) there is no connection between temporary consumption and temporary income, (c) there is no relationship between temporary and permanent income, and (d) over time, average temporary income is zero because positive temporary income is offset by negative temporary income. 7. Homeostasis is the tendency of the human organism to maintain constant blood pressure levels. Consequently, it shapes his behavior accordingly. As a mechanism of “adaptation to temperature changes”, it is the result of a control system operating through basic human mechanisms—such as the hormones, neurotransmitters, dopamine, serotonin and norepinephrine— associated with the hypothalamus of the human brain. This system concerns emotions and motives. Dopamine is associated with the expectation of reward and, consequently, with activation motives. Low dopamine levels are associated with a “melancholic” mood that leads to seeking reward situations. Consequently, conditions for greater rewards at the expense of certainty are created, hence the pursuit of risk and profit. On the other hand, serotonin and norepinephrine are involved in the process of generating motives. Sunshine, for example, enhances human dopamine production, while heat enhances the composition of norepinephrine. Thus, the intensity and duration of sun exposure and consequently, high temperature, creates physical and psychological attitudes that regulate certain behaviors (Petrakis, 2014), such as risk taking and, by extension, business activity analysis. Thus, people living in sunny areas tend to be less active, while those living in northern cold climates, more so. This, of course, does not mean that because of “homeostasis” we can correctly interpret behaviors concerning critical economic phenomena, such as entrepreneurship.

References Acemoglu, D., & Robinson, J. (2012). Why nations fail. New York, NY: Crown Business. Alchian, A. (1950). Uncertainty, evolution, and economic theory. Journal of Political Economy, 58(3), 211–221. Retrieved from http://www.jstor.org/sta ble/1827159. Alesina, A., & Giuliano, P. (2015). Culture and institutions. Journal of Economic Literature, 53(4), 898–944. Ando, A., & Modigliani, F. (1963). The “Life Cycle” hypothesis of saving: Aggregate implications and tests. The American Economic Review, 53(1), 55–84. http://www.jstor.org/stable/1817129. Becker, G. S. ([1957] 1971). The economics of discrimination. Chicago: University Chicago Press. Blau, P. M. (1964). Exchange and power in social life. New York: Wiley.

96

P. E. PETRAKIS

Böhm-Bawerk, E. V. ([1884] 1890). Capital and interest. New York: Macmillan. Borkenau, P., & Ostendorf, F. (1989). A confirmatory factor analysis of the five-factor model of personality. Personallity and Individual Differences, 11, 515–524. Boyd, R., & Richerson, P. J. (2009). Culture and the evolution of human cooperation. Philosophical Transactions of the Royal Society B: Biological Sciences, 364(1533), 3281–3288. https://doi.org/10.1098/rstb.2009.0134. Calvert, R. (1995). Rational actors, equilibrium and social institutions. In J. Knight & I. Sened (Eds.), Explaining social institutions. Ann Arbor: University of Michigan Press. Casson, M. C., Giusta, D. M., & Kambhampati, U. S. (2010). Formal and informal institutions and development. Elsevier, World Development, 38(2), 137–141. Cattell, R. B. (1956). Second-order personality factors. The Journal of Consulting and Clinical Psychology, 20(4), 11–18. Coleman, J. S. (1973). The mathematics of collective action. London: Heinemann. Coleman, J. S. (1990). The foundations of social theory. Cambridge: Harvard University Press. Cook, K. S., & Emerson, R. M. (1978). Power, equity and commitment in exchange networks. American Sociological Review, 43, 721–739. Costa, P. T., Jr., & McCrae, R. R. (1988). From Catalog to classification: Murray’s needs and the five factor model. The Journal of Personality and Social Psychology, 55, 258–265. Davidson, P. (1996). Reality and economic theory. Journal of Post Keynesian Economics, 18(4), 479–508. Dequech, D. (2000). Fundamental uncertainty and ambiguity. Eastern Economic Journal, 26(1), 41–60. Dequech, D. (2006). The new institutional economics and the theory of behavior under uncertainty. Journal of Economic Behavior & Organization, 72(1), 70– 78. Edgeworth, F. Y. (1881). Mathematical psychics: An essay on the application of mathematics to the moral sciences. London: C.K. Paul. Evans, P. (1989). Predatory, developmental and other apparatuses: A comparative political economy perspective on the third world state. Sociological Forum, 4(4), 561–587. Eysenck, H. J. (1970). The structure of human personality. London: Methuen. Fehr, E., & Fischbacher, U. (2003). The nature of human altruism. Nature, 425, 785–791. Fisher, I. ([1892] 1925). Mathematical investigations in the theory of value and prices. Transactions of the Connecticut Academy, 9, 1–124. Reprinted by Yale University Press. Fisher, I. (1930). Theory of interest. New York, NY: Macmillan.

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

97

Freud, S. (1915). The unconscious. S.E., 14, 166–204. Friedman, M. (1957). A theory of the consumption function. Princeton, NJ: National Bureau of Economic Research Princeton. Georgas, J., & Berry, J. W. (1995). An ecocultural taxonomy for cross-cultural psychology. Journal of Cross Cultural Research, 29, 121–157. Georgas, J., Vijver, F. J. R., & Berry, J. W. (2004). The ecocultural framework, ecosocial indices and psychological variables in cross cultural research. Journal of Cross Cultural Research, 35, 74–96. Goldberg, L. R. (1981). Language and individual differences: The search for universals in personality lexicons. In L. Wheeler (Ed.), Review of personality and social psychology. Beverly Hills, CA: Sage. Greif, A., & Kingston, C. (2011). Institutions: Rules or equilibria? In N. Schofield & G. Caballero (Eds.), Political economy of institutions, democracy and voting (pp. 13–43). Berlin: Springer. Guilford, J. P. (1975). Factors and factors of personality. Psychological Bulletin, 82, 802–814. Hammerstein, P., & Stevens, J. (2012). Evolution and the mechanisms of decision making. Strüngmann Forum Reports. Hodgson, G. M. (1988). Economics and institutions: A manifesto for a modern institutional economics. Cambridge: Polity Press. Hofstede, G. (1980). Culture’s consequences: International differences in workrelated values. Beverly Hills, CA: Sage. Hofstede, G. (1991). Cultures and organisations. London: HarperCollins Business. Hofstede, G. (2001). Culture’s consequences: Comparing values, behaviors, institutions and organizations across nations (co-published in the PRC as Vol. 10 in the Shanghai Foreign Language Education Press SFLEP. Intercultural Communication Reference Series, 2008). Thousand Oaks, CA: Sage. Hofstede, G., Hofstede, J. G., & Minkov, M. (2010). Cultures and organizations-intercultural cooperation and its importance for survival. New York: McGraw-Hill. Hofstede, G., & McCrae, R. R. (2004). Culture and personality revisited: Linking traits and dimensions of culture. Cross-Cultural Research, 38, 52–88. Hölzl, W. (2005). The evolutionary theory of the firm. Routines, complexity and change. Working Papers Series Growth and Employment in Europe: Sustainability and Competitiveness, 46. Inst.für Volkswirtschaftstheorie und-politik, WU Vienna University of Economics and Business, Vienna. Homans, G. (1961). Social behaviour: Its elementary forms. London: Routledge and Kegan Paul. House, R. J., Hanges, P. J., Javidan, M., Dorfman, P. W., & Gupta, V. (2004). Culture, Leadership And Organisations. Thousand Oaks, CA: Sage. Retrieved from http://www.econlib.org/library/Enc1/NeoclassicalEconomics.html.

98

P. E. PETRAKIS

Inglehart, R. (2000). Globalization and postmodern values. Washington, DC: The Washington Quarterly, MIT Press. Jevons, W. S. (1888). The theory of political economy. London: Macmillan. Kahneman, D., & Tversky, A. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty, 5, 297–324. Leary, T. (1957). Interpersonal diagnosis of personality. New York: Ronald Press. Loasby, B. J. (2001). Cognition, imagination and institutions in demand creation. Journal of Evolutionary Economics, 11(1), 7–21. Markman, B. A., Grimm, R. L., & Kyungil, K. (2009). Culture as a vehicle for studying individual differences. In R. S. Wyer, C. Chiu, & Y. Y. Hong (Eds.), Understanding culture: Theory, research and application (pp. 93–108). New York: Psychology Press. Maslow, A. H. (1943). A theory of human motivation. Psychological Review, 50(4), 370–396. Max-Neef, M. (1991). Human scale development—Conception, application and further reflections. New York and London: The Apex Press. McClelland, D. C. (1998). Identifying competencies with behavioral-event interviews. Psychological Science, 9(5), 331–340. McDougall, W. (1932). Of the words character and personality. Character Pers, 1, 3–16. McGarty, C., Yzerbyt, V. Y., & Spears, R. (2002). Stereotypes as explanations: The formation of meaningful beliefs about social groups. Cambridge: Cambridge University Press. Modigliani, F., & Brumberg, R. H. (1954). Utility analysis and the consumption function: An interpretation of cross-section data. In K. K. Kurihara (Ed.), PostKeynesian economics (pp. 388–436). New Brunswick, NJ: Rutgers University Press. Nelson, R. R., & Winter, S. G. (1982). An evolutionary theory of economic change. Cambridge, MA: Harvard University Press. North, D. C. (1990). Institutions, institutional change and economic performance. Cambridge: Cambridge University Press. North, D. C. (1991). Institutions. Journal of Economic Perspectives, 5(1), 97– 112. Olson, M. (1965). The logic of collective action. Cambridge: Harvard University Press, Harvard Economic Studies. Osgood, C. E., Suci, G. J., & Tannenbaum, P. H. (1957). The measurement of meaning. Urbana, IL: University of Illinois Press. Pareto, V. (1906). Manuale di Economia Politica. Milan: Societa’ Editrice Libraria. Petrakis, P. E. (2011). The Greek economy and the crisis, challenges and responses. New York and Heidelberg: Springer.

3

ECONOMIC ACTION, CULTURAL BACKGROUND, AND INSTITUTIONS

99

Petrakis, P. E. (2014). Culture, growth and economic policy. New York and Heidelberg: Springer. Putnam, R. (1995). Bowling alone: America’s declining social capital. Journal of Democracy, 6, 65–78. Rae, J. (1834). The sociological theory of capital. London: Macmillan. Ryan, R. M. (1993). Agency and organization: Intrinsic motivation, autonomy, and the self in psychological development. In J. E. Jacobs (Ed.), Nebraska symposium on motivation: Developmental perspectives on motivation (pp. 1–56). Lincoln: University of Nebraska Press. Schwartz, S. H. (1994). Beyond individualism/collectivism: New cultural dimensions of values. In U. Kim, H. C. Triantis, C. Kagitcibasi, S. C. Choi, & G. Yoon (Eds.), Individualism and collectivism (pp. 85–119). Thousand Oaks, CA: Sage. Shleifer, A., & Vishny, R. W. (1994). Privatization in Russia: First steps. In O. J. Blanchard, F. R. Kenneth, & J. D. Sachs (Eds.), The transition in Eastern Europe II (pp. 137–164). Chicago: University of Chicago Press. Smith, A. ([1776] 1977). An inquiry into the nature and causes of the wealth of nations. Chicago: University of Chicago Press. Stoelhorst, J. W. (2008). Generalized Darwinism from the bottom up: An evolutionary view of socio-economic behavior and organization. In W. Elsner & H. Hanappi (Eds.), Advances in evolutionary institutional economics: Evolutionary mechanisms, non-knowledge, and strategy (pp. 35–58). Cheltenham: Edward Elgar Publishers. Tabellini, G. (2008). Institutions and culture. Journal of the European Economic Association, 6(23), 255–294. Tabellini, G. (2010). Culture and institutions: Economic development in the regions of Europe. Journal of the European Economic Association, 8(4), 677– 716. Tsui, S. A., Sushil, S. N., & Yi, A. O. (2009). Nagging problems and modest solutions in cross-cultural research: Illustrations from organizational behavior literature. In R. S. Wyer, C.-y. Chiu, & Y.-y. Hong (Eds.), Understanding culture: Theory, research and application (pp. 163–188). London: Psychology press. Veblen, T. (1898). The theory of the leisure class: An economic study of institutions. New York: Macmillan. Von Mises, L. ([1944] 2007). Human action: A treatise on economics. Indianapolis: Liberty Fund. Von Neumann, J., & Morgenstern, O. ([1944] 1947). Theory of games and economic behavior. Princeton: Princeton University Press. Walras, L. (1954). Elements of pure economics. London: Routledge. WEF. (2019). The Global Competitiveness Report 2019–2020.

100

P. E. PETRAKIS

Wildavsky, A. (1987). Choosing preferences by constructing institutions: A cultural theory of preference formation. American Political Science Review, 81(1), 4–21. Williamson, O. E. (1973). Markets and hierarchies: Some elementary considerations. American Economic Review, American Economic Association, 63(2), 316–325. Williamson, O. E. (1981). The modern corporation: Origins, evolution, attributes. Journal of Economic Literature, 19(4), 1537–1568. Williamson, O. E. (1985). The economic institutions of capitalism. New York: The Free Press.

CHAPTER 4

Complex Economic Systems, Information and Forms of Capitalism

4.1

Introduction

The operation of the economy is perceived as a complex system of economic and social relations and actions. The relationships created within this complex system are particularly elaborate and often cannot be readily described. In a complex system, the concept of information and its transmission are of particular value. As the economic system becomes more complex, the role of information becomes more critical. The concept of information is well known and has been studied thoroughly in most economic models by means of Walras’s general equilibrium theory, which is based on the assumption of perfect information. However, a complex system makes it challenging, if not impossible, to disseminate information to all economic actors. Such a condition would lead to the removal of the economic system from a Walras equilibrium, since it introduces the notion of heterogeneous actors in the place of a homogeneous agent. Over time, the creation of complex economic systems and the evolution of capitalist economies, in combination with the advance of information systems, render production and dissemination of information critical in all facets of economic reality.

© The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_4

101

102

P. E. PETRAKIS

4.2

Simple Versus Complex Economic Systems

Economics, since the era of Adam Smith’s The Wealth of Nations, has been more concerned with the allocation of resources than with economic development and the time trajectory between the points of equilibrium for the economy. However, an equilibrium path marks multiple levels of decisions and implies a macroeconomic development, which is not merely the escalation of microeconomic change. Later, it was attempted to solve the problem of resource allocation by means of mathematical models. The beginnings of natural science greatly influenced neoclassical economics toward the end of the nineteenth century, most notably through the idea that simple mathematical equations could objectively analyze a large number of interacting identical elements. Over the years, it became a shared conviction that simple mathematical expressions could illustrate the core of economic theory. This development led to a simplification of economic theory at the expense of its complexity. This happened as the mathematization of economic thought disregarded important parameters, such as politics, society, uncertainty, expectations and the like. Thus, neoclassicists perceived economy as a simple system with predefined relationships between homogeneous economic actors and their behavior. The complexity of the economic system is linked with achieving the equilibrium of an economy. In a complex system, the economy is not necessarily in equilibrium, as economic actors are constantly changing their strategies and behavior. Thus, economics is a complex system with well-established components which exhibit multiple interactions. Similar complex systems are found in biology, physics, chemistry, and other sciences. A complex system1 describes how relationships between its various parts shape collective and individual behaviors, as well as how interactive relations develop with the economic and social environment. The concept of complexity and, by extension, complex economics, is not a new approach to economic theory but provides a different perspective by focusing on the process of change and creation. The concept of complexity also introduces the concept of time, which adds the creation of new structures, by contrast to simple, neoclassical economics whose treatment of time is inadequate, as it identifies economy with a simple system where the concept of time is absent. Time in a complex system lends a dynamic character to the economy where non-recurring events lead to new results, new structures, new technology, new institutions, and ultimately a new future trajectory.

4

4.3

COMPLEX ECONOMIC SYSTEMS, INFORMATION …

103

Complexity in Economic Theory

The development and growth of the economy refer to the evolution of the economic system over time, mainly through a non-linear dynamic, moving from one state of equilibrium to another. “It is very important to understand that the world that concerns us is constantly changing ” (North, 1990). Our world is non-ergodic 2 and we live and learn in conditions of uncertainty, with limits on knowledge and prediction, always based on representations and images of the past, without, at the same time, being able to develop perfect strategies. This way, however, collective knowledge becomes the main evolutionary force linking and defining the rules of the game in market systems which change qualitatively over time. Complexity is therefore described as a “messy cognitive development ” in which people change beliefs and behaviors. In order to make the transition from evolutionary reality to mechanical models, so as to predict the behavior of a system, Allen (2014) proposed the creation of models that predict behavioral systems. Creative and innovative evolutionary models survive in the long run, but it is challenging to have predictable characteristics or behavior that can explain the simultaneous evolutionary processes observed in markets, organizations and, ultimately, in emerging, evolving practices. Economist and philosopher Friedrich Hayek can be described as one of the historical founders of the analysis of the complex systems phenomenon in economics. His main contribution is that complex economic phenomena need to extend into biology, sociology, psychology, and human agency, in order to build models with limited predicting capacity. According to Schumpeter, markets do not function mechanically creating a balance in markets for homogeneous products, maximizing producer profits and maximizing utility for consumers, while he also points out that what matters is system inputs and outputs. The phrase he coined to describe this was “creative destruction”, a view which is identified with that extrapolated from the science of complexity. According to the proponents of evolutionism, it is impossible to interpret this complex world with a simple theoretical conception involving a series of processes such as production, prices, theory of the firm in the context of profit maximization, and maximization of the behavior of individual utility in a constantly changing equilibrium. Evolutionary thinking encompasses behaviors, practices, routines, and technologies that

104

P. E. PETRAKIS

are constantly changing as innovation evolves and which are transmitted over time between successive actors and businesses through the platform of cultural background.

4.4 “Tableau Économique” and Complex Circular Flow of Economic Activity Should we attempt to describe the complexity of the economic system, we would have to either focus on the parts that make it up, that is, buildings, machinery, infrastructure, raw materials, labor, or focus on the fact that products are made with a content of knowledge (Hausmann et al., 2014). Individuals have access to a huge amount of knowledge distributed around the world. Markets act as a means of disseminating knowledge from the few to the many. The complexity of the economy is related to the abundance of useful knowledge embedded in it. A society should effectively combine the separate knowledge of its members to produce goods and services because, otherwise, societies in which members cannot interact and combine knowledge, cannot provide equivalent products and services. Economic systems in their simplest form are described in classical textbooks (usually with neoclassical approach) on the basis of simple, diachronic relationships and stable behaviors. The idea of circular flow was already present in Richard Cantillon’s work. The circular flow of income is a simplification that attempts to reflect the flow of money and goods from households to businesses and then back to households. François Quesnay developed this idea by creating the “Tableau Économique”. This model, however, in its attempt to clarify the relationships between the numerous economic actors in a country, homogenizes them, thus greatly lacking in interpretive capacity. Figure 4.1 shows the circular flow of economic activity. In contrast to the simple neoclassical description of the economic system, there is a description of a complex evolutionary model. This description of the economic system contrasts with the description of a system with stable mechanical relationships that can produce a stable and predictable result. Figure 4.2 shows the main flows that occur in a complex system within an economy. The question that arises is “Why does economic science use simplified ways of describing economic reality?” This reflection concerns issues of

4

COMPLEX ECONOMIC SYSTEMS, INFORMATION …

105

Fig. 4.1 The simple circular flow of economic activity (Note Both economic activity and money follow a circular flow. The circular flow of money means that the money spent should continue to flow in order to maintain a certain level of economic activity and income. In the above figure, we can see the circular course of money as well as of goods from household to firms and the reverse. Then, as households receive wages, rents and dividends from firms, they use them to consume. Source Author’s own creation)

Fig. 4.2 Complex circular flow of economic activity (Note Consumers are classified according to their income criteria, which obviously affects the attractiveness of the products available, the production of the products [ones that meet consumer needs] and hence the sales of the firms. Each firm faces a multitude of internal flows that ultimately determine its market position—along with the position of each undertaking over its competitors. Of course, precisely because the system is so complex, not all possible flows which affect it can be recorded, especially those relating to the firm’s relationship with the other firms in the market. Source Author’s own creation)

106

P. E. PETRAKIS

a methodological character and the recognition and mapping of reality. The answer is that the mapping usually focuses on highlighting the most important trends and causes out of all the various components, even at the risk of losing the ability to fully describe reality.

4.5

The Analysis of Complexity

The concept of complexity falls within the sciences because of the interdependencies and interactions that are created between the components that make up the economic system. In the same way, the economy is a complex system of relationships among the factors that make it. A change in one system component, which may originate from either an external or internal shock, causes the system to deviate from the equilibrium. In the evolutionary approach to economy, the concepts of information and knowledge come into play as crucial components, as they pass through the mechanisms of dissemination from generation to generation, and information and knowledge act as agents converting creativity and ideas into products. Moreover, the complexity of the economic system raises issues of governance and the effectiveness of the policies implemented. Adam Smith was one of the first to attempt to approach and express this phenomenon clearly. The attempt to identify the forces that determine income distribution by Pareto (1895, [1896] 1965) was one of the first attempts to justify imbalances and complex situations. The inability of economics to incorporate complex systems into its analysis, may be one of the main reasons why economic theory has not made as much progress in recent years as other sciences. A complex system examines how structural components of the system that are low in the hierarchy interact and, thereby, phenomena emerge which can eventually affect the stability of the system and create distortions. Such a system is characterized by both self-organization and by its own rules. Therefore, we could say it is “adaptive”. Beinhocker (2006), in his book The Origins of Wealth: Evolution, Complexity, and the Radical Remaking of Economics, as part of his attempt to explain how the economy operates, clarifies the concept of “adaptivity.” The term “adaptive” is used to emphasize that the economy follows an evolutionary dynamic that is never in equilibrium but is always vulnerable to endogenous or extrinsic shocks.

4

COMPLEX ECONOMIC SYSTEMS, INFORMATION …

107

The differences between neoclassical theory and theorists who view economics as a complex system are summarized, according to Beinhocker (2006), in the following points: 1. System Dynamics: A complex economy is far from an equilibrium as it has dynamic features that keep it constantly away from it, in contrast to Walras’s general equilibrium. 2. Role of Economic Actors: Individuals have limited knowledge and information, while high cost is required to access and process information. As a result, they develop heuristic rules, in contrast to the neoclassical model where there is perfect and cost-free information. 3. Networks: Individuals are involved in networks and groups, so that they can obtain information without the cost being prohibitive. On the contrary, in Walras’s model, individuals do not interact with one another. 4. Evolutionary Process: The evolutionary process provides the system with the elements of diversification and innovation so that it can grow. In Walras’smodel, mechanisms cannot be developed which create new building blocks or expand on the complexity and relationships of economic actors. The relationships that are developed cannot be justified by the assumption that participants in the economic system develop the behaviors of a representative agent. Systems consist of heterogeneous individuals who present entirely different behaviors and respond differently to the situations they are called to face. In a complex system, such as economics, the perception of a representative agent is particularly weak and simplistic. This would be realistic if all participants had access to the same information and knew the reactions of the others. The price mechanism incorporates all the information available on consumer and producer preferences in conditions of equilibrium, but over-supply or over-demand phenomena are translated as the market’s inability to incorporate these preferences. Although the price mechanism is the only mechanism that uses the least information to achieve efficiencies, according to Pareto, this is only possible if the economy is in equilibrium. Assuming that the economy is not in equilibrium, the informal efficiency property is lost; besides, Saari and Simon (1978) emphasize that

108

P. E. PETRAKIS

any process which may lead to a balance, needs a considerable width of available information. All of the above creates a deeper problem in the founding of economic theory, to do with the view that the economy is a complex and selfregulating system. This problem is none other than the fact that all information is dispersed among individuals, something emphasized by Hayek (1945). Durlauf and Young (2001) formulate a similar view of the economy as a complex system. Using the term “New Social Economics” they describe the economy as a socio-economic system consisting of heterogeneous individuals interacting with each other, as do prices through markets. Individuals and other participants in the economy are connected through networks that have a significant impact on the evolution of the economy. Consequently, interactions between consumers, businesses, and institutions are constantly evolving and there is no automatic tendency for equilibrium in the sense this term is used in economics. Walras’s general equilibrium model, while focusing on the actors that interact with each other and the markets that shape prices, fails to take into account externalities that play a central role in people’s behavior and preferences, which often deviate from the axiom of rationality and the assumption of equilibrium. Herein lies the critical difference between the general equilibrium model and the approach of the economy as a complex system. Another important aspect of the complex system is the fact that individuals have limited cognitive capacity to manage and process the multitude of available information. It would be realistic to assume that they have bounded rationality and informational limitations.

4.6

Measuring Complexity

Economic complexity is expressed by the complexity of a country’s productive base and by how well this base reflects the structures that emerge to retain and combine knowledge. Increased economic complexity is necessary for a society to be able to retain and use a greater amount of productive knowledge. It can be measured by the portfolio of products that countries are able to produce. The global picture of international complexity for 2017 is presented in Fig. 4.3. The global picture of complexity and the transformation of the economic system and its continuous change is illustrated in Fig. 4.4.

4

COMPLEX ECONOMIC SYSTEMS, INFORMATION …

109

2.5

2.0

1.5

1.0

0.5

0.0

Fig. 4.3 Global picture of complexity (2017) (Source The Growth Lab at Harvard University [2019] and author’s own creation)

The Economic Complexity Index (ECI)3 is a measure of the productive knowledge of a society, reflecting the complexities of economies and is based on the quantity, complexity of exported products and the frequency of exports for 128 countries. Industry networks, mutual exploitation, and the development of their products, as well as the increasing complexity of their products, can make a significant contribution to the social well-being of countries. Therefore, knowledge and exploitation of common knowledge is vital within a society. Countries with a low ECI export a limited number of products that have a relatively high presence. These countries are not necessarily very variegated; they have little diversity and the products they export are not very sophisticated. The countries with the highest increase in complexity during the period 1964–2010 are Brazil, Turkey, and China. Other countries that have undergone substantial changes during the same period were Spain, Japan, and Argentina. On the other hand, high-income countries, such as the United States, the United Kingdom, and Australia, were the ones lagging behind in the 1964–2010 period (Fig. 4.3). However, it should

110

P. E. PETRAKIS

1.5 1.3 1.1 0.9 0.7 0.5 0.3 0.1 -0.1 -0.3 -0.5

Fig. 4.4 Change in the Economic Complexity Index (ECI) from 1964 to 2010 (Note Higher values indicate greater complexity. Source The Growth Lab at Harvard University [2019] and author’s own creation)

be noted that developed countries have always had positive ECI values, thus limiting the range of possible positive changes.

4.7

Information and Economics

The particular conditions that prevailed in each period acted as a source of criticism of the prevailing theoretical views and also served as a driving force for new approaches and thinking. The way economic theory approaches specific issues has a direct impact on how it evolves. A key element affecting evolution is how a macroeconomic model manages the concept of information. During the 1970s, Keynesian theory was strongly criticized due to its persistent and high inflation, and also because of its inability to incorporate micro-foundations into its analysis. Attempts to incorporate these elements into macroeconomic theory, based on assumptions of the proper functioning of markets, have failed, as the ensuing recessions were characterized by high unemployment rates, which is an indication of market

4

COMPLEX ECONOMIC SYSTEMS, INFORMATION …

111

failures. One of the causes of market failures is the lack of complete information about their operation, their particular characteristics and the behavior of the participants. Incomplete information conditions relate to inadequate allocation of resources to the members of society. Decisionmaking, both at the business level and in the households, is influenced by the information available. At the same time, political decisions at the collective level are far from unaffected by the array of information which comprises the political scene. The amount of information that is being transmitted daily using the internet is enormous, making it even harder to collect and process it. Figure 4.5 shows the sum total of the information traffic on the internet, expressed in zettabyte (unit of measure) from 2005 to 2025 (forecasts after 2020). The rate of growth of information is impressive. Therefore, decision-making becomes a complex process, given the individual’s limited cognitive abilities. The economic science in its last phase of development in the previous century, was based on the assumption of perfect information of the neoclassical model. However, while everyone will agree that such a hypothesis is utopian, the neoclassical model continues being at the forefront of economic thought, using the assumption that economic actors

Fig. 4.5 Evolution of information based on all data transmitted on the internet (in zettabyte) (Source Kleiner Perkins Caufield & Byers [KPCB] [2019] and author’s own creation)

112

P. E. PETRAKIS

have perfect information. While we realize that in most cases, part of the information will not be available to everyone (whether this involves access restrictions or is a matter of quality and reliability), economic theory manages all economies in the same way. This fact highlights the inability of economics to differentiate its analysis and incorporate parameters into its models which reflect the particular characteristics of individuals rather than aggregates. Reduction from the individual to the collective level most of the time appears overly simplistic and leads to arbitrary conclusions. The issue of market participants’ lack of effective information concerns, in addition to understanding how markets function, other practical issues as well, such as the course of the prices of products and services and their quality. In the above we should include the absence of the institutional and historical background of the operation of markets, since it is the law of supply and demand which determines the market equilibrium. There is one way to get perfect information and verify the effective market hypothesis: all participants should have access to the same information. However, such a possibility would entail additional costs, which in itself would lead to a vicious circle that would obstruct the efficient allocation of resources by the market mechanism. In economic science, the concept of information is primarily represented by the expression of asymmetry information. This is a situation in which one of the two parties to a transaction does not have full information. Consequently, issues are raised of moral hazard (Grossman & Hart, 1983; Mirrless, 1999) adverse selection and the need for contractization. These result in the creation of additional transaction costs which create market failures. Typical examples of asymmetric information are the relationship between employer and employee, as the former may not know the magnitude of the effort of the latter, or the insurance company with the insured, who knows his health better, and the banker and borrower relationship, who do not have the same amount of information on business viability. A typical case is the situation of adverse selection. The original work of Akerlof (1970) The Market for Lemons: Quality Uncertainty and the Market Mechanism, has focused on asymmetric information and adverse selection as fundamental causes of market failure. According to Akerlof, market equilibrium depends on the quality of the seller’s information relative to the buyer and, therefore, on the degree of asymmetric information between the two sides of the market.

4

4.8

COMPLEX ECONOMIC SYSTEMS, INFORMATION …

113

Information Effectiveness

A key component of information (and of informing) can only be its quality. The quality of the information available can give its holder a comparative advantage. Exploiting information can only be a source of economic growth if it is based on reliable sources and assumptions. The operation of markets is based on the Efficiency Market Hypothesis (EMH). The basic rule of market efficiency consists of three basic forms of efficiency: • Allocative efficiency, which refers to the way resources are distributed among competing recipients. • Operational efficiency, in which market transaction costs are competitively designed to be as small as possible. • Informational efficiency, in which market prices reflect “instantaneously and fully” all relevant information available. The most important component of the concept of market efficiency is the exchange of perfect information freely among all investors. That is, the information about a business should be fully available to all investors and reflected in share prices. A market is effective if the prices fully and instantaneously reflect all the information available and no profit opportunity is left untapped. In a rational market there are a large number of investors maximizing their profits, competing with each other and trying to predict future market prices, while crucial current information is almost freely available to all market participants. In an effective market, competing participants reflect information rationally and instantaneously on prices, making previous relevant information useless in predicting future prices. An effective market should only react to new information, but as this is unpredictable by definition, changes in prices and returns in an effective market cannot be predicted. In practice, we will find it difficult to find markets where the information available is freely accessible to all participants and potential investors without any transaction costs. Essentially, a complex system moves the economy away from Walras’ equilibrium by creating malfunctions, as there is no perfect information available to economic actors. There are two main sources of market malfunction: (a) private information and/or (b) a limited capacity to act as initially promised. As a result, Walras’s outcome is not optimal.

114

P. E. PETRAKIS

4.9

Complexity and Forms of Capitalism

The analysis of economic systems has traditionally focused on the comparison between market economies and the centrally planned economy. The operation of the economic system depends on the efficiency of the price mechanism and its substitution by non-market allocative mechanisms. The degree of intervention/freedom of markets determines the types of economic systems. There are four main types of economic systems with varying degrees of complexity and social orientation: 1. The traditional economic system, which is the oldest and simplest form of economic organization that we may encounter today in highly underdeveloped, third world countries. Perhaps the model of Robinson Crusoe may be considered its simplest form. 2. The command economic system characterized by the control of most of the economic activity by a central authority. In this form of economic system the role of the state remains distinct, but more complex forms of organization prevail over the traditional economic system. 3. The market economy that can be a capitalist or a free-market economy. The state does not control vital resources or any other major factor in the economy. The economy is free to determine the supply and demand for goods and services, and can be regulated without government intervention. 4. The mixed economic system, which is the most common form of organization of the economy, combines key features of a free economy with the intervention of the state, to provide either a regulatory framework for the functioning of the markets or the complete control of specific markets. A traditional economy is a straightforward economic system. The other three economic systems (centrally controlled, market economy, and mixed economic system) correspond to various forms of economic complexity, the main differentiating element of which is not the complexity of the systems but the orientation of their operation, which in turn impacts on their complexity. The fall of the Berlin Wall (and the collapse of the Soviet Union) in 1989 shifted the interest of scholars in comparative political economy to the various versions of the capitalist system. One approach to the different

4

COMPLEX ECONOMIC SYSTEMS, INFORMATION …

115

forms of capitalism VoC: Varieties of Capitalism (Hall & Soskice 2001), addresses the fundamental differences in national political economies and examines how they affect economic performance, given the intense competitive pressures resulting from globalization. The forms of capitalism are associated with coordination, to the extent that it determines the relationship of businesses with other actors. On the one hand, through competitive markets, businesses cooperate with other actors based on predefined relationships (contractization). In this case, the equilibrium point arises both from relative prices and the market signals received by the economic actors. On the other hand, coordination can be a matter of strategic decision-making in game theory. The equilibrium point in this case depends on institutional factors, which contribute to the dissemination of information, monitoring, sanctions and consultation. We can classify forms of capitalism as Liberal Market Economies (LMEs), in which markets identify business relationships with other players, and as Coordinated Market Economies (CMEs), where businesses are in strategic interaction with other players. Subsequent research has advanced this initial distinction, adding other groups of economies of the market that could not readily be classified as either LME or CME. Mixed Market Economies (MMEs) (also known as State Capitalism) are the category proposed in the comparative political economy literature. Germany, Austria and Japan are typical examples of a Coordinated Market Economy while the US and Great Britain are examples of a Liberal Market Economy. The countries of Southern Europe could be classified among the Mixed Market Economies. The institutional framework formed in each of the above differentiations of the capitalist system allows for estimates on how the economy responds to different situations that occur over time.

Notes 1. Definitions of what a complex system is, vary. However, Herbert Simon’s (1969) definition is prevalent: a complex system is “a system consisting of a large number of parts interacting in a non-simple way. In such systems, the whole is greater than the sum of the parts, not in the absolute metaphysical sense, but in the important pragmatic sense that, given the properties of the parts and the laws of their interaction, it is no trivial matter to infer the properties of the whole.” 2. “In general, the ergodic axiom assumes that the economic future is already predetermined and that the economy is governed by an existing ergodic

116

P. E. PETRAKIS

stochastic process, where it is sufficient to calculate probability distributions in terms of future prices and production, to obtain meaningful and reliable statistical conclusions about the future. Once decision-makers have reliable information about the future, their actions in the free-market will optimally allocate resources to those activities that have the highest possible future returns, thereby ensuring global prosperity.” (Davidson, 2012). “In a non-ergodic world, we can never rely on historical data to obtain a reliable guide to future results. In such a world, markets cannot be effective” (Davidson, 2002). In a world where observations are drawn from a non-ergodic stochastic environment, historical data cannot provide reliable information about future probability distributions. In conclusion, it has been accepted that economic actors in a non-ergodic environment cannot reliably know future results. 3. ECI is defined in terms of an eigenvector in a table that links countries to each other. The table is a view of the table that links countries to the products they export. Since the ECI examines information on the diversity of countries and the widespread presence of products, it is able to produce a measure of economic complexity that contains information, both on the variety of exports of a country and on their complexity (Center for International Development at Harvard University 2014).

References Akerlof, G. A. (1970). The market for ‘lemons’: Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84, 488–500. Allen, P. M. (2014). Evolution: Complexity, uncertainty and innovation. Journal of Evolutionary Economics, 24(2), 265–289. Beinhocker, E. D. (2006). The origin of wealth: Evolution, complexity, and the radical remaking of economics. Boston: Harvard Business School Press. Davidson, P. (2002). Financial markets money and the real world. Cheltenham: Elgar. Davidson, P. (2012). Is economics a science? Should economics be rigorous? Real-World Economics Review, 59, 58–66. Durlauf, S. N., & Young, P. H. (2001). The new social economics. In S. N. Durlauf & H. P. Young (Eds.), Social dynamics (pp. 1–14). Washington, DC: Brookings Institution Press. Grossman, S. J., & Hart, O. D. (1983). An analysis of the principal-agent problem. Econometrica, 51, 7–45. Hall, P., & Soskice, D. (2001). Varieties of capitalism: The institutional foundations of comparative advantage. Oxford: Oxford University Press.

4

COMPLEX ECONOMIC SYSTEMS, INFORMATION …

117

Hausmann, R., Hidalgo, C. A., Bustos, S., Coscia, M., Simoes, A., & Muhammed, A. Y. (2014). The atlas of economic complexity: Mapping paths to prosperity. Cambridge: MIT Press. Hayek, F. A. (1945). The use of knowledge in society. American Economic Review, 35(4), 519–530. KPCB. (2019). Internet Trends 2019. Mirrless, J. A. (1999). The theory of moral hazard and unobservable behaviour: Part I. Review of Economic Studies, 66, 3–21. North, D. (1990). Institutions, institutional change and economic performance. Cambridge: Cambridge University Press. Pareto, V. (1895). La Legge della Domanda. Giornale Degli Economisti, 10(6), 59–68. Pareto, V. ([1896] 1965). La Courbe de la Répartition de la Richesse. Librairie Droz. In B. Giovani (Ed.), Oevres Completes de Vilfredo Pareto (Vol. 3, pp. 1– 15). Geneva: Écrits sur la Courbe de la Répartition de la Richesse. Saari, D. G., & Simon, C. P. (1978). Effective price mechanisms. Econometrica, 46, 1097–1125. Simon, H. A. (1969). The sciences of the artificial. Cambridge: MIT Press. The Growth Lab at Harvard University. (2019). Growth projections and complexity rankings, V2 [Data set].

CHAPTER 5

Politics and Governance

5.1

Introduction

Almost two millennia ago, the ancient Greek philosopher Plato, formulated in The Republic, the first ideas about the relationship between politics and economics. Plato noted that the decline of the Persians was due to the fact that they largely deprived the citizens of liberties through excessive despotism and thus destroyed harmonious coexistence within the State. He also said that citizens should be allowed to freely pursue private concerns, within the bounds of law. With Adam Smith and the classics, and the birth of political economy, the relationship was re-established between politics and economics. Political institutions are a way for individual preferences to find expression and for balancing the collective conflicts that exist in society. They include the processes by which those in government make decisions and exercise control through the systems of election and the selection of representatives. They greatly influence the way the social decision-making system is organized. Political institutions create the right conditions for reducing the pressure from various interest groups, which create problems for both the proper functioning of the economy and the distribution of income and, hence, for economic growth. Naturally, how public administration is exercised and its effectiveness also play an essential role. The interconnection of politics and political institutions in general with governance is a critical issue for every society and for concepts of development © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_5

119

120

P. E. PETRAKIS

and growth. This, quite simply, is because politics takes precedence over the economy, in terms of determining the importance of social priorities and making final decisions. All the same, the role of the economist is expanding the more complex, economies’ problems become.

5.2

Politics, Economics and Growth

The link between politics and economics is particularly important and influences economic developments and decisions. At the same time, there is a strong link between the way political governance is practiced and the way an economy operates. Therefore, how strong or weak a state is in relation to economy and society, is particularly important. 5.2.1

The Link Between Politics and Economics

Political institutions exist to oversee the distribution and exercise of power in society. They include the processes by which decisions are made, including checks of administrators and systems, greatly influencing the political system. The acceptance of political institutions by the majority of citizens—as long as these institutions work—creates the appropriate basis for reducing pressure from interest groups that hinder both the functioning of the economy and the allocation of resources, hence economic development and optimization. They are the means of summing up the individual preferences and conflicts that develop within society. Different political institutions shape different winners and losers and, therefore, represent a different balance of forces at every occasion. This leads to the unceasing presence of social tension around the formation of political institutions. The system of political institutions is the main producer and modifier of the distribution of resources in the economy, which in turn shapes the new political, institutions and, hence, the economic ones as well. That is why political institutions take precedence over economic institutions in terms of importance and impact on citizens’ lives. It is therefore now widely accepted that economic institutions are always important in terms of their effects on economic growth and are shaped primarily by political institutions. The system of government, state organization, electoral law, the party system and the sharing of political influence are all determinants of economic growth.

5

POLITICS AND GOVERNANCE

121

Understanding the interplay between political and economic institutions involves a number of theoretical and methodological issues regarding their role in economic growth. Problems with definitions (i.e., what are political institutions?) exploring the functions they perform (similar functions from different political institutions and different functions from the same political institutions in different countries) as well as problems of separation between their form and function are all issues that invite conflicting approaches. Two central issues concerning political institutions relate to the formation of collective balance options. These are the type and form of political institutions and the power of the various groups which operate in society. When individuals or groups of individuals go into action, they then form political institutions in the direction of their preferences. As mentioned, the way and intensity in which political power is distributed within society depends on the political institutions. Both the distribution of political power, but also the ability to shape institutions, are not determined only by stakeholder pressure. The levels and distribution of technology, wealth and income also play an important role. It is therefore difficult to study political institutions, because they are not only usually endogenous to other variables, such as cultural background or geography, but also because institutional change is rare or occurs very slowly. Box 5.1 The Determinants of Political Power The distribution of political power as well as the capacity to shape institutions are determined, in addition to the pressure by stakeholders and the existing level of technology, by the accumulation of wealth, as well as by the distribution of income and wealth (Fig. 5.1). The type of society and, by extension, economy (rural, industrial, and post-industrial society—technology or an oil economy) is of particular importance for the type and nature of the institutions which are to be formed. It should be noted that social preferences are linked not only to the outcomes of political institutions, but may also concern the institutions themselves. For example, democracy itself, as a political system, has its own characteristics and one does not necessarily judge its desirability on the basis of the outcomes of its operation.

122

P. E. PETRAKIS

Interest groups and elites

Level and distribuƟon of income

Level and distribuƟon of PoliƟcal Power

Level and distribuƟon of technology

Level and distribuƟon of wealth

Fig. 5.1 Factors that shape the level and distribution of political power (Source Author’s own creation)

5.2.2

Politics and Economic Results

There is a strong link between the way governance is conducted and the way an economy operates. Particularly during the last century, the relationship between economics and politics and specifically between economists and politicians, has completely changed. Whereas this relationship was entirely distant, with economists staying at arm’s length from politics, they have nowadays begun to examine political behavior using the same conceptual framework they use for consumers’ and producers’ decisions in the marketplace.

5

POLITICS AND GOVERNANCE

123

It is thus found that: • politicians may depend on strong societal elites • beneficiaries of commercial protectionism are usually concentrated and have political influence, while consumers are dispersed, unorganized and do not promote their own interests. • the political elite is blocking reforms that would promote growth and development because this would undermine its control over political power • banks intervene in political processes to take excessive risks at the expense of the general public In sum, political decisions play an important role in economic developments. Economic activity affects political decisions and political decisions affect the state of the economy (Frey, 2011). Firstly, the government systematically influences economic activity through a large number of policy tools, from taxation and public spending to every manner of regulations, and secondly, economic activity affects how popular a government is with the people and hence the likelihood of its re-election, as reflected in the size and the change in GDP, the unemployment rate and the inflation rate. Williams, Duncan, Landell-Mills, and Unsworth (2008) present a framework that helps to clarify the mechanisms through which political variables influence economic outcomes. They state that growth is profoundly influenced by the nature of the interactions between those holding state power and potential investors. They place particular emphasis on motives as an explanation of why growth can either be promoted or prevented in different circumstances. There are five stages to the process of politics interacting with the economy: In the first stage, the political system performs diagnostic checks on the growth process. Questions arise such as what the necessary conditions for growth are, which of them exist in a particular country, and whether there are any binding restrictions. In the second stage, the policy is linked to economic development and questions are raised such as whether and how the relationships between economic and political players, if any, influence the essential conditions for growth, while at the same time, a typology evolves of the interactions between the state and the private sector. In the third stage,

124

P. E. PETRAKIS

an analysis of the political motives is made and the reasons are sought for why the political and economic powers interact in specific ways. The fourth stage describes the factors that influence political purposes and, more specifically, what the sources of pressure are and which incentives influence political decision-making. Finally, the fifth stage identifies some elements that are expected to promote growth and analyzes the pressures which can be applied to push these elements in the direction of growth. The different architecture of institutions and of their effects on economic growth, is reflected in the variety of conclusions offered by various research studies. Some see a positive correlation between democracy and economic growth (Butkiewicz & Yanikkaya, 2006; Cervellati & Fortunato, 2004; Papaioannou & Siourounis, 2008; Rodrik, 2000; Vollmer & Ziegler, 2009), while others express reservations (Pereira & Teles, 2008; Tavares & Wacziarg, 2001). Other research highlights cases of countries with authoritarian regimes (e.g., East Asia) that have achieved significant economic growth or cases of countries with a democratic regime whose growth has slowed down (e.g., India until the 1980s). Specifically targeted studies also consider federal state formation as a key factor in preventing harmful interference of the state in the citizens’ well-being (Weingast, 1995), while other studies examine the separation of powers in terms of its impact on economic growth (Marsiliani & Renstrom, 2004) while yet others focus on the political and electoral cycle or the impact of the electoral system on fiscal policy (Alesina & Roubini, 1992; Persson & Tabellini, 2001). Recognizing the decisive role of institutions in economic growth has no universal validity. On the contrary, this relationship is extremely complex. For example, historical confirmation of the inability to enforce global policies embedded in exemplary institutional models, was provided in the 1990s by the neoliberal so-called Washington Consensus which was being promoted by international organizations. The belief that transitional societies, such as those of Eastern Europe which experienced the collapse of their economies in the late 1980s, could emerge from the crisis and thrive by adopting the neoliberal suggestions of the then dominant economic model was not confirmed. The same thing happened with Latin America. The policies of the Washington Consensus fuelled social tensions and boosted income inequality and unemployment. Countries which strictly adopted these policies performed poorly (e.g. Russia), while others with different orientations (such as China, India, and Vietnam) achieved more significant growth rates.

5

5.2.3

POLITICS AND GOVERNANCE

125

Strong/Powerless State and Economic Outcomes

A state’s political power can affect the efficiency of the economy (Acemoglu, 2005) in several ways. In a strong state, the absence of controls on the redistributive power of government and the political elites that control the state mechanism, creates an environment where citizens’ investment and efforts are discouraged. In a powerless state, which is unable to manage a sufficient portion of society’s resources, those who control the state have a limited incentive to invest. Thus, a balanced distribution of power between the state and society is necessary to encourage investment by both citizens and those who control the state mechanism. On the one hand, in countries and periods with strong trends toward government collapse, growth is significantly lower (Alesina, Ozler, Roubini, & Swagel, 1996) than in others. Political instability adversely affects growth by reducing productivity growth rates and, to a lesser extent, the accumulation of physical and human capital. On the other hand, economic freedom, although favorable to growth and democracy, may also have limited negative effects, as has been proven. On the contrary, the concept of political stability is closely linked to economic development and growth. The relationship between political stability and economic development can be two-way, as the uncertainty associated with an unstable political environment can reduce the rate of economic development, while at the same time poor economic performance can lead to government collapse and political unrest. Political instability is likely to lead to the selection of inferior and more short-term macroeconomic policies, as well as to reshuffles among those exercising power, resulting in greater volatility and negative economic performance. Studies show that growth rates are lower in economies with government instability (Alesina et al. 1996). This argument is also confirmed by Barro (1991) and Jong-a-Pin (2009). In addition, Kormendi and McGuire (1985) and Barro (1989) argue that political rights are positively related to growth. In conclusion, economists link political instability to macroeconomic performance associated with economic growth. Socio-political instability creates an uncertain political and economic environment resulting in increased uncertainty and reduced levels of investment in economies. Political instability shortens the governments’ terms, disrupting longterm economic policies and leading to higher inflation (Alesina & Perotti, 1996).

126

P. E. PETRAKIS

5.3

Policy and Distribution of Income and Wealth

The theoretical foundation of the relationship between institutions, income distribution and resources produced in an economy, despite appearing self-evident but is in fact an issue extremely difficult to prove empirically. The issues of the distribution of income and resources are directly linked to the system of political institutions, the main product of which is the observed allocation of resources. Its main foundation should come primarily from the field of political science. It can be easily understood that a political structure represents certain political forces, which then make certain they harvest the benefits of their dominance (Alesina & Perotti, 1996). At the same time, it has been shown that the concept of democracy as a political institution, is directly linked to the distribution of income (Acemoglu, Johnson, Robinson, & Yared, 2008; Herwartz & Theilen, 2014; Perotti, 1992), whether through legal ways or indirect procedural interventions. When it comes to economic institutions, it is easy to understand their role in the redistribution of income and resources (e.g., the tax system, the insurance system). It is not easy, however, to formulate empirically confirmed assessments, for example, of the relationship between economic systems and wealth distribution issues. However, it can be seen that systems centered on the development of banks may favor a redistribution of funds that serves the interests of financial capital. On the contrary, systems that rely more on the unmediated functioning of markets, do not feature such a redistribution of resources. Based on the above, we see that the process of allocation of resources and the formulation of incentives are crucial for the evolution of the economic and political system, not only because its level of performance is thereby determined, but also because, through that process, future conditions of the distribution of resources and new political institutions are shaped. Of course, at the macro-economic level, it is difficult to relate political and economic institution changes to specific characteristics of the economic environment which affect the distribution of wealth and income. Nevertheless, we can observe the general means of measuring income inequality and, through these, draw conclusions about the policies (e.g., redistribution policies) that are followed. Economic theory has focused on measuring income inequalities and has proposed indicators that calculate them. These indicators are useful tools and

5

POLITICS AND GOVERNANCE

127

they represent—often with some imperfections—the degree of wealth distribution. Income redistribution takes place through several mechanisms which mainly focus on fiscal policy responsibilities. The focus should be on identifying the policies that are most relevant to effectively improving income distribution and the politicians who support them (Frankel, 2014). In particular, income redistribution mechanisms are divided into: 1. Transfer payments: such as unemployment benefits, disability benefits, social security programs, and pensions. 2. Progressive (or non-progressive) taxation through which higher incomes face higher levels of taxation. 3. Provision of public services, such as education and health. Although taxes and social transfers have a direct effect on income distribution, public provision of social services is an indirect way of redistribution and has a more long-term character. Income inequality has been increasing worldwide in recent years, and has been influenced mainly by technological progress, globalization and the liberalization of the labor market. The widening of inequality has grown even worse due to the global financial crisis of 2008, while at the same time the reverse does not seem to be the case, as, though we can blame a great many things on inequality, the global crisis is not one of them. Recently, Barry Eichengreen gave a speech in Lisbon on inequality (De Long, 2016), identifying six related processes over the last 250 years: (a) The increase in the uneven distribution of British income from 1750 to 1850: the profits from the British Industrial Revolution were not directed to the poor of the cities and the countryside, but, rather, to the middle class. (b) From 1750 to 1975, income inequality widened worldwide, since the profits from industrial and post-industrial technologies were not equally distributed to everyone. (c) From 1850 to 1914, living standards and levels of labor productivity converged to the global north, as 50 million people fled Europe to settle in countries with abundant resources, bringing with them their institutions, technologies and their capital. (d) From 1870 to 1914, domestic inequality increased in the global north, as entrepreneurship, industrialization and financial manipulation channeled new profits mainly to the more affluent. (e) From 1930 to 1980, higher

128

P. E. PETRAKIS

taxes on the wealthy helped pay for new public benefits and programs. (f) Since 1980, economic policy choices have again increased uneven distribution to in favor of the global north. Figure 5.2 illustrates the picture of inequality in OECD countries, by income distribution, as expressed by the Gini index. An increased Gini coefficient means an increased imbalance. Also, indicative of the increase of uneven distribution in recent decades is the work of Dao, Das, Koczan, and Lian (2017), which shows a sharp decline in the share of labor worldwide. The factors behind the significant reduction in labor shares are not fully understood. In developed countries, the decline observed may be largely due to technological progress, which is accompanied by a sharp decline in the relative price of labor accompanied by the emergence of occupations characterized by non-repetitive routine procedures, a fact which appears to have a more significant impact on the profits of semi-specialized workers. In developing economies, the declining labor share may be due mainly to processes of global integration, and in particular to the expansion of global value chains that have contributed to an increase in capital intensity in production. Despite the enormous theoretical literature on 0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

Fig. 5.2 Income distribution in OECD countries (2018) (Note Zero represents perfect equal distribution. Source OECD [2020] and author’s own creation)

5

POLITICS AND GOVERNANCE

129

the relationship between inequality and growth, there is no clear empirical evidence of whether inequality has a positive or negative effect on growth rates and to what extent. Structural reforms aimed at improving the living standards of societies are affecting income distribution. For example, taxes and transfer payments not only affect income distribution but also negatively affect GDP per capita through labor use and productivity. If it is accepted that the relationship between growth and distribution is negative, while inflated wealth inequalities are observable, then, we must assume negative long-term pressures on growth opportunities. The increase in inequalities relates to the long-term dynamics of the economic system in the ratio of capital to income (Piketty, 2014) and to the evolution of the net after-tax rate of return combined with the rate of growth. At the same time, the political system will likely develop forces fuelled by the increasing redistribution of income and wealth, which tend to sustain and affect income distribution itself and, ultimately, the potential for economic growth.

5.4

Political Costs and Structural Reforms

As economies evolve and external conditions change, there are new constraints in accordance with which economic policymakers have to adapt their reform priorities. Differences in economic performance between countries are often due to structural factors and the extent to which economies implement structural reforms in their product and service markets and the labor market in response to their chronic problems and competition. Structural reforms entail changes in the way the state operates, and, if effective, ensure long-term growth. Structural reforms and policies can be arduous but they improve highly problematic functions, although political parties and government members prefer to provide painless solutions that do not discomfort voters, so as to remain in power. Under such circumstances, the incentives that drive real reform policies are weakened or even disappear. Only the arguments remain over the need for reform plans. To the extent that the influence of political parties is primarily a function of the distribution of state resources and benefits, there is no strong motive for them to channel these resources to promote growth. Their actions are mostly aimed at balancing conflicting interests (providing “solutions” for the majority of the population), rather than methodically designing and implementing

130

P. E. PETRAKIS

reforms which, insofar as they entail costs for certain social groups, also entail costs for the political parties themselves. Under such circumstances, usually the think tanks of political parties have very little involvement in the formulation of their policy. Often, they are simply elaborating ways to justify policies formulated from the top of the party pyramid. Reform plans—to the extent that there are any—are the product of the top of the party pyramid, rather than collectively shaped through political participation. The personalization of politics—enhanced by the conditions of media dominance—is exemplified in the cases of those political leaders who traditionally enjoy a hegemonic position in party politics. There are controversial views in the literature as to why some governments are willing to undertake reforms, while others are not. The primary reason for there being no reforms are budgetary constraints and sectoral shifts which result in the subsequent regulation of the labor market becoming a significant challenge. Other important factors that could be considered are pressure groups (lobbies) as well as the various elites who, due to their interests and favoritism, often impede the implementation of measures that would change conditions favorable to themselves (Grossman & Helpman, 2001). Every reform implies changes that create two sides, one of winners and one of losers. Uncertainty about this cost–benefit assessment along with the potential risks arising from innovative reforms, can be a hindrance to their implementation (Fernandez & Rodrik, 1991). Political expediencies and the re-election of parties which, understandably, want to keep their constituents satisfied in order to secure a long-term political course, are additional reasons for not adopting reform policies (Bonfiglioli & Gancia, 2011). However, the opposite view has also been expressed on the latter point, namely that the reforms do not affect the likelihood of re-election. Referring to demographic studies, it has been observed that as the population ages, the more there is increased reluctance to support structural reforms (Favero & Galasso, 2015), in favor of fiscal policy reforms whose effects can be seen in the short-term.

5.5

Politics and Representation

In today’s complex societies, the problem of “representation” is observed. This refers to whether those who represent the citizens in parliament do adequately represent and effectively promote the collective interests

5

POLITICS AND GOVERNANCE

131

of those who voted for them. The issue of representation is linked to the existence of a democratic system and its interconnection with the economic system and with growth, the role of elites and pressure groups, the cultural background of policymakers and the role of the mass media. 5.5.1

Democracy and the Economic System

The link between democracy and economic growth has attracted the interest of prominent economists (Barro, 1996, 1999; Lipset, 1959). The primary position of the hypothesis of Lipset (1959) is that democracy promotes higher standards of living. Indeed, the origin of this idea is traceable to Aristotle, who stresses that “only in a prosperous society, where relatively few citizens live in conditions of true poverty, could there be a situation in which the bulk of the population could participate intelligently in politics and could develop the necessary restraint so as not to give into the prompts of irresponsible demagogues.” The force of the hypothesis of Lipset and Aristotle as empirical rule is elaborated by Barro (1999). Specifically, there is a two-way relationship between democracy and growth. On the one hand, analysis shows favorable effects of abiding by the rule of law, free markets, low state spending and high human capital. As long as such variables are maintained, along with the initial level of GDP, the overall impact of democracy on growth is marginally negative. On the other hand, concerning the effects of economic growth on democracy, improvements in the standard of living, significantly increase the likelihood that political institutions will become more democratic as time goes on.1 Tavares and Wacziarg (2001), calculating a common system of equations in which democracy has the ability to influence a number of decisive variables of growth, find that the overall effect of democracy on growth is slightly negative, confirming the results of previous studies. Acemoglu, Suresh, Restrepo, and Robinson (2014) also identify a negative relationship between democracy and economic development, at least for the least developed countries. Also, the effect of democracy on inequality is described as weak in many research studies (Acemoglu, Naidu, Restrepo, & Robinson, 2013; Gil, Mulligan, & Sala-i-Martin, 2004; Gradstein & Milanovic, 2004; Scheve & Stasavage, 2009, 2010, 2012; Sirowy & Inkeles, 1990). On the other hand, some scholars point that democracy has a strong magnifying effect on growth. For example, Acemoglu, Suresh et al.

132

P. E. PETRAKIS

(2014) believe that a non-democratic country that becomes democratized achieves about 20% higher GDP per capita within the next three decades. Democracy increases future GDP by stimulating investment, increasing education opportunities, introducing economic reforms, improving public goods provision, and reducing social unrest. In addition, the quality levels of governance are significantly higher in most democratic countries. In the same direction, Siourounis and Papaioannou (2008) show that countries undergoing democratization attain greater growth in the long run, after a fluid transition period. Furthermore, in agreement with Acemoglu and Robinson (2000), Meltzer and Richard (1981) argue that democracy reduces the level of inequality and improves redistribution. There is also evidence that democracy affects the level of public spending (Lindert, 1994), the amount of tax revenue (Acemoglu, Naidu et al., 2013) and is related to higher wages and a higher share of labor over the national income (Rodrik, 1999). 5.5.2

Elites and Pressure Groups

The term elite was introduced into sociological reflection by Pareto to denote individuals who are high performing in their field of activity. They are members of society who are directly involved in economic policymaking and have a significant influence on government policy decisions, as they usually hold strong positions in businesses and organizations and are closely associated with decision and policy centers (think tanks or policy discussion groups).They can refer to large industrial and financial clusters. The power of the elites is independent of a state’s democratic electoral process. The term pressure groups refers to any social group, small or large, whose members share at least one common trait. These are organized groups that defend certain interests and exert pressure on power centers. They include trade unions, confederations, and professional associations. Both elites and pressure groups apply pressure on the state power mechanism so as to achieve their own goals. These two groups could be described as interest groups, their difference being that first, the members of an elite group are usually closer to the rulers than the members of a pressure group,2 making their interests more easily attainable, and second, elites usually consist of a smaller number of members than pressure groups. Societies, from the most to the least developed, are structured by a set of interest groups.

5

POLITICS AND GOVERNANCE

133

There is a positive correlation between organized interest groups and political stability. Interest groups are more easily formed in societies where stability and freedom of opinion prevail. Many research findings support this view after investigating the relationship between political stability, political freedom and economic development. In conclusion, political and institutional instability lead to an increase in the role of interest groups. The basic principles of interest group theory which had been introduced in the mid-1960s were built on by Olson (1965). Olson’s main conclusion was that, without coercion or selective motivation, rational persons who are members of large groups would not take collective action or mobilize to further their mutual interests. He argues that special interest groups are a crucial factor in how capital accumulation and technological progress evolve. In particular, he concludes that, through their activity, interest groups reduce investment as well as innovation, and thus hurt economic progress. In 1982, Olson argued that society could not expect to achieve a specific allocation of resources through a process of negotiating with these groups. Consequently, already formed groups, as opposed to groups whose interests are not represented, are characterized by the fact that they dominate the market. His theory has launched study and research on the subject, as well as provided grounds for intense dialogue. It has been argued that interest groups provide collective goods to their members, often leading to the appearance of phenomena of free-riding (Coates, Heckelman, & Wilson, 2007). Olson’s theory (1982) is based on the argument that political and economic stability helps to increase the number of interest groups in a society, which in turn leads to a redistribution of income and wealth. These groups ultimately divide the “economic pie” in such a way as to damage its growth. However, Olson’s (1982) theory has received considerable criticism, as it does not make clear the link between pressure or interest groups and economic progress. Subsequent to Olson’s argument on the relationship between organized interest groups, investment and economic growth, several studies have provided contradictory findings, often based on different statistical samples and different methods. Some findings indicate that pressure group activity is a negative factor for economic growth and investment. The main arguments about the negative impact of interest groups are based on the accumulated inefficiency and the economy’s reduced ability to adapt to economic turbulence.

134

P. E. PETRAKIS

Coates and Heckelman (2003) examine this theory by correlating pressure groups and the percentage of GDP absorbed by investments. Their rationale is based on the idea that more interest groups will exert more pressure and lobbying3 to protect specific markets, with the result that there is no particular emphasis on research and development which would lead to increased investments and GDP. So, they conclude that interest group activity hurts investment and income growth. There is a negative relationship between the number of pressure groups and the rate of economic growth and productivity growth. Also, there is a negative relationship between pressure groups and capital investment and economic progress, when it comes to developed countries. The resulting negative relationship is traceable to resources allocated to lobbying and activities aimed at increasing profits. For less developed countries, the results are reversed. In countries that are not members of the OECD, lobby groups seem to be working favorably for investment and economic growth, and, if the analysis includes all countries, then interest groups appear to have no bearing on economic growth. Organized interest groups can often harm the economy by defending specific interests as opposed to the “common good.” Particular changes that are not merely necessary but also beneficial, such as the adoption of new technology in the production of a product that will reduce the need for human resources, may not be promoted due to trade union interests. This does not promote change and improvement of processes for the benefit of companies alone, but also for the benefit of society. This avoidance of adapting to new data and conditions impedes evolution, nor does it support the need for change, and the redefinition of needs and processes, thereby slowing the country’s progress and increased adaptability to new conditions. DiCaprio (2012) defines the impact of elites on the economic development of the societies in which they belong in terms of: 1. Their ability to control and market the desired resources, especially those of high monetary value. 2. The way they influence the allocation of resources, which is also the most direct way in which they influence the process of development and growth. 3. Their political influence, though they may not hold positions of power.

5

POLITICS AND GOVERNANCE

135

4. The fact that institutions designed by the elites themselves usually promote the participation and flow of information and reinforce the position of a particular group within the government structure. 5. Their ability to frame how issues are perceived. 6. Their ability to influence public opinion by disseminating or holding information. From the above it is reasonable to think that such actions (of avoiding adaptation to change) create negative dynamics in society and the economy. When rapidly developing countries follow and adapt to developments, they create conditions for development and progress, the discovery of new technologies, products, etc. Societies that are unable to follow have less room to adapt and respond to external disturbances that may arise, as they lag behind in readiness, and the speed in which development, adaptation, and contact with new data take place. If each group operates separately in order to defend specific interests, this can only work negatively for the efficient functioning of the economy but also for the equal income distribution. Specifically, if members of each group use whatever means are available to achieve their goals, this implies political choices which, while being economically ineffective for society as a whole, will give organized groups an advantage, given that the costs of policies weigh disproportionately on non-group members. Overall, there is a likelihood that the cost of negotiation and slow decision-making will render society economically ineffective. 5.5.3

Politics and Cultural Background

Initially, the cultural background influences the quality and functioning of political institutions (first round of impact). Next, the political institutions form the system of economic institutions (second round of impact), which in turn creates structures and incentives for individuals to act. The prevailing economic institutions ultimately determine the distribution of wealth and the degree of economic growth (third round of impact). A typical example of the first round of effects is when societies that place great importance to concepts of collectivity, form participatory institutions at the various levels of social organization. If, on the other hand, the concept of outcome is dominant in social cultural organization, then society will more readily accept an authoritarian by a governing body, especially in a time of crisis.

136

P. E. PETRAKIS

Inglehart (1997) states that “it is nonsensical to believe that culture is neutral: every society legitimizes the establishment of a social class—in part because the ruling class is trying through culture to shape the values that will help it survive.” Alesina and Glaeser (2004) argue that in order to identify the forces that have shaped the current form of society, an analysis must include the historical account of events, while attending to the interests served by the dominant cultural background. As support to their argument, they refer to the Western world and, in particular, to how political leaderships have succeeded in steering the public to support their ideas and positions. So-called politicized culture, is a cultural background viewpoint deliberately created by political leaders so as to steer groups of people (De Jong, 2013). There are numerous examples4 of leaders choosing to pursue development programs based on the values of other countries or religions in an effort to lead their country to economic growth. As evidenced by examples in history, the cultural background can be used to advance the goals of political leadership. A cultural background dominated by collective characteristics and by the denial of privacy, will tend to develop processes in which the state is strongly interventionist. However, a cultural background dominated by individualism and the valuing of privacy, develops a very different environment, wherein the two types of political institutions coexist in a context more akin to northern Europe. On the other hand, a cultural background dominated by uncertainty will tend to tackle a situation by creating a large number of complex laws and regulations, as is the case in the European South. On the contrary, a cultural background dominated by trust and certainty—as in the case of Britain—can organize the functioning of society along simpler processes of customary law. It should be noted that the multitude of laws and the complexity of the legal framework do not necessarily guarantee effectiveness. The cultural background, therefore, influences political institutions which in turn shape structures and motivations. However, apart from this indirect process, the individual elements of economic institutions are also directly affected by the cultural background. Economic institutions ultimately shape the conditions for growth and distribution of income and wealth (third-round impacts). These variables, as is the case for the individual elements of economic institutions, are directly dependent on cultural values. That is, whether the goals to be achieved by a society are related to the per capita product or income or the per capita happiness

5

POLITICS AND GOVERNANCE

137

enjoyed by its members, depends on the culture it possesses. At the same time, the distribution of income and wealth may be the result of the functioning of economic institutions, but they are nonetheless directly linked to the values of society and, more specifically, to whether the socially desirable goal is greater or lesser redistribution. In summary, cultural background influences the shaping of political institutions and the politics practiced, while, at the same time, the political field influences the shaping of the cultural background. 5.5.4

Politics and Media

The media have a significant influence on social, economic, and political developments. The effects of media on politics first appeared in the 1930s, when Hitler and Mussolini made extensive use of radio to propagate their message and influence public opinion. Prat and Strömberg (2013) record four different views on how media influence voters’ opinion: 1. The agenda setting theory where media engagement with a topic automatically makes this topic important. 2. The priming theory according to which people evaluate politicians on the basis of the issues covered by the media. 3. Memory-based models where media cannot tell the public what to think, but can have a significant impact on what the public thinks. 4. The framing theory where the way a media presents a topic can affect how the public perceives it. Particularly in recent decades, when their role has been dramatically enhanced due to technological developments, the media have played a particularly important role between society and governments. In addition to its significant benefit of providing general information and entertainment, the media informs society of all the political events (policies being implemented, inform on laws in force or changing) happening locally or globally, and about the profiles of the government and their actions, so as to allow them to decide whether to re-vote or replace them. Also, the media have succeeded in educating the illiterate masses of the countryside and eliminating the distance that separates someone’s place of residence from the centers of policy. For these reasons, the freedom of the media

138

P. E. PETRAKIS

is a reflection of the success of governance and a democratic regime, rendering the system more accountable so that it can be more responsive and citizen-friendly. The power of the media is such that economic developments are significantly influenced by the public statements of government members and people in general who are politically influential. More generally, the images and perceptions created in the market and in people’s minds, affect reality. Thus, statements by important persons in the international political and economic arena, could exacerbate the negative climate for an economy. For example, the expansion of the Greek spread (i.e., the yield of the Greek bond compared to the performance of the corresponding German one) during the crisis of 2010, may have been due not only to the deterioration of the country’s macroeconomic position and the general aversion to risk that characterized markets during this period, but also to interventions at the political level. Petrakis, Papadakis, and Daniilopoulou (2012) have analyzed the causality of these relationships and concluded that the negative statements made, did actually influence the likelihood of the rise of the Greek spread and that the positive statements—which were made in the French media—did allay the change in the Greek spread. An ECB research has confirmed this conclusion (Gade, Salines, Glöckler, & Strodthoff, 2013). In general, political statements have also played a critical role in the evolution of the borrowing costs of countries in difficulty (Greece, Ireland, and Portugal). Positive statements contributed to lower borrowing rates and, conversely, negative ones aggravated market concerns. The result was the creation of self-fuelling negative cycles between markets and political decisions.

5.6

Politics and Economic Change

At a global level, changes are taking place that have a significant impact on economic functioning and political institutions. Some major examples are the change observed in the resilience of states to meet modern challenges, the early onset of de-industrialization which may have significant economic, political and social implications, the great change observed in the middle class at a global level and, finally, the rise of populism as a result of the Great Recession (2008–2010).

5

5.6.1

POLITICS AND GOVERNANCE

139

Resilience of Society and the State

The concept of resilience was first used by Holling in 1973 to help understand the ability of ecosystems to absorb or tolerate disturbances and adapt to change. It has been used in many disciplines, such as engineering, as the ability of materials to return to their original state after a shock, physics, as the speed at which a system returns to equilibrium after shifting irrespective of the required number of oscillations, in psychology, as the process of coping with traumatic experiences by individuals. Resilience concerns the degree of adaptability and flexibility and refers to the ability to successfully adapt to causes of stress, while the individual retains their psychological well-being in the face of adversity and the ability to recover after difficult experiences. The European Union Global Strategy (2016) states that resilience is the ability of states and societies to reform and, thus, survive and recover after internal and external crises. Emphasis is placed on the ability of social units to mitigate risks, limit the impact of disasters when they occur, carry out recovery activities so as to minimize social disruption and survive an emergency without suffering catastrophic damage, decrease in productivity or in quality of life. The concept of resilience in the relevant literature is presented in two forms. 1. Equilibrium resilience is defined as the ability of a system to absorb shock without any changes. This approach focuses on existing systems for restoring stability, without emphasizing the impact of this return to a prior state. 2. Evolutionary resilience rejects the idea of returning to a previous stable state by emphasizing the ongoing evolutionary change processes and emphasizing adaptability and adaptive behavior. This approach focuses on new transformation paths of adopting alternative and innovative methods for the system’s survival following a crisis and places the emphasis on adaptive capacity, adaptability and transformation. The political stability of a state refers to its ability to carry out reforms in order to recover from internal and external difficulties. A state is resilient insofar as it can overcome difficulties, while at the same time fostering confidence among its citizens and taking care of them. But even when the

140

P. E. PETRAKIS

state fails, it can be possible for a resilient society to overcome difficulties. In a resilient society characterized by democracy, sustainable growth and confidence in institutions, in cases where the market and the state fail to fulfill their role, self-organized relationships based on mutual assistance, cooperation, solidarity, and the human community assume a crucial role for survival. Vulnerability is central to the concept of resilience in society and also includes those characteristics of individuals or groups that foster it in order to cope with the effects of disruption. A resilient state is a state in which members of society feel that their situation is improving, and they are hopeful for the future. In order for countries to be regarded as resilient, they need to adopt a flexible approach to policies related to society, economic development, immigration, trade, investment, infrastructure, education, health and research. They should also be able to combat poverty and inequality, facilitate social insurance and access to public services and offer decent work opportunities (especially for women and young people). They should create a favorable environment for new economic endeavors and for the social integration of marginalized groups and facilitate strategic investment through public-private partnerships and trade agreements. Also, they should create jobs as well as promote skills development and the transfer of technology. Finally, they need to protect human rights and promote culture, pluralism, coexistence, and respect. 5.6.2

Society and de-Industrialization

The modern world we live in is the result of a process of industrialization that involved the three waves of the Industrial Revolution: Steam production (mechanical production of equipment during the period from 1760 to 1840). An increase in the division of labor (arrival of electricity and mass production from 1870 to 1914). And, finally, the Electronic phase (information technology and automated production dominating from 1969 to the present). These three waves have led to a steady increase in productivity. However, in recent decades, there has been a great deal of de-industrialization with most economies converting from being industry-based to being service-based. Indeed, this is a change affecting almost all economies, whether developed or developing, and is the result of a long period of increasing relative wages in the workforce and an increase in the highly skilled labor force (Rodrik, 2015). This has led to the increasing prevalence of service-based economies.

5

POLITICS AND GOVERNANCE

141

At the same time, we seem to be entering a new era that will significantly affect the future conditions of economic activity. This period is driven by the merger of certain technological advances some of which are natural (self-driving vehicles, 3D printing, advanced robotics, new materials), some digital (everything done online) and some biological (innovations in the field of biology, expansion of genetics, synthetic biology). As a result, new opportunities are being created and dramatic impacts are observed on the economy, on businesses, on society and on individuals, both nationally and globally. In other words, this is a process of automating and interconnecting processes and of rapid change, making simultaneous use all the existing positive elements which comes in the wake of the third wave of electronic industrialization, information technology, and automated production. This change is said to constitute the Fourth Industrial Revolution which concerns the merging of the natural world with cyberspace. The early onset of de-industrialization is likely to have significant economic and political implications, as it slows economic growth and delays economic convergence by creating democratic failures. Indeed, the fourth industrial revolution is expected to be an extremely painful chapter in world history, as the technological change that is causing it may increase the wealth and profitability of some economies and professional groups, without however working for the benefit of the many. Machines are already replacing most types of human labor, with automated production affecting less skilled workers. As intelligent machines become cheaper and more skilled, they will increasingly replace human labor, and this is expected to be more pronounced in the more routine and repetitive tasks. Based on the above developments, the further reduction of labor costs in developing countries may affect the wages of workers in developed countries. Developing countries will also have to choose how to respond to these developments: cheap labor is no longer their comparative advantage as the economies of operation and the interconnection of economies are structurally changing. Indeed, this change may also cause geopolitical imbalances, since cheap labor has so far been the sole factor compensating for the low productivity and low skill levels of developing economies. Because of these changes, developing countries in particular, need a new model of growth, due to their dependence on capital inflows and commodity booms, which makes them vulnerable to economic crises.

142

P. E. PETRAKIS

The impact of the above developments on the way economies operate and interconnect, on economic growth, economic convergence, democratic functioning, income inequalities, and geopolitical developments, is expected to also register at the level of societal structure, as the social costs of de-industrialization are significant, long-lasting, and wide-ranging. The social costs of de-industrialization include job losses, deteriorating health care, tax base reductions resulting in cuts in essential public services, such as police and fire fighting, and increased crime rates, both immediately and in the long term. There is also depreciation of local open spaces, increased suicides, drug and alcohol abuse, domestic violence and depression, reduced non-profit and cultural resources, and loss of faith in institutions such as the public sector, businesses, associations, the church, and traditional political organizations. 5.6.3

Social Change and the Middle Class

In recent decades, perhaps the most significant developments have been the significant accumulation of wealth in the hands of 1% of the world’s population, the reduction of poverty in the developing world—especially in China—and the emergence of large middle classes in developing countries. The period from the mid-1980s to today, is the period of the most significant redistribution of personal income since the Industrial Revolution and is the first time that global inequality has declined in the last two hundred years. The “winners” were the middle and upper classes of the relatively poor Asian countries and the world’s top 1%, while the (comparative) “losers” were the people in the lower and middle sections of income distribution in rich countries. The tendency to increase inequality is also accompanied by a decline in intra-social intergenerational mobility. Both trends have been linked to globalization. Economic developments include critical reflection around the world emerging after the great global crisis of 2008 (developed and developing countries, richer and poorer). Logically, based on the centuries-old history of capitalism, a period of long recovery is expected. Yet, this recovery is by no means certain to take place and to have strong growth rates or that its benefits will be shared with all participants. The nature and characteristics of this recovery will depend on its driving forces and whether it will be driven by demand as a result of the rise of the middle class5 in developing countries, which will overcome the negative impact of the squeeze on the middle class in developed countries.

5

POLITICS AND GOVERNANCE

143

Kharas (2010) very clearly shows the declining role of the European and American middle-class consumer power over time (by 2050) and its replacement by corresponding powers from China and India. Of course, shifting the demand pattern will have multiple implications for the global organization of production and growth. The recovery that will be generated can be driven by supply stemming either from energy supply conditions or the use of new technologies. It may also be driven by supply in the sense of expanding supply opportunities resulting from the reduction of debt-to-GDP ratios and the correction of macroeconomic imbalances. Thus, in many developed countries (mainly in the United States and Europe), there is a decline in the importance of the middle class. But a large and secure middle class is a solid foundation upon which an effective, democratic state is built and maintained in line with the ideas of the French Enlightenment. Its disappearance can be a significant reason for deficient levels of development, high corruption and social tensions, mainly due to the weakening of supporters of institutions for development and to the negative prevalence of pressure groups. Also, the constriction of the middle class is not a slow, evolutionary process butt happens abruptly, within a short time, mainly in times of economic recession. The reasons for the squeeze on the middle class are, in addition to increased taxation, the decline in employment and the introduction of flexible forms of employment. At the same time, in developing countries, the middle class is strengthening. These are countries that did not have a middle class three decades ago, as their societies were characterized by large income inequalities with the majority living below the poverty line and the upper classes enjoying the concentration of economic power. The economic growth of these countries—since the 1990s with most notable examples being China, India, and Brazil—has given significant impetus to large masses of the poor population by raising their per capita income and thereby strengthening the middle class. Indeed, this is an ongoing process in countries such as Kenya, Nigeria, and Tanzania. 5.6.4

Economic Crisis and Populism

Populism is defined as a shallow ideology which considers that society is completely divided into two homogeneous and competing groups, the “pure people” and the “corrupt elites”, and which argues that politics

144

P. E. PETRAKIS

should be the expression of the general will of the people (Mudde, 2004). It is a specific view of how society is and how it should be structured, but deals only with a small part of the broader political agenda. Populism is in favor of democracy, but against liberal democracy, and supports popular sovereignty and the rule of the majority, but rejects elitism6 and pluralism7 and minority rights. The populist wave is partly a rational response to the obvious political failures of established parties. It is also an emotional reaction to a sense of deprivation of rights. The roots, however, of the growth of the populist wave are the challenge posed by immigration and the prolonged economic crisis. According to Inglehart and Norris (2016), it is due: 1. To the perspective of economic insecurity,8 which emphasizes the consequences of the profound changes that are transforming the workforce and society in post-industrial economies. 2. In the thesis of cultural backlash,9 which considers that support can be explained as a backward reaction by those segments of the population that were once dominant, against the progressive change of values. Mudde (2013) argues that the rise of populism in Europe is due to the fact that: 1. Much of the European electorate believes that important issues are not (adequately) addressed by political elites; 2. national political elites are increasingly considered “all the same”; 3. more and more people see national political elites as essentially “powerless”; 4. the media are much more favorable to political dissenters. Political environments appear systematically different in the aftermath of the financial crisis than prior to it. The political ramifications of a financial crisis can be severe. Following a crisis, political functioning may not be as effective, as it is likely that a country will fail to make reforms at exactly the time when they are needed. Evidence from the impact of banking crises over the last century, shows that crises have a dramatic impact on the governments’ survival prospects.

5

POLITICS AND GOVERNANCE

145

However, if we ignore politics, the crises will not be adequately understood. “Political blooms“, which mean an increased popularity of the government, are a good measure for predicting financial crises. Indeed, it appears that political instability is greater after financial crises than after other types of economic crises. In particular, Funke, Schularick, and Trebesch (2015) comparing the political impact of recessions after a financial crisis with the impact of normal recessions (not associated with a financial crisis) concluded that financial crises stand out and are followed by political instability to a much greater degree, in relation to other types of economic crises. This seems to be due to the fact that financial crises (Funke et al., 2015): 1. are characterized by endogenous problems resulting from the failure of politicians, moral hazards, and favoritism, and they 2. include bailouts for the financial sector that could lead to even greater political discontent. Funke et al. (2015) conclude that the first five years after the onset of a crisis are critical and that most effects begin to dissipate after the first five years. Indeed, a decade after the onset of a crisis, most of the variables for political outcomes do not appear to differ significantly from their historical average. In addition to the evident overseeing of people’s conflicting choices and preferences, political institutions ensure (or not) the stability required for any economic activity. This stability, however, is not a given, but is linked to two crucial functions of political institutions. These are the redistribution of the social product and the incentives for economic action that shape or favor it. As Acemoglu (2008) typically points out, it is the balanced policies that make up the two sources of power (de facto and de jure), operating in a balanced way and without causing the unequal distribution of the social product. Policies which channel the wealth produced to politically dominant groups undermine political stability. Even if there are no conditions of extreme poverty to cause immediate social conflicts, the resulting devaluation of the political system cancels any reform effort toward adapting an economy to the demands of international competition. In this way, the potential for economic growth is reduced in the long run, which in turn contributes to political instability and unrest. The

146

P. E. PETRAKIS

ways in which economic action incentives are made available, also reinforces this situation of self-sustaining subversion of economic growth. The ineffective functioning of political institutions fosters the development and diffusion of counterproductive behaviors, as positive expectations for productive action disappear. This has significant implications for growth, thereby reinforcing the vicious cycle of political instability and economic inefficiency. However, the economic crisis and the slowing down of the global economy, appear to create additional problems for economies. The situation is exacerbated by the increasing pressure on the poor and middle classes, due to the effects of the crisis and the income shocks caused in recent years by neoliberal globalization in the United States and the European Union. The result of the recent Great Recession—especially in the last decade—is increasing support for populist parties which have created political turmoil in many western societies (Inglehart & Norris, 2016; Mudde, 2013).

Notes 1. More generally, there is an ambiguity in literature about the extent of democracy’s impact on development. By studying 16 empirical studies, Borner, Brunetti, and Weder (1995) conclude that three of them result in a positive relationship between democracy and development, three in a negative relationship, and the remaining ten do not result in any statistically significant relationship. The finding that democracy has a minor effect on economic growth may conceal the fact that it entails both costs and benefits (Tavares and Wacziarg, 2001). 2. In economics, the term interest groups, in its broad sense, refers to any non-governmental social group that seeks to exert pressure on policymakers and exert power in a particular direction, in order for their goals, interests and aims in general not to be undermined or, else, promoted. The terms pressure groups and interest groups are used interchangeably in the literature, as being identical. Not every interest group necessarily puts pressure on the power mechanism. It is, nevertheless, a potential pressure group, since its interests influence the social fabric and wider social interests and it can, as such, exert pressure in specific directions. Therefore, the interchangeability of the two terms is neither wrong nor arbitrary. As Mavrocordatos (2000) typically points out, the term pressure group has a serious drawback. It has a negative charge and, so, the term interest group is considered to more scientifically appropriate, due to its characteristic neutrality.

5

POLITICS AND GOVERNANCE

147

3. An activity in which organized interest groups with specific interests seek to influence the authorities in enacting favorable laws and rules to their advantage. 4. In the early 1980s, Malaysia, while in a deep recession, adopted a campaign in which Japan and Korea set the standards for economic growth. Values such as hard work, austerity, and patience, were the drivers of growth. These values needed to be endorsed by the indigenous people of Malaysia. However, later in the 1980s and 1990s, when the great economic boom had been achieved, the political leadership attempted to incorporate the values mentioned above and convince the people that they already existed in Islamism and, as such, were part of their cultural heritage. Their purpose was to promote Islamism by emphasizing that values such as hard work, austerity, and the pursuit of knowledge were characteristic features of it. Another example of politicians influencing public opinion through cultural background, is the so-called African Renaissance, which South African President Thabo Mbeki devised when he and his supporters sought to reestablish the state and the economy and apply a democratic government. The adoption of Western world values and perceptions has ultimately had little impact. 5. The middle class is defined as the population whose disposable income ranges from 60 to 200% of the median disposable income. Households earning below this income level are considered lower class and those earning over 200% of the median income belong to the upper class. Median is the income that divides the income distribution into two: 50% of the population earns below that amount and 50% above it. It is a size that differs from the average, as it is not affected by the extreme values of the income scale. According to another definition, middle-income people live on $10.01–$20 a day, which is estimated at $14,600–$29,200 a year for a family of four. The other four income groups are defined as follows: the poor live on less than US $2 a day, the low income class on US $2.01–US $10 a day, the upper middle class on US $20.01–US $50 a day, and the high income class on more than US $50 a day. 6. Elitism holds that the elite are pure and the people corrupt. 7. Pluralism has a completely different worldview than elitism and populism; it consider that society is divided into different groups with different interests and is in favor of a policy based on consensus among these groups. 8. The theory of economic insecurity explains populism as a product of rising income inequality, a sense of injustice on the part of the losers in the global market, of dissatisfaction with the dominant center-left parties, and of the loss of faith in the ability of the dominant parties to cope with these matters. 9. If the theory of “cultural backlash thesis” is true, then the strongest support for the populist parties will be found among older generations,

148

P. E. PETRAKIS

men without higher education, and among traditionalists who are most opposed to its progressive cultural values (e.g., sexuality, religion, multiculturalism, cosmopolitanism, and tolerance for foreigners). Severe economic insecurity and rising levels of social inequality can also reinforce cultural shifts, suggesting an interactive phenomenon wherein traditional values will be stronger among the poorest and older constituents.

References Acemoglu, D. (2005). Politics and economics in weak and strong states. Journal of Monetary Economics, 52, 1199–1226. Acemoglu, D. (2008). Political economy of institutions and development: Lecture 1. Retrieved from web.mit.edu/14.773/www/2003%20Class%20notes.pdf. Acemoglu, D., Johnson, S., Robinson, J. A., & Yared, P. (2008). Income and democracy. American Economic Review, 98(3), 808–842. Acemoglu, D., Naidu, S., Restrepo, P., & Robinson, J. A. (2013). Democracy, redistribution and inequality (NBER Working Paper, No. 19746). Acemoglu, D., & Robinson, J. A. (2000). Why did the west extend the franchise? Quarterly Journal of Economics, 115, 1167–1199. Acemoglu, D., Suresh, N., Restrepo, P., & Robinson, J. A. (2014). Democracy does cause growth (NBER Working Paper, No. 20004). Alesina, A., & Glaeser, E. L. (2004). Fighting poverty in the US and Europe: A world of difference. Oxford: Oxford University Press. Alesina, A., & Perotti, R. (1996). Income distribution, political instability and investment. European Economic Review, Elsevier, 40(6), 1203–1228. Alesina, A., & Roubini, N. (1992). Political cycles in OECD economies. Review in Economics Studies I, 59, 663–688. Alesina, A., Ozler, S., Roubini, N., & Swagel, P. (1996). Political instability and economic growth. Journal of Economic Growth, 1, 189–211. Barro, R. J. (1989). A cross country study of growth, saving and government (NBER Working Paper, No. 2855). Barro, R. J. (1991). Economic growth in a cross section of countries. Quarterly Journal of Economics, CVI (425), 407–443. Barro, R. J. (1996). Democracy and growth. Journal of Economic Growth, 1(1), 1–27. Barro, R. J. (1999). Determinants of democracy. Journal of Political Economy, 107 (S6), 158–183. Bonfiglioli, A., & Gancia, G. (2011). The political cost of reforms (CEPR Discussion Paper, 8421). Borner, S., Brunetti, A., & Weder, B. (1995). Political credibility and economic development. New York: Macmillan Press.

5

POLITICS AND GOVERNANCE

149

Butkiewicz, J., & Yanikkaya, H. (2006). Institutional quality and economic growth: Maintenance of the rule of law or democratic institutions, or both. Economic Modeling, 23, 648–661. Cervellati, M., & Fortunato, P. (2004). Growth and endogenous political institutions. Retrieved from www2.dse.unibo.it/…/Endogenous%20Political%20I nstitutions_MIT_DP2004.pdf. Coates, D., & Heckelman, J. C. (2003). Interest groups and investment: A further test of the Olson hypothesis. Public Choice, 117, 333–340. Coates, D., Heckelman, J. C., & Wilson, B. (2007). Determinants of interest group formation. Public Choice, 133, 377–391. Dao, M., Das, M., Koczan, Z., & Lian, W. (2017, September 8). Routinisation, globalisation, and the fall in labour’s share of income. VoxEu.org. De Jong, E. (2013). Culture and economics: On values, economics and international business. London: Routledge, Routledge Advanced Texts in Economics and Finance. De Long, B. (2016). A brief history of modern inequality. World Economic Forum and Project Syndicate. DiCaprio, A. (2012). Introduction: The role of elites in economic development. In A. H. Amsden, A. DiCaprio, & J. A. Robinson (Eds.), The role of elites in economic development. Oxford: Oxford University Press. European Union Global Strategy. (2016). Shared vision, common action: A stronger Europe. A global strategy for the European Union’s Foreign and Security Policy. Favero, C. A., & Galasso, V. (2015). Demographics and the secular stagnation hypothesis in Europe (CEPR, DP10887). Fernandez, R., & Rodrik, D. (1991). Resistance to reform: Status quo bias in the presence of individual-specific uncertainty. American Economic Review, 81(5), 1146–1155. Frankel, J. (2014). How to address inequality (Vox CEPR, Policy Portal Vox Eu.org). Frey, B. S. (2011). Political economy: Success or failure? (CESIfo Working Paper, No. 3684). Funke, M., Schularick, M., & Trebesch, C. (2015). The political aftermath of financial crises: Going to extremes (Vox CEPR, Policy Portal, VoxEu.org). Gade, T., Salines, M., Glöckler, G., & Strodthoff, S. (2013). Loose lips sinking markets? The impact of political communication on sovereign bond spreads (Occasional Paper Series, No. 150). Gil, R., Mulligan, C. B., & Sala-i-Martin, X. (2004). Do democracies have different public policies than nondemocracies? Journal of Economic Perspectives, 18, 51–74.

150

P. E. PETRAKIS

Gradstein, M., & Milanovic, B. (2004). Does Liberte Égalité? A survey of the empirical evidence on the links between political democracy and income inequality. Journal of Economic Surveys, 18(4), 515–537. Grossman, G., & Helpman, E. (2001). Special interest politics. Cambridge and London, UK: MIT Press. Herwartz, H., & Theilen, B. (2014). On the political and fiscal determinants of income redistribution under federalism and democracy: Evidence from Germany. Public Choice, 159, 121–139. Holling, C. S. (1973). Resilience and stability of ecological systems. Annual Review of Ecology and Systematics, 4, 1–23. Inglehart, R. F. (1997). Modernization and postmodernazation: Changing values and political styles in advanced industrial society. Princeton: Princeton University Press. Inglehart, R. F., & Norris, P. (2016). Trump, Brexit, and the rise of populism: Economic have-nots and cultural backlash (Harvard Kennedy School Research Working Paper Series, RWP16-026). Jong-a-Pin, R. (2009). On the measurement of political instability and its impact on economic growth. European Journal of Political Economy, 25, 15–29. Kharas, H. (2010). The emerging middle class in developing countries. OECD Development Centre. Kormendi, R. C., & Mcguire, P. G. (1985). Macroeconomic determinants of growth: Cross-country evidence. Journal of Monetary Economics, 16(2), 141– 163. Lindert, P. H. (1994). The rise of social spending, 1880–1930. Explorations in Economic History, 31(1), 1–37. Lipset, S. M. (1959). Some social requisites of democracy: Economic development and political legitimacy. American Political Science Review, 53(1), 69–105. Marsiliani, L., & Renstrom, T. (2004). Political institutions and economic growth. Retrieved from http://ideas.repec.org/p/mmf/mmfc05/53.html. Mavrocordatos, G. (2000). Presure groups and democracy. Athens: Pataki Publications. Meltzer, A. M., & Richard, S. F. (1981). A rational theory of the size of government. Journal of Political Economy, 89, 914–927. Mudde, C. (2004). The populist zeitgeist. Government and Opposition, 39(4), 542–563. Mudde, C. (2013). The 2012 Stein Rokkan lecture: “Three Decades of Populist Radical Right Parties in Western Europe: So What?”. European Journal of Political Research, 52(1), 1–19. Olson, M. (1965). The logic of collective action, Harvard Economic Studies. Cambridge: Harvard University Press.

5

POLITICS AND GOVERNANCE

151

Olson, M. (1982). The rise and decline of nations: Economic growth, stagflation and social rigidities. New Have: Yale University. Papaioannou, E., & Siourounis, G. (2008). Democratization and growth. Retrieved from http://econ.uop.gr/~econ/RePEc/pdf/MS2005647democ_ and_growth.pdf. Pereira, C., & Teles, K. V. (2008). Political institutions matter for incipient but not for consolidated democracies: A political economic analysis of economic growth. Retrieved from http://ideas.repec.org/p/anp/en2008/200807211 539390.html. Perotti, R. (1992). Income distribution, politics, and growth. American Economic Review, American Economic Association, 82(2), 311–316. Persson, T., & Tabellini, G. (2001). Political institutions and policy outcomes: What are the stylized facts? Retrieved from www.cepr.org/meets/wkcn/1/ 1450/papers/Tabellini.pdf. Petrakis, P. E., Papadakis, E., & Daniilopoulou, N. (2012). Public statements on sovereign yield spreads: The Greek case. Cyprus Economic Policy Review, 6(2). Piketty, T. (2014). Capital in the twenty-first century. Harvard University Press. Prat, A., & Strömberg, D. (2013). The political economy of mass media, advances in economics and econometrics. Cambridge: Cambridge University Press. Rodrik, D. (1999). Democracies pay higher wages. Quarterly Journal of Economics, 114, 707–738. Rodrik, D. (2000). Institutions for high-quality growth: What they are and how to Acquire them. Studies in Comparative International Development, 35(3), 3–31. Rodrik, D. (2015). Premature deindustrialization (NBER Working Paper, No. 20935). Scheve, K., & Stasavage, D. (2009). Institutions, partisanship, and inequality in the long run. World Politics, 61, 215–253. Scheve, K., & Stasavage, D. (2010). The conscription of wealth: Mass warfare and the demand for progressive taxation. Inter. Organ, 64, 529–561. Scheve, K., & Stasavage, D. (2012). Democracy, war, and wealth: Lessons from two centuries of inheritance taxation. American Political Science Review, 106(1), 82–102. Siourounis, G., & Papaioannou, E. (2008). Democratisation and growth. The Economic Journal, 118, 1520–1551. Sirowy, L., & Inkeles, A. (1990). The effects of democracy on economic growth and inequality: A review. Studies in Comparative International Development, 25, 126–157. Tavares, J., & Wacziarg, R. (2001). How democracy affects growth. European Economic Review, 45, 1341–1378.

152

P. E. PETRAKIS

Vollmer, S., & Ziegler, M. (2009). Political institutions and human development, does democracy fulfill its “Constructive” and “Instrumental” role? (WBPR Working Paper, No. 4818). Weingast, B. (1995). The economic role of political institutions, marketpreserving federalism and economic development. Journal of Law, Economic & Organization, 11(1), 1–31. Williams, G., Duncan, A., Landell-Mills, P., & Unsworth, S. (2008). Politics and growth: An analytical framework, politics and growth. London, UK: The Policy Practice Ltd.

CHAPTER 6

Uncertainty

6.1

Introduction

The dimension of time entails the distinction between past, present, and future. But where there is a future, there is also uncertainty. Consequently, uncertainty is present in every aspect of human life. In particular, the projection of uncertainty in economic science is a significant issue, as it affects expectations and subsequently, human incentives for decisionmaking and ultimately, the decisions as such themselves. Concern over the prevalence of high levels of uncertainty has intensified in recent years. It is at the heart of economic science, given the global financial crisis of 2008 and the debt crisis in the Eurozone countries. The concept of uncertainty is already present in the first texts of political philosophers and, then, in those of political economy. In modern economics, uncertainty has many dimensions, which were first introduced by economists around 1950, but are, in fact the result of a wider debate within economic thought since the eighteenth century. Two streams can be distinguished that attempt to analyze uncertainty— which are completely separated between 1920 and 1950. A landmark in approaching uncertainty in economics is the work of Frank H. Knight, an economist of the Chicago school, Risk, Uncertainty and Profit (1921). His work forms the basis of the ongoing research into the concept of uncertainty in the modern, highly competitive environment.

© The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_6

153

154

P. E. PETRAKIS

6.2

Risks and Uncertainty

Knight, in his work Risk, Uncertainty and Profit distinguishes the concept of uncertainty from the concept of risk.1 1. The concept of risk: refers to events recurring with a relative frequency which are, therefore, highly likely to be accurately predicted. Therefore, past experience can be a crucial factor of predictability when engaging in strategic decision-making. 2. The concept of uncertainty: relates to non-recurring events, which, therefore, cannot be used as precursors to the unfolding of situations. Consequently, there is no prior experience giving an indication for the direction of developments. This chapter deals mainly with the concept of uncertainty, which is considered extremely important for the analysis of development and growth, since both concepts refer to future economic changes. On the contrary, the concept of risk has received much greater elaboration and is much more widely used in the field of finance. Uncertainty disorders and their impact on the real economy are at the heart of economic science, which studies uncertainty for at least three distinct things (Kozeniauskas & Veldkamp, 2017): 1. Macroeconomic uncertainty: refers to macroeconomic variables, such as GDP growth and unemployment rate. 2. Microeconomic uncertainty: refers to the evolution of business results. 3. Higher order uncertainty: the uncertainty of individuals in relation to the beliefs of others. Trying to measure risk and uncertainty is critical processes for businesses to be able make strategic decisions about future situations. The rejection of traditional methods of measuring uncertainty led to the creation of modern ways of measuring it, which fall into two main categories: • Quantitative indexes: they result from the creation of quantitative models that are used to make strategic decisions under conditions of

6

UNCERTAINTY

155

uncertainty over the short term, while their predictability may sometimes extend up to the medium-term. Other quantitative indicators of uncertainty focus on deviation from the trend of a variable or on volatility. Volatility Index (VIX) reflects the expectations of volatility and represents the uncertainty of the actors about future prices. • Qualitative indexes: they result from scenario planning 2 and are used for strategic decision-making under uncertainty over a long time span, from five up to fifty years. These two basic categories of uncertainty measurement (quantitative vs. qualitative variables) may have different starting points (use of quantitative vs. qualitative models), differentiated time span (short-term vs. long-term planning), and differentiated target (strategic planning for decision-making under low uncertainty vs. high uncertainty). When policymakers face an uncertain situation, they have three strategic options available: 1. Waiting: A waiting strategy enables policymakers to see how things will turn out and, once the negative effects are mitigated, take action. 2. Focusing: Focusing as a strategic option, implies that all resources can be directed to specific activities. 3. Flexibility: If the flexibility strategy is followed, policymakers have the ability to adapt easily and directly to ongoing external changes, in the belief that they can adequately assess future situations. However, the existence of uncertainty in a highly competitive, globalized environment, reduces the likelihood of adequately assessing future situations through quantitative indexes of uncertainty. Therefore, scenario planning is the only option for managing future uncertainty situations. The more policymakers avoid risk, the stronger the incentive they have to wait, postponing action for a later time. If policymakers act early, while there is still uncertainty, they must decide on how to manage their resources. They must choose whether to put all resources in a single scenario, or allocate them into different scenarios, thereby gaining in flexibility. This presupposes that they have previously created the appropriate scenarios, which include all the variables (economic, political, cultural, and geographical) that may influence future developments.

156

P. E. PETRAKIS

By extension, scenario can significantly contribute to the attempt to approach the “cloudy and uncertain future,” as Aristotle also, characteristically mentions. The nature of uncertainty is mainly due to two factors: • incomplete knowledge and information (incomplete knowledge or subjective uncertainty); • the existence of continuous and volatile events (system/process volatility or objective uncertainty). Limited knowledge as a factor of uncertainty comes directly from the following sources (Van Asselt & Rotmans, 2002; Walker et al., 2003): 1. Measurement inexactness: This is the uncertainty caused by the inadequate ability to measure the parameters and to correctly assess the information received, leading to uncertain situations, or by errors in the method of calculating uncertainty. 2. Lack of observations of measurements: This is important data and information very useful in calculating uncertainty, but which cannot be collected and used so as to limit it. 3. Practically immeasurable: These are cases where it is possible to calculate uncertainty on the basis of existing technical and technological capabilities, but this is not feasible due to other reasons, independent of such capabilities, e.g. lack of resources and high costs. 4. Conflicting evidence: Through the use of databases and recording of available data, through divergent estimates of qualitative aggregates, and due to the incorrect use of these, it is difficult to determine the nature of uncertainty and to calculate it. 5. Reducible ignorance: This is the case where uncertainty comes from the inability of businesses to understand what they actually know and what has escaped their attention. 6. Indeterminacy: This refers to a satisfactory level of knowledge of the data, the situations, and the institutional framework of market functioning, which, nevertheless, leads to the perception that the results are completely unpredictable.

6

UNCERTAINTY

157

7. Irreducible ignorance: This refers to the inability to compensate for uncertainty due to the fact that markets cannot evaluate it because of complete ignorance. Uncertainty due to system volatility is caused by (Petrakis & Konstantakopoulou, 2015): 1. Inherent randomness of nature: This is the existence of the uncertain and completely unpredictable function of societies and economies worldwide, which has a significant impact on business activity. 2. Value diversity: This refers to the uncertainty caused by different perspectives, subjectivity of views, experiences, cultural background, and rules under which societies and markets function. 3. Human behavior: This includes irrational behavior and continuous variations in the behavior of individuals which directly affect strategic business planning and impede the decision-making process. 4. Societal variability: This refers to social, economic, and cultural variables and dynamics and the ways in which they determine the nature of uncertainty. More specifically, it relates to the different way social processes and negotiations are performed with different value systems, to the exertion of social pressure, to the way economic institutions operate and to cultural specificity. 5. Technological surprises: This includes the uncertainty caused by the dynamics of technology and the prospects of new technological achievements and innovations, and the penetration of technology into a market, as well as the receptivity to these of the society and economy in which the business operates (Fig. 6.1). The creation of filters reducing the uncertainty that threatens businesses with failure in their investment policy and activity plays a crucial role in strategic decision-making. These filters lead to the classification of uncertainty into levels (Courtney, 2001; Courtney, Kirkland & Viguerie, 1997). At the base of the pyramid are placed the most common situations of uncertainty, while as we go up the pyramid, we come across situations of complete uncertainty and zero predictability. The situations described below have been studied mainly at the level of business and executives making decisions at the microeconomic level, but this scheme also applies

158

P. E. PETRAKIS

Uncertainty levels

Level 1: A clear enough future Level 2: Alternate futures Level 3: A range of futures Level 4: True ambiguity Level 5: An unknown future

1. Macroeconomic Uncertainty 2. Microeconomic Uncertainty 3. Uncertainty of Beliefs

Uncertainty sources

System/process volaƟlity 1. 2. 3. 4. 5.

Inherent randomness of nature Value diversity Human behavior Societal variability Technological surprises

Limited knowledge 1. 2. 3. 4. 5. 6. 7.

Ȼnexactness Lack of observaƟons of measurements PracƟcally immeasurable ConflicƟng evidence Reducible ignorance Indeterminacy Irreducible ignorance

Fig. 6.1 Uncertainty sources and levels (Source Author’s own creation)

to the macroeconomic level, when there are no countervailing forces to eliminate them (Fig. 6.2). Level 1: A clear enough future The first level of uncertainty refers to those cases where the future can be estimated with a satisfactory degree of predictability. At this level, we can satisfactorily know the realization of an action as well as the time to achieve it. In the clear enough future, economic actors can make more confident decisions by limiting the degree of failure, as they are able to identify trends that will prevail in the short and long term through proper study of market parameters. Statistics, data, and market research (e.g., demographics, cultural variables, study of the competition and the industry, financial statements) may point to a direction on how demand

6

UNCERTAINTY

159

5th Level: A Completely Unkown Future

4th Level: True Ambiguity

3rd Level: A Range of Futures

2nd Level: Alterna ve Futures

1st Level: A Clear Enough Future

Fig. 6.2 Uncertainty levels (Source Author’s own creation)

may potentially be formed. Another characteristic of this level is the existence of parameters that, while seemingly unknown, can become known and identifiable through appropriate processing. A typical example of 1-level uncertainty in businesses is the possibility of a new competitor entering the market and providing similar services. Level 2: Alternate futures The second level of uncertainty refers to more problematic situations than the first, as several new parameters emerge. At this particular level of uncertainty, the outcome is only partially known. Time, however, plays a very important role in trying to predict when that outcome will be achieved. At the second level of uncertainty, the perspective is known in advance, but the parameters are more unclear that relate to the timing of achieving the outcome, as well as the particular circumstances under which it will take place, even though the expected outcome will be identifiable with some clarity. At the business level, the strategy each player will follow in the market depends more on the strategy of their competitors and less on what kind of strategy the player himself will choose.

160

P. E. PETRAKIS

However, even competitors’ strategies at this level are relatively unclear, as, pure business activities aside, the macroeconomic environment and the intentions of the institutions, play a key role. A typical example of 2-level uncertainty is the case when the state wishes to change the laws regarding how certain sectors operate and the “opening up” of professions. Before the state changes such laws, there is a time of intense uncertainty, including uncertainty about when such a situation will take effect. Moreover, until the final agreement is reached, there will be restlessness, consultations, and behind-the-scenes discussions between the social partners and the businessmen, as well as adoption and ratification of laws by the legislative powers. All strategies to prevent 2-level uncertainty must come from the use of distinct scenarios that consider all possible alternatives. Level 3: A range of futures The third level of uncertainty is associated with the likelihood of even higher restrictions on the ability to predict the outcome. Based on the third level of uncertainty, the potential final outcomes are numerous and very difficult to predict, even if we resort to the logic of creating many alternative scenarios. The bounds between which possible outcomes fluctuate are very wide, making it difficult to develop strategies and make effective and profitable decisions. Consequently, at this level of uncertainty, there are no physically discrete scenarios associated with the outcome. A typical example of 3-level uncertainty are businesses that want to operate and invest in new and emerging sectors of the economy or markets unknown to them in terms of geography—mainly in developed countries—in order to promote their products and services. Businesses that are active in or want to enter new and unknown sectors face problems related to the unclear institutional and legal environment in which they wish to operate and the demand that is expected to be formed, as the impact is thoroughly unknown of the products and services of the business on consumers. This obviously hampers the business strategy, as both the cost of production and the pricing policy to be followed are often hidden from view.

6

UNCERTAINTY

161

Level 4: True ambiguity The fourth level of uncertainty relates to the existence of uncertainty about possible outcomes. This is a level of uncertainty in quite particular circumstances, where economic actors are unable to understand or even approximate the outcome, regardless of the intensity and range of scenarios used. Unlike the third level of uncertainty, the range itself of possible outcomes is very fuzzy and impossible to determine. At the fourth level of uncertainty volatile macroeconomic variables emerge which economic actors cannot define or even barely distinguish and which call for oracular powers rather than scientific methods. A typical example of 4-level uncertainty is the investment effort of businesses to expand by investing in either emerging markets or markets with severe macroeconomic problems and in a state of complete volatility, as in many countries in Africa, Latin America, and Asia. In such economies, there is a great uncertainty about the perspectives of the economy, regarding key macroeconomic variables inextricably linked to demand, such as inflation evolution, unemployment, and foreign exchange rates. The problem is even more aggravated in countries under totalitarian regimes, with a high rate of corruption, as well as in countries where war conflicts are raging. Other problems that businesses face in cases of 4level uncertainty are the lack of proper legal framework and the constant changes of laws, regulations, and property rights, related to either the investment regime or the tax regime. Level 5: An unknown future The fifth and last level of uncertainty is identified with the unknown in all its manifestations. The complete ignorance that results from the fifth level of uncertainty, can only be accounted by extreme concepts such as “totally unpredictable” or “enormous surprise.” The levels of uncertainty have been graded in such a way as to show the investment potential of the economic actors, and at the same time, enable them to understand what strategies to develop and what decisions to make in order to limit the uncertain situations they face and manage to increase the chances of successful business. It should be made clear that the level of risk a business faces, regardless of the industry or the market in which it operates, does not necessarily remain constant throughout its business

162

P. E. PETRAKIS

course. A business, depending on the strategies it adopts and their results, may shift from one level of uncertainty to another one, either higher or lower. There are specific strategies that a company can follow to limit its exposure to risk for each level of uncertainty (uncertainty management). At least half of the strategic problems that businesses have to face belong to the second and third levels of uncertainty, while most of the rest belong to the first level. However, most executives, in their attempt to develop strategies dealing with uncertainty, act as if developing strategies to deal with uncertainty of the first or fourth level. Of course, this doesn’t seem appropriate, as a different set of strategies needs to be followed for each level of uncertainty. A typical example of 5-level uncertainty is the financial crisis that started with the collapse of the US mortgage market in 2007 and, of course, the devastating consequences that followed in the wake of this crisis, through its spread to European countries. This whole situation made particularly clear the disadvantages of how the markets of the developed Western world had been operating up to that point and helped to change the balance—economic and social–globally. Another typical example of 5-level uncertainty is the large-scale damages related to natural phenomena that are almost impossible to predict, e.g., the massive earthquake in Japan in 2011 which had nuclear repercussions and greatly affected the economy of a particularly robust country and, naturally, the businesses operating in it. As can be seen from the above analysis, the possibilities for developing flexible risk hedging strategies at the fifth level of uncertainty are very limited and transnational measures and agreements are required to be taken. But even these possibilities require highly flexible, diplomatic, and complementary policies, as each country is primarily interested in defending its own particular interests.

6.3

The Global Outlook on Risk and Uncertainty

The Great Recession of 2008 extended the climate of uncertainty already present in the global economy during the last decades of the twentieth century, into the first decades of the twenty-first century as well. In an attempt to quantify uncertainty, Baker, Bloom, and Davis (2015) invented the Economic Policy Uncertainty-EPU Index for the USA3 and subsequently, for a number of major economies (Australia, Canada, Europe, France, Italy). Figure 6.3 shows the Global EPU Index. The Global EPU

6

UNCERTAINTY

163

Index value (units) 400 350 300 250 200 150

Financial crisis in Russia and China

9/11

Iraq Invasion

Global Financial Crisis

Eurozone Crisis, change of leadership in China, US fiscal “baƩle”

MigraƟon flows, Fears about the course of the Chinese Economy

Covid-19 Trade crisis War USAChina Trump eclecƟon

Brexit

100 50 lowest index value before the crisis

1997 1997 1998 1999 2000 2000 2001 2002 2003 2003 2004 2005 2006 2006 2007 2008 2009 2009 2010 2011 2012 2012 2013 2014 2015 2015 2016 2017 2018 2018 2019

0

Fig. 6.3 Global Index of Economic Policy Uncertainty (Source Davis 2016 and author’s own creation)

Index is the weighted average of the national EPU indices, based on the GDP of 16 countries: Australia, Brazil, Canada, China, France, Germany, India, Ireland, Italy, Japan, Russia, South Korea, Spain, United Kingdom, and the United States of America. The peaks in the graph reflect the intensification of the climate of uncertainty due to significant developments after the 1980s. Figure 6.3 shows the Global EPU Index. The most important negative events that have taken place are reflected in the strong peaks of the index, such as the Great Recession of 2008, the Brexit, and the COVID-19 pandemic of 2020. Figure 6.4 presents the risk levels in the largest economies based on the Oxford Economics Economic Risk Index. The evolution of the index follows a stabilization course at higher levels than in the pre-Great Recession of 2008 period, until the beginning of 2020.4 Focusing on the latest major source of uncertainty, the COVID-19 pandemic, one can observe a projection of the evolution of the world and how rare events can shape the global outlook on risk and uncertainty in the future. Covid-19 has spread almost all over the world. This development has led to the imposition of quarantine measures and social distancing, while

164

P. E. PETRAKIS

5

4.5

4

3.5

3

2.5

2

1.5 2006

2007 USA

2008

2009 China

2010

2011

2012

Japan

2013

2014 France

2015

2016

2017

Germany

2018

2019 UK

Fig. 6.4 Economic risk index by Oxford economics (Source Oxford EconomicsGlobal Economic Model (January 2020) and author’s own creation. Note The index receives values from 1 to 10, where 1 = lower risk, 10 = higher risk)

the fear of transmitting the virus and the loss of income have increased uncertainty around the world. Ahir, Bloom, and Furceri (2018) in an effort to quantify the uncertainty associated with Covid-19 pandemic, construct the World Pandemic Uncertainty Index (WPUI) which is a measure of comparison with the uncertainty caused by previous pandemics/epidemics. As Fig. 6.5 presents, the level of uncertainty associated with the Covid19 pandemic was unprecedented. On March 31, 2020 the uncertainty was three times higher than the uncertainty that prevailed during the SARS epidemic in the period 2002–2003 and twenty times the uncertainty during the Ebola epidemic. The level of uncertainty surrounding the coronavirus is expected to remain high as active cases of Covid-19 infected continue to exist (at the time the book was written) and it was not yet clear when the crisis would end. High uncertainty historically coincides with periods of low growth and tighter financial conditions. The level of uncertainty associated with the

6

UNCERTAINTY

165

COVID-19 2020

14

12

10

8

6

SARS 200203

4

Avian flu 2003-09

2

0 Q1-1996

Q1-2002

Q1-2008

Swine flu Bird flu 2009-10 2013-17

Ebola 201416

Q1-2014

MERS 2014-20

Q1-2020

Fig. 6.5 World Pandemic Uncertainty Index (WPUI) (Source Ahir et al. [2018] and author’s own creation)

coronavirus crisis was no exception, as the economic impact was visible in the countries affected by the pandemic. The Covid-19 crisis has shown in the most categorical way that rare events at any time can take place and change the prevailing social and economic conditions. The big question is whether we are prepared to deal with future rare events. The answer to the above question is not easy as generally people tend to be well prepared for high-probability events following the right actions, and consequently the losses of a negative event are quite small. In contrast, in low-probability events, individuals are initially unprepared for these events, and then take bad actions and as a result the expected

166

P. E. PETRAKIS

losses are great. Crisis management is the second major issue that arises. Ma´ckowiak and Wiederholt (2020) suggest a guide for future similar situations: 1. When a rare event occurs, individuals must recognize that they are not prepared to act in this situation and that they must think carefully before making decisions. 2. Second, policymakers must recognize that individuals do not behave in an optimal manner in a rare event. 3. Policymakers will need to set up a central information processing system to take advantage of economies of scale in information processing to help them make their choices. 4. Approving legislation that subsidizes or requires preparation for future rare events can improve the well-being of society. At the same time, the COVID-19 pandemic made it clear that uncertainty may be due to policy responses to the virus and not just the pandemic itself. While the rise in uncertainty stemming from international politics is largely due to populist phenomena (Brexit, Trump authorities), there is no shortage of cases where policymakers have exacerbated the climate of uncertainty. A typical example is during the Great Recession of 2008 where the central banks contributed to policy uncertainty, alongside increased international uncertainty (Müller, 2020). The global outlook on risks and uncertainty expected to affect the economy and investment climate in the long term in the early twenty-first century is delineated (World Economic Forum, 2016, 2017) by: 1. Extreme weather events (e.g., floods, storms, etc.): Significant damages to property, infrastructure, and the environment, as well as human casualties due to extreme weather events. 2. Large-scale migration: Unintentional migration caused by conflicts, disasters, environmental, or economic reasons. 3. Major natural disasters (e.g., earthquakes, tsunamis, volcanic eruptions, geomagnetic storms): Damages to property, infrastructure, and the environment, as well as human casualties due to geophysical disasters.

6

UNCERTAINTY

167

4. Large-Scale Terrorist Attacks: Individuals or non-state groups with political or religious objectives that successfully cause large-scale human casualties or material damages. 5. Incidents of massive data theft: Illegal exploitation of private or other official data on an unprecedented scale. 6. Failure to mitigate the effects of climate change and to adapt to it: Governments and businesses failing to implement or adopt effective measures to mitigate climate change to protect individuals and help businesses affected by climate change. 7. Intrastate conflicts with local/regional consequences: Bilateral or multilateral differences within states, escalating to economic (e.g., trade/monetary war, nationalization of resources), military, social, or other types of conflicts. 8. Illegal trade (e.g., illegal financial flows, tax evasion, human trafficking, organized crime, etc.): Large-scale activities outside the legal framework, such as illegal financial flows, tax evasion, human trafficking, counterfeiting, and organized crime, which undermine social interactions, regional or international partnerships and global development. 9. High structural unemployment or underemployment: A prolonged high level of unemployment or insufficient utilization of the productive potential of the working population, which prevents economies from achieving high employment rates. 10. Crisis over the quantity of available water: Significant reduction of the quality and quantity of clean water available, resulting in harmful effects on human health or/and economic activity. 11. Failure of national governments (e.g. failure of the rule of law, corruption, political stalemate, etc.): Inability to govern nations of geopolitical importance due to the weak rule of law, corruption, and political stagnation. Beyond the above, however, global risk factors are also expected to be affected by the emerging technologies of the fourth industrial revolution. How will human beings be able to handle the challenges of new technologies is a complicated question. Too fast and large-scale reform may slow progress, but a lack of governance can exacerbate risks as well as create uncertainty, not useful to potential investors and innovators.

168

P. E. PETRAKIS

6.4

The Economic Outcome of Uncertainty

The high levels of uncertainty regarding macroeconomic figures indicate that the overall effective functioning of economies is deteriorating. The impact of uncertainty on the economy varies as it shapes the behaviors and actions of economic actors, leading to deviations from the optimal pattern of resource allocation. The effects of uncertainty and risk on the real economy become evident by the contraction of production, increasing unemployment, and a decline in investment activity. Production, employment, productivity, and investment are being reduced in response to an unexpected increase in uncertainty. The role of uncertainty in investment decision-making has been pointed out in the literature by Marschak (1949) and Arrow (1968). The evolution of uncertainty is intertwined with the evolution of the economic cycle and, particularly, with the recession phase, as we observe businesses either delaying or postponing their investment activity. As a result, the effects of the recession are widening and the negative effects of the crisis become even more apparent. During growth periods, levels of uncertainty are lower than during periods of recession. Keynesian theory places uncertainty at the center of the debate on the evolution of the economy, starting with the Great Depression of 1929. The sources of uncertainty and its impact on economic performance vary. However, they have the same effect, as they spread throughout the economy as apparent long-term effects. The impact of uncertainty on the economy can be determined at macro-economic and microeconomic levels. At the macroeconomic level, uncertainty has an impact on fiscal and monetary policy. At the microeconomic level, increased uncertainty affects the consumption and investment decisions of businesses and households. As a result, the potential output of the economy is curtailed, causing a deepening of the recession. Many studies investigate the impact of uncertainty on economic activity, as uncertainty plays an important role in economic policymaking. Complex relationships that are created in an environment dominated by uncertainty about the future state of the economy, do not favor the making of long-term policy decisions. Decisions are limited to a shorter-term with a lack of long-term planning. So, the existence of uncertainty affects the investment decision-making process both in the short and long term. Suspension of investment and employment, due to high uncertainty, may lead to economic recession. Moreover, the existence of

6

UNCERTAINTY

169

uncertainty may have a significant effect on the cost of consumption or lead workers to seek higher wages which, if implemented, will hurt employment and hence, investments and GDP. The impact of uncertainty also affects other areas, such as increased financing costs, high-risk aversion, and intensification of the principal–agent problem. In conditions of high uncertainty, economic actors demand a higher risk premium resulting in higher borrowing costs. In such a case, higher borrowing costs create a constraint on the economy as businesses have no access to financing. A typical characteristic of countries with high uncertainty over time is reflected in the prevalence of the traditional SME productivity model, leading to absence of innovative business activity, the prevalence of smallscale business activity and, from time to time, the incidence of “bank liquidity panic.” While it is widely accepted that volatility (or uncertainty) has an impact on the real economy, the problem of endogeneity poses problems concerning the direction of causality. While we realize that uncertainty slows economic growth, it is not easy to empirically explore the inverse relationship, namely, whether bad economic conditions increase the levels of uncertainty in the economy. The existing literature identifies another situation through which uncertainty affects economic performance (Bloom, 2014). This is associated with the emergence of the “wait and see” rule, as economic actors postpone decision-making for the future. But this way, businesses do not invest while, at the same time, consumers limit their purchases only to durable goods. Moreover, there are theoretical approaches that support the opposite view, namely, that uncertainty can contribute to improved economic performance (Bar-Ban & Strange, 1996). Sandmo (1970) and Black (1987) believe that increased uncertainty can accelerate the average growth rate as investors seek higher average returns as a result of higher risk. Finally, there are also studies showing that the effect of uncertainty on economic activity is not significant (Bachmann & Bayer, 2011; Bachmann, Elstener, & Sims 2010; Knotek & Khan, 2011).

Notes 1. Historically, Knight’s view of risk was accepted, while that of uncertainty gave rise to controversy. The first approach, influenced by David Hume,

170

P. E. PETRAKIS

Adam Smith, and Carl Menger, considers uncertainty as the fundamental source of economic phenomena, since the economy is not a fully defined system and therefore, the problem of knowledge is insurmountable. The second approach, influenced by marginal economics, interprets uncertainty as a subjective probability problem. Indeed, William Stanley Jevons (1835– 1882), based on the idea of regularity and average, assumes that future certainty could be achieved on the basis of sufficient historical evidence. The neoclassical approach, in tackling the problem of uncertainty, assumes full information and rational action by individuals. 2. Company executives used Scenario Planning try to predict the future. Scenario planning was developed by the military and used during World War II as a key preparation tool to counter enemy strategies. In an environment of rapid technological changes, businesses use scenario planning to identify potential market opportunities. Scenario planning is usually used for long-term decision-making actions that will be made by the company at present and whose results will remain visible for a long time (5–50 years) (Kennedy and Avila, 2013). 3. US EPU index calculates policy-related economic uncertainty, which consists of three types of underlying data: The first component quantifies the coverage by the policy-related type of economic uncertainty. The second component reflects the number of federal provisions of the tax code that will apply in the coming years. The third component uses disagreement among financial analysts as a means of estimating uncertainty. 4. However the course of the index is expected to change in 2020 with the outbreak of COVID-19 crisis, as at the time the book was written (May 2020) there were no available data.

References Ahir, H., Bloom, N., & Furceri, D. (2018). World Uncertainty Index. Stanford mimeo. Arrow, K. J. (1968). Optimal capital policy with irreversible investment. In J. N. Wolfe (Ed.), Value, capital and growth. Edinburgh: Edinburgh University Press. Bachmann, R., & Bayer, C. (2011). Uncertainty business cycles-really? Retrieved from http://www.wiwi.unibonn.de/bayer/Working_Papers_files/bachmann_ bayer_UBCR.pdf. Bachmann, R., Elstener, S., & Sims, E. (2010 [2013]). Uncertainty and economic activity: Evidence from business survey data. American Economic Journal: Macroeconomics, 5, 217–249. Retrieved from http://www.nd.edu/ ~esims1/bachmann_elstner_sims_current.pdf.

6

UNCERTAINTY

171

Baker, S. R., Bloom, N., & Davis, S. J. (2015). Measuring economic policy uncertainty (NBER Working Paper, No 21633). Bar-Ban, A., & Strange, W. (1996). Investment lags. American Economic Review, 86(3), 610–622. Black, F. (1987). Business cycles and equilibrium. New York: Basil Blackwell. Bloom, N. (2014). Fluctuations in uncertainty. Journal of Economic Perspectives, 28(2), 153–176. Courtney, H. (2001). 20/20 Foresight: Crafting strategy in an uncertain world. Boston: Harvard Business School Press. Courtney, H., Kirkland, J., & Viguerie, P. (1997). Strategy under uncertainty. Harvard Business Review, 75(6), 67–79. Kennedy, P. J., & Avila, R. J. (2013). Decision making under extreme uncertainty: Blending quantitative modeling and scenario planning. Strategy & Leadership, 41(4), 30–36. https://doi.org/10.1108/SL-04-2013-0025. Knight, F. (1921). Risk, uncertainty and profit. Boston, MA: Houghton Mifflin Co. Knotek, E., & Khan, S. (2011). How do households respond to uncertainty shocks? Kansas City Federal Reserve Board Economic Review, 96(2), 5–34. Kozeniauskas, N., & Veldkamp, L. (2017). Unusual outcomes and uncertain times. Vox CEPR, Policy Portal, voxEU.org. Retrieved from http://voxeu. org/article/unusual-outcomes-and-uncertain-times. Ma´ckowiak, B., & Wiederholt, M. (2020). Lack of preparation for rare events and policy implications in the time of COVID-19. VoxEU.org. Marschak, J. (1949). Role of liquidity under complete and incomplete information. The American Economic Review, Papers and Proceedings of the Sixty-first Annual Meeting of the American Economic Association, The American Economic Association Via JSTOR, 39(3), 182–195. https://doi.org/10. 2307/1831743. JSTOR 1831743. Müller, H. (2020). COVID-19: Governments must avoid creating additional uncertainty. VoxEU.org. Petrakis, P., & Konstantakopoulou, D. (2015). Uncertainty in entrepreneurial decision making the competitive advantages of strategic creativity. New York, NY, USA: Palgrave Macmillan. Sandmo, A. (1970). The effect of uncertainty on saving decisions. Review of Economic Studies, 37 (3), 353–360. Van Asselt, M. B. A., & Rotmans, J. (2002). Uncertainty in integrated assessment modelling. Climate Change, 54(1), 75–105. Walker, W., Harremoës, P., Rotmans, J., Van der Sluijs, J., Van Asselt, M. B. A., Jansen, P., & Krayer Von Krauss, M. P. (2003). Defining uncertainty: A conceptual basis for uncertainty management in model-based decision support. Journal of Integrated Assessment, 4, 5–17.

172

P. E. PETRAKIS

World Economic Forum. (2016). Global Risk Report 2016. Retrieved from http://www3.weforum.org/docs/GRR/WEF_GRR16.pdf. World Economic Forum. (2017). Global Risk Report 2017 . Retrieved from http://www3.weforum.org/docs/GRR17_Report_web.pdf.

CHAPTER 7

Expectations

7.1

Introduction

Expectations are about how people form their perceptions of the future. Essentially, they are the human response to the existence of uncertainty. They are the projection of human behavior over time and concern the ways in which an individual makes decisions. It should be noted that both the fundamental economic issues, the one related to closing the output gap and the other related to enhancing growth potential, are future-related processes. Expectations are therefore a crucial component in addressing these issues, both in theory and in policymaking. The Great Recession of 2008 intensified the critical discourse about the determinants of the expectations of economic actors and about which models of expectations are best suited for use in macroeconomic growth models. This discourse is not recent; it has already been at the heart of economic thought since the 1970s, where rational expectations replaced adaptive expectations, which, until then, was the most widely accepted way of shaping expectations. These considerations intensified in the wake of the Great Recession of 2008 because of economists’ failure to foresee it. Indeed, there is the suspicion that the forecasting models incorporated expectations in such a manner that it was impossible to allow predictions for the future. This view mainly concerned rational expectations but adaptive expectations as well. © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_7

173

174

P. E. PETRAKIS

Although the role of expectations in shaping economic theory and policy has been acknowledged, there is still strong disagreement around the manner in which they are shaped and modeled. A ready example is the way in which current consumption depends on expected future income. But what information do individuals take into account in order to assess their future income? The discourse on rational versus adaptive expectations follows the wider debate between dominant schools of economic thought (neoclassical VS Keynesian VS New Keynesian) and the non-dominant ones, such as the heterodox approach. The neoclassical school of thought is built on the assumption of rational expectations. Other schools of thought criticize this assumption and look for different approaches to how expectations are being shaped.

7.2

Foresight and Forecasts

The existence of uncertainty in every aspect of economic activity leads individuals, enterprises, and policymakers to assessments about the future. The presence of time introduces the concepts of volatility and risk, which influence decisions about the future. Changes and the uncertainty that accompanies them, oftentimes make planning difficult or even impossible. There will always be some who are willing to accept whatever the future holds for them. These are the ones who believe that the future is predetermined and, therefore, there is no wiggle margin for action. They rely on the notion that, since no intervention is possible, then they should not so much as be concerned about it. They also believe that since the future cannot be predicted, considering it is merely a waste of resources (time, effort, etc.). It is evident that many people are keenly inclined to avoid any thought about the picture of the future, but also their position in that picture. Still, most people realize that, given that the future cannot be predicted, it is advisable to prepare for different versions of it. Thus, believing that human beings are rational and that their every action is based on logic, they consider that, as rational thinkers, they should prepare for possible future situations and for whatever will bring about changes to their current situation in the future. Lack of preparation signifies failure, while good preparation helps to overcome problems and difficulties. The underlying premise behind all methods of predicting the future, is that the present—as opposed to the future—literally exists, and we are

7

EXPECTATIONS

175

experiencing it. The future is not known and it is not possible to make it known in the present. Nevertheless, one can theoretically have “access” to the future, albeit in an abstract way. Knowledge of the past and the present, as well as the ability to use logic in combination with imagination, allows us to give “form” to the possible future. Both the individual, as well as organizations and enterprises, necessarily need to try to intervene in the future in order to shape it—to the extent possible—as they wish. Yet, in order to intervene, they need to be able to predict it. The endeavor begins with an assessment of the potential changes in the environment in which they operate. The failure of predictions is particularly severe when changes are rapid and turbulent or when the information available cannot be deemed to be useful (due either to a lack or an abundance of data). Consequently, significant opportunities and serious threats which will occur in the environment, might be overlooked, resulting in survival becoming endangered. In the attempt to tackle the uncertain nature of the future, a central issue is the meticulous and continuous monitoring of events and the identification of the conditions that cause changes. The dominant factor of the whole process is the detection and monitoring of trends. Trend is the dominant direction of the development process observed in a sequence of events, as opposed to the individual elements that occasionally comprise these events. It is the trends which indicate the coming changes and the picture of new situations that are under way. New situations require adjustments to, and even modifications of central strategic axes, aiming on in pursuance of the objectives set on each particular occasion. It is particularly useful to distinguish between strong and less powerful trends. There are some trends that are very strong and persist over long periods with no major changes. Other trends, however, are relatively weak and subject to sudden and significant changes. Therefore, trends are a viable factor in maintaining continuity between past–present–future, but they are also a factor causing change. Some of the changes they cause are very subtle, with slight deviations from the norm, while others are enormous and occur suddenly. The notion of foresight has its roots in a deep comprehension of trends. Foresight and, at a later stage, the ability to predict accurately, is a key component of successful businesses and a characteristic needed to successfully address the changes occurring. It signals the ability to see changes before they become trends, to see patterns as they emerge, and to understand the characteristics of the social trends likely to shape the

176

P. E. PETRAKIS

course of future processes. Therefore, the role of forecasts is to provide entrepreneurs and policymakers with the opportunity to hearken to the future and the impacts flowing from it, through the use of contemporary processes and an ongoing evaluation of alternatives. New information and events which people either ignored or thought would never take place and which, therefore, were outside their field of predictions, are usually more frequent and common than they think. Most importantly, their influence is far greater than one might imagine.

7.3

Forecasts and Expectations

Economic theory and, in particular macroeconomic and growth models, ascribes a central position to expectations. The current debate on the role of expectations is gaining ever greater interest, having the Great Recession of 2008 as its starting point. As economic models have a dynamic perspective, expectations for future developments influence current decisions and thus determine social phenomena. The notion of expectations, certainly, does not always coincide with that of forecasts, although one might argue that the expectations of professional forecasters do coincide with their forecasts. We therefore find that the expectations of professional forecasters and the actual fundamental economic figures (Fig. 7.1) unfold in parallel. This does not mean, however, that they predict the future with accuracy. In fact, what is shown in Fig. 7.1 is that expectations are adjusted very quickly to real developments, since expectations can be formulated on a monthly basis and, as such, can be continuously adjusted. Individuals’ economic choices are based on expectations of what will happen in the future, through adjusting their behavior accordingly. At the same time, human behavior is, in most cases, being influenced by changes in terms of the beliefs of third parties. As collective beliefs change, altering expectations, at the same time the course of the economy is affected. Interest in the importance of expectations goes through two channels of reflection to do with: 1. the role of expectations in economic models and their ability to effectively incorporate human behavior into decision-making, and 2. the types of expectations (rational versus adaptive or other expectations) involving a better explanation of human behavior.

7

EXPECTATIONS

177

6% 4% 2% 0% -2 % -4 % -6 % -8 % Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Expected GDP Growth Rate

GDP Growth Rate

Fig. 7.1 GDP growth rate and expected GDP growth rate in the Euro area (Source Oxford Economics, ECB-Survey of Professional Forecasters and author’s own creation)

7.4

Adam Smith and Expectations

For Adam Smith, economic agents are in a constant process of seeking new knowledge that will enable them to understand the transaction. Adam Smith indirectly introduces the idea of expectations and uncertainty into various aspects of his work. He recognizes the instability of human nature as individuals possess limited rationality and, as a result, do not have sufficient understanding of economic reality or, else, they have limited information. We use the notion of natural prices1 which serve as a reference point in shaping expectations. They are known to the participants in a transaction process and are essentially the measure of the predictability of behavior. Thus, through “natural prices,” expectations are introduced as a condition of market stability. Expectations are the key elements in shaping market clearing mechanisms. Thus, the current price is not the only element for providing information to agents. Adam Smith, in order to determine prices in a competitive market, relies upon an institutional framework that provides agents with the tools

178

P. E. PETRAKIS

needed to reduce uncertainty. Institutions provide the necessary information to the agents in order to define their decisions and, thereby, institutions contribute to shaping expectations by increasing the likelihood of the realization of a desired scenario over others. It is important to note that Adam Smith does not use past experience as a key determinant of price formation. That is, the expectations for Adam Smith do not arise by past events. In turn, natural prices do not reflect average market prices from past transactions, otherwise they would be determined during the transaction and not beyond. At the same time, natural prices consist of wages, profits, and earnings, individual components that are not easy to be estimated, since effective demand2 depends on natural prices. A change in employees’ expectations (e.g., due to a possible increase in the price level) will result in a change of the natural price. Regarding the natural level of profit, Smith considers it as the most difficult part to be determined. Individuals shape their expectations based on profit and cost of money. However, as Smith points out, it is not easy to determine precisely the average earnings per share but also the interest rates.3 Smith’s natural price of the substance is the pillar of expectations in determining the competitive exchange.4 Deviations in market price from natural price require the existence of a mechanism to eliminate them. This is what Smith calls “gravity” and is a tool for correcting price fluctuations between the quantities offered and the quantities demanded. The competitive exchange is the one that determines the difference between the real price (market price) and the expected (natural price). The market price is determined during the exchange based on effective demand and supply.5 The identification between the natural price and the market price determines the stability of the market. Therefore, expectations are thus involved through natural prices in determining equilibrium. The greater the divergence between market price and expectations (natural price) the more the competition is being manifested at its highest level, signaling the levels of production. If the market price is lower than expected, then the producers reduce all components of the production process (wages, profits, income) to levels below the natural rate. In the opposite case, where the market price is higher than expected, then the higher expected income of the producers allows the factors of production to be compensated above the natural rate. Temporary changes in effective demand are those causing the imbalances between supply and demand.

7

EXPECTATIONS

179

Economic agents follow certain rules to make a transaction based on the information available for decision-making. These rules are internalized by individuals during the exchange process, expressing the commercial relationship and thus are unknown terms that allow us to understand the functioning of the competitive market. Smith presumes that agents have sufficient knowledge and information to understand the difference of the expected price from the market price.

7.5

Adaptive Expectations

Adaptive expectations were first used as a concept by Nerlove (1958), who stated that his theory of adaptive expectations was derived from Hicksian6 elasticity of expectations. Adaptive expectations had a dominant role in the 1960s and 1970s. According to Nerlove’s (1958) assumption on adaptive expectations, the individual reconsiders his expectations for the future, based on his own forecasting error.7 Individuals, that is, shape their expectations based on the past. Thus, the expected value can be considered the sum of the immediate past expectations and the weighted error. The individual shapes his expectations using the current forecasting errors he has perceived to revise his previous expectations. If, therefore, there is a perfect forecast for the prior period, the previous forecast will be maintained for as long as extrinsic factors affect actual values. Past expectations and past values of variables are being incorporated in the present expectations. The fact that adaptive expectations are based on historical data has been at the center of criticism, as their main disadvantage since they ignore forward looking. Part of the criticism focuses on the fact that expectations function as a process that actually influences the decisions of the individual rather than being a mean of assessing the future. It is thus argued that adaptive expectations suggest that history influences reality. The argument of adaptive expectations is that history influences behavior and beliefs about the future. Forecasting errors can interfere and therefore expectations may mutually influence each other, hence expectations could fall short of reality when conditions are changing. Changes in the trend of one variable may derive from the change of another variable which in turn has been affected by current conditions (e.g., due to the financial crisis). This implies that

180

P. E. PETRAKIS

the value of the variable depends not only on past values but also on the values of other relevant variables in the past, present, and future. Box 7.1 Adaptive Expectations Chow (2011) considers that the case of adaptive expectations presupposes that economic agents act as good statisticians, although he stresses that the rejection of adaptive expectations by the dominant neoclassical school has no empirical basis.8 For Nerlove (1958) the question of expectations arises in the context of the mechanism that determines future prices. As he points out, the question that arises is whether entrepreneurs try to predict a specific value for an economic variable or are trying to forecast the “normal” level of future values of the variable. The hypothesis of adaptive expectations, according to Nerlove (1958), implies the existence of “expected price” as a weighted average of past prices, with the weights declining geometrically as one goes back in time: Pt∗ = H (1 − β)t +

t  λ=0

β(1 − β)t−λ pλ−1

where Pt∗ is the expectations of individuals during period t of the longterm “normal ” price, H is a constant value depending on the initial condition, βdenotes the expectation factor. Assuming that the economy was in equilibrium before the period t = 0 and all values are expressed as deviations from the equilibrium value at time t = 0, then H equals zero and the above equation becomes: Pt∗ =

t  λ=0

β(1 − β)t−λ pλ−1

In this manner, Nerlove (1958) expresses normal values as a weighted average of past values. However, since the expected value is not observable at t = 0, the weighted average of values depends on the prior period value and the correction parameter taking into account the actual and expected value at t −1.

7

7.6

EXPECTATIONS

181

Rational Expectations

Rational expectations are introduced in Muth’s (1961) work entitled “Rational Expectations and the Theory of Price Movements.”9 Expectations are forecasts for the future that incorporate all the information available. The accuracy of information about the future is uncertain and uncertainty concerns not only the future but also the misinterpretation of the current situations and the impacts they have.10 Rational expectations assume that human knowledge is being inductively acquired through the learning process and presuppose the existence of a stable reality (ergodic world), therefore the conformation of expectations always takes into account the effects of economic policy (which is the product of the application of the economic model). Therefore, expectations are shaped according to the forecasts of the economic model. Thus, according to some analysts, expectations as an independent human process are neutralized and being replaced by economic forecasts. The hypothesis of rational expectations is often criticized as to whether expectations can be modeled. The fact that rational expectations are an optimal process which finally eliminates systematic errors does not appear to be consistent with the view that rational expectations are born out of uncertainty, so, as the future cannot be predicted, expectations cannot be truly “rational.” An additional problem related to the assumption of rational expectations is about aggregate behavior: As the assumption of individual behavior does not automatically determine the behavior of the aggregate, the same holds for rationality. Even if all individuals follow rational expectations, the representative household characterized by these behaviors may have such a behavior which does not fulfills the rational hypothesis. Therefore, the case of rational expectations, as far as it applies to representative households, is irrelevant to the presence or non-presence of rational expectations at the micro-level, and therefore does not have a microeconomic basis. The accuracy of expectations, as Gertchev (2007) argues, does not necessarily lead to optimal results. As expectations incorporate information, the accuracy of the information is important to the accuracy of one’s decisions. If, on average, people form the correct expectations based on all the information available, then equilibrium would be inevitable. But the existence of uncertainty, the dynamic nature of markets, and the competition make impossible the existence of an equilibrium, by hampering

182

P. E. PETRAKIS

the quality and quantity of information available. On the other hand, a market that is in disequilibrium cannot transmit the proper information, distorting expectations. Finally, due to the information problem, equilibrium may not be reached and the rational expectations may not be realized. Wren-Lewis (2013), defending rational expectations, argues that we need to focus on learning to understand how expectations are being shaped and adapted. The validity of macroeconomic thinking should be based on realistic social learning environments. A person can choose between rational and adaptive expectations. The problem, however, with adaptive expectations is that they rely on past observations to predict the future, without taking into account the current state of the economy. Thus, Levine (2012) argues that it is impossible to predict a coming crisis, while he underlines that there is no alternative approach beyond rational expectations. Uncertainty exists because, whatever the form expectations take, with the exception of rationales, a theory based on them would be incorrect once people would start to believe and act based on that theory. Box 7.2 Rational Expectations Hypothesis (REH) According to Rational Expectations Hypothesis for variable, the expected value for period t is expressed by the equation: pte = E( pte |It−1 ), where denoted the mean and the information available at period. That is, REH assumes that agents do not make systematic errors for the future, and any deviation from the perfect foresight is a random error. The forecast error is a stochastic variable with the following Mean equals zero, E(εt ) = 0, (2) No autocorrections, E(εt , εt−1 ) = 0, (3) Muth (1961) notes on REH: Information is scarce and the economic system generally cannot spend resources on obtaining it. The way expectations are shaped particularly depends on the structure of the relevant system that describes the economy.

7

EXPECTATIONS

183

A “public forecast,” as defined by Grunberg and Modigliani will not have a significant impact on the functioning of the economic system (unless it is based on internal information).

7.7

The Simplicity of the Rules of Thumb

The simplicity of the assumptions in determining expectations is a matter for debate. Syll (2012) argues that, while the assumption of rational expectations seems to be strong, its weaknesses can be similar to those of microeconomics. While enterprises may not know the actual demand curves for their products, the profit maximization assumption may be a better approach to how firms set prices in relation to a fixed mark-up cost model. Thus, it seems reasonable to assume that agents use the information available to shape their expectations when they cannot predict with certainty the future outcome of events. Thomas (2013) considers that is naive to assume that individuals do not incorporate in their decisions the new information they have and rely solely on past observations. For example, the trend in a market may be an increasing one, but who will not take into account new information suggesting otherwise? It would certainly be unreasonable to assume that individuals fully understand the rules and impact of economic policy. However, he argues, rational expectations, despite their simplifications, can be a good milestone for how markets operate. As Sargent (1993) points out, “model-based” expectations (that is, rational expectations) are obviously not realistic, as only a few economists can solve dynamic macroeconomic models to determine their expectations. The literature on learning and the discussion of the limitations of rational expectations attempt to formulate models of expectations that depart from the rational expectations hypothesis. In fact, because of the cost of information, economic actors often resort to “rules of thumb”11 to shape their future expectations. The expectations of the rules of thumb are not necessarily irrational, to the degree that these rules reproduce future values from past values, as they can incorporate all available information. Hence, simple general rules can provide the optimum choice between the precision of expectations and the effort made to achieve them. However, especially in times of

184

P. E. PETRAKIS

persistent changes in a macroeconomic variable (e.g., inflation), rules of thumb which are based on past events can lead to repeated forecasting errors. However, it is unreasonable for individuals to use rules of thumb that do not reflect reality and are not being adapted to an ever-changing world. The problem, however, is that individuals are not always able to know how the world, and therefore the rules of thumb, changes. Using rules of thumb is, in fact, a rational strategy for individuals, as long as the approach of the world is a good one based on the rule which is being used.

7.8

The Role of Knowledge and Learning

Levine (2012) argues that the weakness of the Rational Expectations Hypothesis (REH) lies in learning by doing theory through the concept of error, since the individual learns from his mistakes. According to his work, rational expectations differ from adaptive ones in terms of: • the duration of the learning time • the frequency of adjustments • the range of variables. Specifically, in adaptive expectations, the time period for acquiring knowledge is shorter and adjustments are more frequent. On the contrary, rational expectations can be characterized as a process of longer adjustment. Individuals find it difficult to know how each variable evolves (e.g., inflation, unemployment, GDP growth rate), but they can learn it through the experience that will acquire in the long run. However, as individuals have different mental abilities, the timing of adjustment may vary between agents. Another fact is that rationality, and therefore the optimal result, are subjective concepts, as they vary from person to person and from group to group. The logic of rational expectations ignores the fact that each individual is not an economist, since it assumes that each individual can analyze complex economic relationships and reach the same conclusion as an economist who uses specific models. Given that rational expectations incorporate the available information, the concern arises as to whether all individuals have equal access to the information. Access to information is difficult, given the cost of accessing it. The cost of an optimal forecast can increase depending on the degree

7

EXPECTATIONS

185

of its accuracy. In turn, increasing transaction costs tend to limit market efficiency. This is also reflected in the inability of the price mechanism to integrate the available information and to engage in speculative arbitrage to balance them. As our day-to-day choices are being taken by considering not just the present but the future as well, and oftenly they have a long-term impact, a prerequisite for the decision-making process is the usage of the information available. That is, the person wants to know the future conditions and the range of options available, in order to be able to accommodate his expectations. Syll (2012) argues that rational expectations could not exist in the real world. Rational expectations could only apply to an ergodic world, where stable structures and static stochastic processes exist. Samuelson (1969) was the first to argue that the ergodic axiom should be included in economic models. Following Samuelson’s principle, many economists, including Stiglitz, Mankiw, Friedman, and Scholes assume, directly or indirectly, that economic events are being generated through an ergodic stochastic process. However, Lucas (1977) studies the probability that some economic phenomena may be non-ergodic, although he argues that economic analysis should deal exclusively with ergodic ones. Looking at the past behavior of economic agents in order to predict future actions, induction automatically enters the debate. The problem of induction was first posed by Hume (1748) who studied whether induction-derived data can be used beyond available information to predict the future. As he says, the facts of the past can only tell us about the events of the past. According to Popper’s theory, knowledge and learning mean that the individual is unable to know whether a given hypothesis is true. The assumption that individuals act according to the model is incorrect, since there is no way to ensure the accuracy of the model, which is, in any case, an oversimplification of reality and thus false. Assuming that individuals, on average, make unbiased predictions and thus do not make systematic errors, any errors are random ones and therefore individuals cannot learn from them. The assumption of rational expectations ignores the factor of social learning and does not include any mechanism that enables the individual to learn. As the evolution of human behavior is heavily influenced by accumulated knowledge, it is of particular interest to examine whether it is compatible with the evolutionary theory of knowledge and learning, Ayala and Palacio-Vera (2014) argue that the mechanism of generating

186

P. E. PETRAKIS

rational expectations differs substantially from Popper’s theory in three aspects: Conjectural Knowledge: The cumulative nature of knowledge theory, which is being hidden in rational expectations, implies that as all information increases over time, individuals improve their predictability and can produce economic forecasts, displaying fractional standard errors. Definitely, such a scenario is in line with the steady state condition proposed by Lucas (1986), in which individuals do not have to reconsider their decision-making rules. However, if individuals are not in a position to reconsider their decision-making rules, this is equivalent to the inability to improve their predictive ability through additional information. The adaptive learning process conflicts with Popperian theory of knowledge and learning, as we cannot know whether a hypothesis is in fact true, and therefore the assumption that economic agents always know the truth is an incorrect one. If the forecast is always correct, then economic agents do not make systematic mistakes. If they make mistakes, these mistakes are accidental and therefore they cannot learn from them. Popper’s theory means that we “learn” by correcting our mistakes. Imperfect Adaptation: A second problem with the REH is based on the fact that the process of adaptive learning leads to a stable situation where expectations are rational. However, according to Popperian theory, the process of adaptive learning is sometimes successful and sometimes is not. Many times, mistakes are inevitable and that is why we can make mistakes (Popper, 1990). Consequently, Popper (1994) argues that the application by deletion error does not lead to an “optimal” fit. On the contrary, adjustment is always incomplete. Non-determinism: The third aspect of REH in Popper’s theory is about determinism. Popper’s theory rejects determinism.12 Popper defines the “deterministic” world as the one where “there is no room for human decisions” (Popper 1990). If the actions of economic agents affect the structure of rational expectations, then the actions of each individual will trigger a continuous process of revising expectations as a result of the observed changes in the structure of the economy. On the other hand, according to Lucas (1986), the adaptive learning process implies that the environment is an ergodic one, as it assumes that any action by the economic agents during the adaptive learning process (and therefore before their expectations are being rationalized), does not affect the future course of the economy.

7

EXPECTATIONS

187

7.9 Achieving Equilibrium: History Versus Expectations Krugman (1991) in his text “History versus Expectations” argues that establishing an equilibrium is a matter of history versus expectations. On the one hand, knowledge of past events acts as the guardian of future behaviors and sets the conditions that drive the economy in equilibrium. On the other hand, the key factor for achieving equilibrium are the expectations that for Krugman are characterized as self-fulfilling prophecies. Krugman (1991) developed a multiple equilibrium model that relates to an economy that produces two goods, and the wage in each sector depends on the division of labor in each one. Thus, if in one of the two sectors none will be employed, then the wage will be lower and therefore the economy will be specialized in producing the goods that most people work for (since the wage is higher in this sector). The initial division of labor between the two sectors of the economy is exogenously determined and then is being endogenously redistributed. The initial distribution of the workforce, since it can be moved from one sector to another without cost, does not pose a problem in the economy and the movements are to the sector with the highest wage. But if costs of adapting the labor force to move from one industry to another are assumed, then each worker faces his movement as an investment, as he expects a higher wage.13 Thus, the orientation of expectations, only on the basis of higher wages, is not the only factor, as other workers’ decisions also depend on the expected future wage being dependent on the expected division of labor between the two sectors. Expectations, because they act as self-fulfilling prophecies, play an important role in determining the equilibrium. The introduction of the cost of moving from one sector to another breaks down the initial distribution (historical equilibrium) and the expectations are determined by the equilibrium. The contribution of Lucas (1972) to expectations focuses on the way rational expectations meet the theory of general equilibrium. Lucas (1972) recognizes that the information available in markets should be consistent. The introduction of rational expectations into the theory of general equilibrium presupposes the adoption of common behavior by market participants. In his work, “Econometric Policy Evaluation: A Critique” (1976), Lucas opposes the effectiveness of economic policy as

188

P. E. PETRAKIS

the latter changes the structure of the economic system.14 The quantitative change in policy objectives affects the coefficients of the estimated behavioral equations, as business and household expectations depend on the policy instruments under consideration. Lucas’s critique has helped economists change the attitude of large-scale macroeconomic models of the 1960s and early 1970s until then. According to Lucas’s criticism, econometric analysis based on past experience cannot be used to examine and predict in advance the impact of economic policy.15 The impact of expectations on the economy is the result of their coordination that leads to economic boom or economic collapse. A key feature of expectations is that in order to influence the functioning of the economy they need to be coordinated. That is, the majority of the population should expect the same evolution of macroeconomic variables. Coordination of expectations is triggered by factors that drive human behavior and are integrated into processes of social learning, cultural background, and ideas.

Notes 1. “When the price of any commodity is neither more nor less than what is sufficient to pay the rent of the land, the wages of the labour, and the profits of the stock employed in raising, preparing, and bringing it to market, according to their natural levels, the commodity is then sold for what may be called its natural price.” 2. The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market, and the demand of those who are willing to pay the natural price of the commodity […] Such people may be called the effective demanders, and their demand the effectual demand […]. 3. “But though it may be impossible to determine, with any degree of precision, what are or were the average profits of stock, either in the present or in ancient times, some notion may be formed of them from the interest of money” (Smith, 1981 [1776]). 4. “The natural price, therefore, is, as it were, the central price, to which the prices of all commodities are continually gravitating. Different accidents may sometimes keep them suspended a good deal above it, and sometimes force them down even somewhat below it. But whatever may be the obstacles which hinder them from settling in this centre of repose and continuance, they are constantly tending towards it.” 5. “It is the nominal or money price of goods, therefore, which finally determines the prudence or imprudence of all purchases and sales, and

7

6.

7. 8.

9.

10.

11.

12.

EXPECTATIONS

189

thereby regulates almost the whole business of common life” (Smith, 1981 [1776]). “The elasticity of a particular person’s expectations of the price of a commodity X as the ratio of the proportional rise in expected future prices of X to the proportional rise in its current price” (Hicks, 1946, p. 205). Forecasting Error: the difference between the prediction for the current price and the actual current price (p–pe). Chow (2011) used an econometric model to examine equity prices for large cap companies in Taiwan (1971–2010). His findings state that equity prices follow the assumption of adaptive expectations. […] business expectations (or in general the subjective distribution of probabilities) [are rational if] tend to be distributed, for the same set of information, on the prediction of the relevant economic theory (or the distribution of “objective” probability results) (Muth, 1961, p. 316). The best thing to do, according to Muth, is to use the best harmonized assumption to separate the essential data from the non-essential ones, to interpret the observations (or data) and deduce their effects. It is considered as a means of forecasting, according to an approximate and practical rule, not based on science or accurate measurement. The exact origin of the phrase is uncertain. The earliest known reference is found in J. Durham’s book, Heaven upon Earth, 1685 ii. 217: “Many profane Christians are like foolish builders, who think by building, and by the rule of thumb and not by Square and Rule.” Determinism: A philosophical concept according to which any event or phenomenon is due to a cause, of which is a natural consequence. The word is derived from the Latin word determinismus. Determinism has several forms: (a) Geographical (climatic): considers the evolution of a society and consequently historical movement to be determined by geographical or climatic factors. (b) Ethical: Argues that there is no self-esteem of human, therefore human is not free. (c) Social: considers individual behavior as the result of the influence of social factors. (d) Economic: claims that only material needs determine the action and behavior of individuals.

The physical sciences today with kinetic theory, with Einstein’s machine and with the theory of quanta, have shaken the strict causality and the requirement of science to formulate laws with absolute force. 13. “Whatever the starting position, all workers will move to the industry they expect to earn the highest wage - which is the industry they expect

190

P. E. PETRAKIS

all other workers to move to. So, since there is no cost to move labor, any equilibrium can be achieved as a self-fulfilling prophecy, whatever the starting position” (Krugman, 1991). 14. Lucas (1976) criticizes market effectiveness for failing to consider the extent to which estimates differ from reality. Lucas, in this text, does not assume that economic agents are rational, however, in his criticism of the macroeconomic models of Keynesian tradition he uses the framework of rational expectations. The problem for Lucas stems from the fact that the behavior of households and businesses often depends on the rules of government policy, which are ignored by these models. 15. “[…] the features which lead to success in short-term forecasting are unrelated to quantitative policy evaluation, that the major econometric models are (well) designed to perform the former task only, and that simulations using these models can, in principle, provide no useful information as to the actual consequences of alternative economic policies. These contentions will be based not on deviations between estimated and ‘true’ structure prior to a policy change but on the deviations between the prior ‘true’ structure and the ‘true’ structure prevailing afterwards” (Lucas, 1976, p. 258).

References Ayala, I. H., & Palacio-Vera, A. (2014). The rational expectations hypothesis: An assessment from Popper’s philosophy (Levy Economics Institute, Working Paper No. 786). Chow, G. (2011). Usefulness of adaptive and rational expectations in economics (CEPS Working Paper No. 221). Durham, J. (2010 [1685]). Heaven upon Earth. EEBO Editions, ProQuest. Gertchev, N. (2007). A critique on adaptive and rational expectations. The Quarterly Journal of Austrian Economics, 10, 313–329. Hicks, J. R. (1946). Value and capital: An inquiry into some fundamental principles of economic theory. Oxford: Clarendon Press. Hume, D. (2006 [1748]). An enquiry concerning human understanding: A critical edition. Oxford: Oxford University Press. Krugman, P. (1991). History versus expectations. The Quarterly Journal of Economics, 106(2), 651–667. Levine, D. (2012). Why economists are right: Rational expectations and the uncertainty principle in economics—Part I . Retrieved from http://www. huffingtonpost.com/david-k-levine/uncertainty-principle-economics_b_1220 796.html. Lucas, R. E., Jr. (1972). Expectations and the neutrality of money. Journal of Economic Theory, 4, 103–124.

7

EXPECTATIONS

191

Lucas, R. E., Jr. (1976). Econometric policy evaluation: A critique. CarnegieRochester Conference Series on Public Policy, Elsevier, 1(1), 19–46. Lucas, R. E. (1977). Understanding business cycles. In K. Brunner & A. H. Meltzer (Eds.), Carnegie-Rochester conference series on public policy, 5. Stabilization of the Domestic and International Economy, 7–29. Lucas, R. E., Jr. (1986). Adaptive behaviour and economic theory. In R. M. Hogarth & W. M. Reder (Eds.), Rational choice: The contrast between economics and psychology (pp. 217–242). Chicago and London: University of Chicago Press. Muth, J. F. (1960). Optimal properties of exponentially weighted forecasts. Journal of the American Statistical Association, 55, 299–306. Muth, J. F. (1961). Rational expectations and the theory of price movements. Econometrica, 29(3), 315–335. Nerlove, M. (1958). Adaptive expectations and cobweb phenomena. Quarterly Journal of Economics, 72(2) 227–240. Popper, K. R. (1990). A World of propensities. Bristol, UK: Thoemmes. Popper, K. R. (1994). In search of a better world lecture and essays from thirty year. London: Routledge. Samuelson, P. A. (1969). Classical and neoclassical theory. In R. W. Clower (Ed.), Monetary theory. London: Penguin Books. Sargent, T. J. (1993). Bounded rationality in macroeconomics. Oxford: Clarendon Press. Smith, A. (1981 [1776]). An inquiry into the nature and causes of the wealth of nations. In R. H. Campbell & A. S. Skinner (Eds.), The Glasgow edition of the works of Adam Smith, 2. Indianapolis: Liberty Fund. Syll, P. L. (2012). Rational expectations—A fallacious foundation for macroeconomics in a non-ergodic world (Real-World Economics Review, No. 62). Thoma, M. (2013). How economists can tame irrational exuberance. The Fiscal Times. Retrieved from http://www.thefiscaltimes.com/Columns/2013/11/ 05/How-Economists-Can-Tame-Irrational-Exuberance. Wren-Lewis, S. (2013). Defending rational expectations. Mainly macro. Retrieved from http://mainlymacro.blogspot.de/2013/11/defending-rational-expect ations.html.

CHAPTER 8

Entrepreneurship

8.1

Introduction

The contribution of entrepreneurship to the activity of the economy is particularly important as it operates as both a cause and an effect. Entrepreneurship generates economic development, as the entrepreneur is a potentially productive growth factor. Also, the economic development of a country promotes entrepreneurship, as it increases demand and creates needs that cultivate fertile ground for its growth. The traditional neoclassical theory view is that the supply of labor and capital and the level of technology determine economic growth. Therefore, it overlooks the role of entrepreneurship. Indeed, it ignores any direct impact that entrepreneurship can have on economic development. Creative thinking is a concept intertwined with entrepreneurship, while innovative activities are considered as one of the most important tools in order for businesses and thus, for economies at the micro-level, to be competitive in their wider field of operations. New emerging conditions resulting from an ever-changing environment—in terms of economic and political conditions, globalization, and disruptive technologies—raise questions about the factors that shape business development and creativity in globally competitive markets, and about the effectiveness of traditional investment evaluation methods. In

© The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_8

193

194

P. E. PETRAKIS

addition, businesses base their strategic planning on a background of sociological, psychological, and economic information at the individual and business level.

8.2 Entrepreneurship as a Basic Concept of Human Economic Activity Entrepreneurship is linked both to the creation of new businesses and to all actions involved in launching novelty and innovation. It is also the process that integrates innovation and business behavior into existing businesses, contributing to their strategic renewal. At the same time, it can be combined with the supply of new products. By providing vision and perspective, entrepreneurs drive companies to grow by increasing their competitiveness over the long term. The entrepreneur is the one who expands the production function by increasing the total of variables, while having to use and combine the available resources effectively, taking into account the business risk of his choices. This process is part of the overall project of economic growth. There are three stages in the business development of economies (Porter, Sachs & McArthur, 2002): 1. Factor-Driven Stage: This is the baseline where society is focused on productive resources. Society produces low-value products by leveraging existing knowledge without creating any new knowledge or innovation. Furthermore, society produces for self-consumption, as there is no export sector. This stage is similar to the first stage of traditional society developed by Rostow (1960). 2. Efficiency-Driven Stage: This category represents the gradual efforts of a society to grow and modernize, to make its international market debut and to acquire a national identity. Economies increase the efficiency of production and the levels of education of their workforce, while having effective productive practices to take advantage of economies of scale. Self-employment rates are decreasing, while capital, labor, and technology play a key role in productivity. 3. Innovation-Driven Stage: Society has perfected the two previous stages (exploitation of resources and effectiveness) and the only way for more development is to diversify products and services through knowledge and innovation. This stage may be considered

8

ENTREPRENEURSHIP

195

as a parallel to the emergence and development of the concept of entrepreneurship. The transition to the third stage is characterized by business activity based on human capital. The interconnection of these three stages with the development of economies is shown through an “S” shape curve which indicates that all societies have some degree of economic activity, but their activity is divided between productive and non-productive entrepreneurship (Acs and Szerb, 2010). Entrepreneurship occurs spontaneously as the country enters the innovation-driven stage. As institutions are increasingly strengthened, entrepreneurship shifts to productive entrepreneurship by boosting economic growth. It appears, then, that economic growth is at its peak when business growth is at the stage based on innovative activity. Countries with low per capita incomes, which are in the process of development, usually achieve high levels of early-stage entrepreneurship due to a large number of small businesses that characterize them. Early-stage entrepreneurship includes aspiring entrepreneurs (people who had begun preparations for starting a business or started a business in the quarter before the survey) as well as new entrepreneurs (owners/managers of a new businesses, companies who started a new activity no more than 42 months previously) and refers to the age groups of 18–64 years. However, growth and more specifically, industrialization and economies of scale, require more extensive and well-established business units that can meet growing demand, and thus a decrease on early-stage entrepreneurship in low-income countries may be an indication of growth and a shift to a higher standard of living. Nevertheless, after a period of continued development, it is permissible to seek new business opportunities, as established businesses play an essential and increasing role. At all events, over time, countries have been observed to show stability in a convex curve, which characterizes the link between early-stage entrepreneurship and GDP per capita, as shown in Fig. 8.1. In particular, several EU countries are at low levels of entrepreneurship in its early stages and below the convex curve, while among EU countries, only Luxembourg seems to stand out, to the right of the graph. Countries with low per capita incomes but with high levels of entrepreneurial activity such as Colombia and Brazil stand out. Note that the historical, cultural, and institutional parameters of the countries, influence the relationship between the level of economic growth and entrepreneurship in

196

P. E. PETRAKIS

25%

Early- Stage Entrepreneurship

Brazil Colombia

20% USA

15%

India

Portugal Slovak Republic Israel Netherlands UK Switzerland China Greece Slovenia Sweden Spain Germany

10%

5%

Ireland

Luxembourg

Italy

0% 0

20,000

40,000

60,000

80,000

100,000

GDP per capita (ppp, 2011) (International dollars)

Fig. 8.1 Entrepreneurship in the early stages and per capita GDP (2019) (Source IMF—World Economic Outlook Database, October 2019, GEM [2019] and author’s own creation)

the early stages. Neighboring countries with similar traditions achieve similar levels of entrepreneurship among themselves, creating uniform groups of countries. The process of converting production factors into products and services is related to technological progress. Looking back at Adam Smith (1981 [1776]) the division of labor has a limited potential of which the market economy can take advantage. However, entrepreneurs can increase division of labor and productivity by improving technological progress and innovation. By contrast, David Ricardo (1817) believes that diminishing returns create a constraint on the increase in the income of the population, which is also in line with the Malthusian approach to economic growth. Investments are what creates new capital, but diminishing productivity gains, population growth, and the scarcity of production factors, create obstacles to economic growth. The absence of entrepreneurship in models of economic growth is associated with the ascendancy of neoclassical economics as a dominant school of thought. For the neoclassics, there are no profit

8

ENTREPRENEURSHIP

197

opportunities and, therefore, the concept of entrepreneurship does not exist. The neoclassical model is based on the assumption of perfect information and rationality and thus leaves no room for the entrepreneur to act. As markets work well, there is no incentive for entrepreneurs to take risks or take innovative actions. At the same time, the particular characteristics of the human personality, such as those embedded in the face of the entrepreneur, fail to integrate into the neoclassical model. “The model is essentially a tool for analyzing the optimization of well-defined problems which do not require the entrepreneur to be solved” (Praag, 1996). The lack of entrepreneurship in macroeconomic models has generated a great deal of concern among economists in recent decades. Although many associate entrepreneurship, either directly or indirectly, with economic growth, no specific theory has been formulated to explain the process or how it occurs. Schumpeter (1934 [1911]), through the concept of development, introduces the role of the entrepreneur whom he identifies with innovation. In essence, he argues that entrepreneurship is a production factor, which is involved in the composition of other production factors. Economists have often tried to introduce entrepreneurship into an economic model (Lucas, 1978; Schmitz, 1989; Braunerhjelm, Acs, Audretsch, & Carlsson, 2010) or provide some relevant conceptual framework (Leibenstein, 1968; Kirzner, 1997). Empirical studies, however, examine specific cases, reducing the scope of research and the generalizations of results, while in some cases entrepreneurship is seen as the residue of regressions.

8.3 Entrepreneurship and Entrepreneurial Opportunity In the literature, the concept of entrepreneurial opportunity has been approached and analyzed in a variety of ways. There are two general positions on the types and sources of entrepreneurial opportunities: • Entrepreneurial Opportunities, according to Schumpeter (1934 [1911]), who argued that entrepreneurial opportunity relates to individuals in a society creating innovative forms of entrepreneurship. Entrepreneurship contributes to significant positive impacts, such as boosting economic activity and creating new jobs.

198

P. E. PETRAKIS

Entrepreneurial opportunities can be identified in technological change, political/regulatory change, and social/demographic change. • and according to Kirzner (1973) who considers an entrepreneur the person who discovers opportunities that may be found in the environment as a result of market imbalance. Entrepreneurial opportunities can be identified anytime and anywhere (Shane, 2003), as they are bound to arise due to market imbalances caused by errors or omissions. So, then, in view of the above considerations, entrepreneurial opportunities are categorized into three areas, focusing on: • the individual entrepreneur, • the business environment, and • the actual activities undertaken by the entrepreneur while seizing the opportunity. Shane and Venkataraman (2000) are considered to have provided the most credible and complete treatment of the entrepreneurial opportunity as it relates to entrepreneurship wherein is presented the exact dimension of both of these concepts. In particular, Shane and Venkataraman’s approach focuses on entrepreneurial opportunities by asking three key questions: (1) When, how, and why do opportunities arise for the creation of new goods and services? (2) When, how and why do some people—and not some others— discover and take advantage of these opportunities? (3) When, how, and why are different ways of modes of action employed to exploit business opportunities? To have a complete definition of the concept of entrepreneurship, who the entrepreneur is and what he/she does, an approach is needed that tackles issues such as creative opportunity, sharpness, ability to perceive opportunities and scope for action. Indeed, it is particularly important to understand how individuals use existing knowledge and experience to discover and exploit entrepreneurial opportunities, how they develop

8

ENTREPRENEURSHIP

199

strategies to achieve higher returns from the allocation of resources involved in activating an entrepreneurial opportunity, and how they find and create competitive advantages in an uncertain and competitive environment. At this point, there should be a distinction between general opportunities and entrepreneurial opportunities. Entrepreneurial opportunities are defined as situations in which new products and services are created that are linked to the innovation process as a source of comparative advantage, in the broader form which includes new processes and organizational methods, intended to create new value. Therefore, it is important to realize that the spread of innovation across the economy and technological discrepancies generate entrepreneurial opportunities. There are three basic schools of thought (Companys & McMullen, 2007) about where and how entrepreneurial opportunities can be identified: 1. The economic school considers that entrepreneurial opportunity is an objective phenomenon that exists in time and space but is not known/visible to all individuals. Entrepreneurial opportunities are attributed to the nature of information sharing, in terms of material opportunities in society. 2. The cultural school considers entrepreneurial opportunities to be subjective. That is, it treats them as subjective constructs that depend on the uncertainty and ambiguity of daily life, as well as on individuals’ rational and cognitive ability to interpret information, influenced by the cultural background of the society in which they live. Thus, entrepreneurial opportunities are subjective phenomena that are defined by entrepreneurs through social interactions. 3. The socio-political school, on the one hand, emphasizes the objective properties of entrepreneurial opportunities but, on the other, considers that entrepreneurial opportunities are located within and are products of the complex social networks and relationships which shape economic activity. Within the networks, social protagonists will need to mobilize resources to exploit objective opportunities. The position that someone holds in networks (see elite) is of major importance for their ability to discover opportunities. In addition, the nature of administrative mechanisms determines the degree of freedom that the protagonists have in undertaking business and social actions. Consequently, changes in administrative mechanisms

200

P. E. PETRAKIS

change the structural values with which socio-economic networks operate and ultimately define entrepreneurial opportunities.

8.4

Entrepreneurial Failure

There are several views in the literature on the definition and cause of entrepreneurial failure. Generally, it is considered to be related either to the cessation of the operation of the business or to its bankruptcy. Some researchers believe that entrepreneurial failure exists only when one business goes bankrupt, while others argue that there are a variety of forms of entrepreneurial failure (such as mergers and acquisitions with other business). Finally, some hold that entrepreneurial failure occurs if the business is unable to meet its obligations to the organization’s stakeholders (employees, suppliers, customers, and owners). These simplified definitions are not considered satisfactory.1 Ulmer and Nielsen (1947) defined failure as “the situation where businesses were abandoned (sold or liquidated), without the trader making a profit from that sale, so as to avoid future losses.” This definition, though satisfactory, as it covers both bankruptcies and those businesses that have found themselves on the road to bankruptcy and were sold to avoid it, does not include those sold for profit. The problem with this definition is the difficulty in finding companies that meet this criterion, for lack of statistics. By another definition, failure is related to the inability of businesses that have closed down to achieve the goals of their owners. However, here too the lack of appropriate data limits its usefulness. Bruno and Leidecker (1988) define as unsuccessful business those that are liquidated without declaring bankruptcy, those that are restricted to their average size, those that want to merge under difficult conditions, businesses that cannot repay their debts, and others that are insolvent, and unsuccessful in fulfilling their obligations. The main factors responsible for the failure of a business may be exogenous or endogenous. Exogenous factors include: 1. Government policy (tax rates, increasing money supply, and lowering interest rates, etc.). 2. The impact of the business cycle2 on entrepreneurial failure rates, as a recession will have an impact on the number of businesses that are

8

ENTREPRENEURSHIP

201

shutting down. On the other hand, an economic rise would increase the number of new businesses. 3. Natural disasters and, more generally, extreme events (e.g., terrorist attacks), since they can psychologically affect the crowd and their economic behavior, destroy business assets, cause disruption to the economy and to competition. Moreover, they can create new entrepreneurial opportunities as they influence the perceptions of the population and therefore their habits. If a business has identified a good entrepreneurial opportunity, the appearance of serious problems is usually the result of management error, although external, uncontrolled factors can lead to crisis. Thus, endogenous factors of business failure may be: 1. Stagnation, as small businesses fail when they do not learn new ways of operating and rely on a method that sometimes ceases to be functional, while also an existing business structure may damage productivity and intrapreneurship. 2. The lack of capital or the wrong estimation of capital needs, as entrepreneurs usually underestimate the capital and time needed to make their businesses profitable when starting them. At the same time, they do not know where to raise funds or have no access to financiers. 3. Mismanagement and characteristics of the entrepreneur: Undertakings that are planned, achieve a greater degree of profitability. At the same time, the role and character of the entrepreneur play an important role both in starting a business and in its course. Entrepreneurs may not always recognize that their skills, which were valuable in creating the business, cease to be valuable past a certain stage, resulting in selfish choices. 4. Misunderstanding of competition and the market: Gaskill, Van Auken, and Manning (1993) emphasize the importance of a firm’s ability to remain competitive once it has become successful. They cite the importance of high-quality services and products as a component of successful businesses. Regarding market mismanagement, some high-tech startups tend to fail in this area because they are often technology-driven. The fact that something is new, does

202

P. E. PETRAKIS

not mean that customers will buy it, or that competitors will not find a way to deliver a better product. In general, according to several conceptions (Ekanem & Wyer, 2007; Metzger, 2006; Schror, 2006; Ucbasarana, Westhead, Wright, & Flores, 2009), the failure of a business is not the definitive termination of the person setting it up. Indeed, it may even be the starting point for a new business endeavor. Many times, important entrepreneurs and business endeavors succeeded in their second or third attempt. For this reason, it is very important that bankruptcy law allows the second opportunity.

8.5

Opportunity and Necessity Entrepreneurship

Depending on the motivation of the individual to enter the world of business, entrepreneurship is divided into: • Necessity entrepreneurship, which refers to the case of a person who took up business because of a lack of other job options, dissatisfaction with existing employment, fear of a possible, imminent dismissal, or in order to maintain his income which he expects will be gradually decreasing. • Opportunity entrepreneurship, where the motivation is to take advantage of an entrepreneurial opportunity identified by the prospective entrepreneur. This entrepreneurial opportunity is assessed in the context of a person’s economic environment and considered capable of either leading to an increase in income, offering job independence or meeting some other internal need. The distinction between necessity entrepreneurship and opportunity entrepreneurship is directly related to the level of per capita income of each country. The higher the income per capita (usually in developed countries), the greater the proportion of young entrepreneurs who are motivated by the desire to take advantage of an opportunity, relative to their living needs. In developing countries, the need for entrepreneurship is more frequent, as opportunities to secure wage-earning employment are relatively limited.

8

ENTREPRENEURSHIP

203

Table 8.1 Motivations for starting a business per country as a percentage of Total Early-stage Entrepreneurial Activity (TEA) (%) (2019) Countries

Necessity entrepreneurship (% of TEA)

Opportunity entrepreneurship (% of TEA)

North America USA Canada Europe Germany Italy Spain United Kingdom Asia China India Korea Latin America and the Caribbean Argentina Brazil Middle East and Africa Egypt Lebanon Morocco

10.9 8.1 13.7 15.9 16.7 11.4 22.6 12.9 31.7 27.8 46.3 21 32.7

78.8 78.3 79.3 76.4 69.8 81 70.7 84.2 63.8 70.5 43.2 77.7 68.8

27.9 37.5 38.3 47.6 36.1 31.2

68.8 68.8 58.6 47.5 63.7 64.5

Source GEM (2019) and author’s own creation

Table 8.1 presents the picture of entrepreneurship in main world economies, based on the distinction between necessity driven entrepreneurship and opportunity entrepreneurship. Opportunity entrepreneurship is perceived to be higher in economies such as those in North America (78.8% of TEA) and Europe (76.4% of TEA). In Asia (63.8% of TEA), Latin America and the Caribbean (68.8% of TEA) and the Middle East and Africa (58.6% of TEA) the concept of necessity entrepreneurship is more developed.

8.6

Institutions and Entrepreneurship

The critical role of entrepreneurship in economic outcomes and growth has been clearly defined by Schumpeter (1942) and Kirzner (1997) to be

204

P. E. PETRAKIS

the creation of new technologies that offset the costs of creative destruction. Entrepreneurs treat these new technologies as new opportunities (Kizner, 1997) to achieve successful entrepreneurship. For entrepreneurs to be successful, they must leave behind outmoded ways of handling and organizing production, and introduce new methods and technologies that will propel new developments. Entrepreneurs frequently try to convince other members of society that the innovative use and application of new tools, concepts, and artifacts is both appropriate and legitimate. Through persuasion, entrepreneurs help break down the cognitive, legal, and political barriers which prevent the emergence of institutions that support the market. As a result, entrepreneurs spearhead—through political processes—changes in the institutional background. The view that the theory of institutional change can be treated as a learning theory is another version of the approach of how entrepreneurship leads to institutional change. Entrepreneurship involves the use, redistribution, and investment of productive resources in the undertaking of activities that bring innovation. It can be seen as an explanation of how entrepreneurs, as agents of change, contribute to changes in rules and belief systems, using already existing knowledge. At the same time, business activities are based on existing beliefs and behaviors but also on existing institutional structures. These structures largely determine whether entrepreneurs will use their creativity in a productive or non-productive way. Thus, the institutional background can impede or promote interactions between economic agents. However, despite the fact that entrepreneurs are restricted by existing thinking habits, they do often, whether directly or indirectly, influence established routines and set in motion processes that disrupt the status quo. These reflections have led to the development of the term institutional entrepreneurship. The term institutional entrepreneurship introduces the influence of interests on power and on institutional change. It refers to the actions of entrepreneurs3 who have a particular interest in specific institutional arrangements and who aim to create new conditions to form new institutions or to change existing ones. After all, this is how new institutions are created in an economy: “New institutions arise when organized agents with sufficient resources regard them as an opportunity to pursue interests which they perceive as valuable” (DiMaggio, 1988).

8

8.7

ENTREPRENEURSHIP

205

Cultural Values and Entrepreneurship

The nature of entrepreneurship is interlinked with the human factor, embodied in the person of the entrepreneur, in the form of intellectual skills and defining characteristics of the human personality and the cultural background. Cultural values determine the way people think, behave, and make decisions. Hence, the behaviors of leadership and the workforce determine the prospects for business growth at the microeconomic level and subsequently throughout the economy (macroeconomic level). Studying the relationship between cultural values and business decision-making is particularly important in determining a company’s strategy and expanding its activities. Different cultural values lead to different types of social structures in economic relations (Greif, 1994) and contribute to the start-up of business activity. A typical example is the US economy, with its core values of freedom, independence, individuality, and achievement of goals, where entrepreneurship is highly developed (Spence, 1985). However, entrepreneurship varies between countries and between different periods, because companies vary in their orientation toward it. Empirical studies examining the relationship between business culture and economic growth, although of great interest to the scientific community, are limited in number. Lynn (1991) concludes that different approaches of society to entrepreneurship are capable of providing explanation for the different rates of growth. In addition, Beugelsdijk (2007) argues that business culture influences and shapes patterns, ultimately having an indirect impact on economic growth. A society that is characterized by a certain business culture can lead to higher levels of entrepreneurship and, subsequently, to a process of consolidation of the economy and its economic growth. In shaping the cultural business environment, several other behaviors4 may be included, that are reflected in the World Values Survey and, at the social level, form a friendly or less friendly environment in terms of entrepreneurship (Table 8.2). (1) This is the percentage of those who answered between 6 and 10 (on a scale of 0–10) on the question of whether or not they do routine work (0: mainly routine work, 10: mainly non-routine work).

4.4

31.6

9.4

57.6

68

3.3

86.5

92.2

8.9

4.6

42.5

85.4

90.3

2.2

0.6

45.4

69.7

61.6

26.4

2.3

43.9

85.4

96.7

7.8

9.3

52

74.7

98.4

14.4

2

23.9

67.1

89.7

36.4

1.3

38.4

72.3

93.7

Netherlands

15.6

8.4

88.4

91

76.2

S. Africa

7.9

1.2

67.3

88.8

91.5

14.5

4.9

59.8

85

96.6

Spain USA

Note The more value a country receives, the stronger the variable—and therefore the corresponding behavior—it expresses Source Inglehart et al. (2014) and author’s own creation a This is the percentage of those who answered between 6 and 10 (on a scale of 0–10) on the question of whether or not they do routine work (0: mainly routine work, 10: mainly non-routine work) b This is the sum of the percentages of the population who have answered “Just like me,” “Like me,” “Approximately like me,” “Somewhat like me” in relation to = Schwartz’s positions above

Community service

Risk-taking

96

89.2

India Japan

Creativity: To what extent does someone not engage in routine tasksa Schwartz: It is important for the person to be creative and inventivea Schwartz: Taking risks is important for the individualb Percentage of population with active membership in a self-help group, mutual help group Percentage of the population with active membership in sports or leisure organization

Germany

Creativity

China

Variables

Behaviors

Argentina Australia Brazil

Behaviors that influence the modulation of the business cultural background

Table 8.2

206 P. E. PETRAKIS

8

ENTREPRENEURSHIP

207

(2) This is the sum of the percentages of the population who have answered “Just like me,” “Like me,” “Approximately like me,” “Somewhat like me” in relation to = Schwartz’s positions above. As the business is a living organism that is continually evolving, it should be able to adapt to new circumstances. The entrepreneur, who is at the heart of this process, should have cognitive skills that allow him to seek out entrepreneurial opportunities. The cognitive skills5 may differentiate people who do business with the rest of the population. However, in addition to cognitive skills, the particular characteristics of the human personality can affect productivity levels and growth rates. The personality traits of the individual have a bearing on both the work environment and more generally to professional behavior. In this context, the individual—to be more efficient and productive in employment - is capable of evaluating and adapting his personality to the organizational culture of the company.

8.8

Organizational Culture

The personality traits of the employees of a business or organization largely modulate its organizational culture. According to Hofstede (1980), organizational culture is defined as the collective planning of the mind that differentiates the members of one organization from others. Personality traits in the workplace should be such as to enable the individual to feel comfortable in the work environment and motivated to deliver the expected results in the work which they undertake. Thus, the performance of an organization largely depends on the degree of convergence between the personality traits of its constituent members and the dimensions of the organizational culture that characterize it. As defined by Hofstede, Hofstede, and Minkov (2010), the cultural dimensions that express organizational culture are: • Means-Oriented versus Goal-Oriented: this cultural dimension is closely linked to the effectiveness of the organization. Unlike goalsoriented cultures, in the means-oriented cultures, people avoid risk and uncertainty situations and spend only a small part of their potential at work, paying attention to how the work needs to be carried out and they love the routine.

208

P. E. PETRAKIS

• Employee-Oriented versus Work-Oriented: This cultural dimension reflects the management philosophy of an organization. In employee-oriented cultures, individuals feel that the organization is taking into account their problems, that they are taking care of their staff—even if this is at the expense of work objectives—and that important decisions of the organization are made by groups or committees. The opposite features appear in work-oriented cultures. • Local versus Professional: This cultural dimension contrasts units whose employees mostly draw their identity from the organization (local orientation) with units where individuals identify with the type of work (professional orientation). In localist cultures, unlike professional ones, individuals feel that the norms of the organization cover their behavior at home as well as in the workplace and that the company, after hiring them, has equally taken into account their social and family background and professional abilities. In localist culture, individuals’ orientation concerns the short term. • Open System versus Closed system: This cultural dimension concerns the accessibility of an organization. In the culture of open systems, individuals consider all members of the organization open to new entrants and to those outside the organization, and consider that everyone could join the organization. Hence, new employees are characterized by adaptability (e.g., adapted in a few days). On the contrary, in the culture of closed systems, the organization is closed and introverted. • Easygoing Work versus Strict Work Discipline: This cultural dimension refers to the extent of the organism’s internal structure. In easygoing cultures, as opposed to strict work cultures, no one assesses costs and meeting times are only approximately observed. • Internally Driven versus Externally Driven: This cultural dimension concerns the extent to which the organization is customer-oriented or otherwise. Pragmatic cultures revolve around the market. There is a greater emphasis on meeting customer needs, results are more important than sound procedures and there is a pragmatic, rather than dogmatic, approach to business ethics. On the contrary, in internally driven cultures, people perceive their work in relation to the outside world as the application of inviolable rules.

8

ENTREPRENEURSHIP

209

8.9 Entrepreneurial Decisions Under Conditions of Uncertainty The environment in which businesses operate is frequently characterized by a particularly high degree of uncertainty. The result is that a high degree of uncertainty affects the decision-making process of businesses. Therefore, for a business to be sustainable, it must be able to anticipate the ongoing developments in the economy and society. The degree of acceptance of risk and uncertainty by the entrepreneur is related to his cognitive biases which, in turn, influence the decision-making process. Furthermore, human creativity plays an essential role in the business decision-making process under uncertainty, as it leads to the successful evolution of an already existing strategy or to the creation of novel and groundbreaking strategies that will prove effective in terms of cost and efficiency. The uncertainty that exists in a non-ergodic world influences decisionmaking, it rejects the basic assumptions of the neoclassical model and makes necessary the concept of the entrepreneur and entrepreneurship so as to exploit market imperfections and generate profit. Thus, the issue of uncertainty in business decision-making is considered even more important nowadays as low nominal returns and high uncertainty distinguish the modern changing world. Under these circumstances, even low levels of uncertainty cause significant fluctuations in real returns. Thus, entrepreneurship operates under conditions that are an essential source risk but also of wealth for the entrepreneur. For businesses to understand the form of uncertainty, they need to identify the causes that cause uncertainty in each business and be able to formulate appropriate strategies for dealing with it more effectively. In this context, the traditional methods of estimating uncertainty6 are considered inadequate as tools for predicting future situations. This is due to their limited ability to take into account multiple parameters, factors, and variables. Therefore, under these circumstances, the introduction and use of the most modern investment valuation tools and methods are non-negotiable, so as to profit from a multitude of indicators and scenarios that can identify opportunities and threats, distinguish between short- and long-term risks and help manage them effectively. Consequently, new approaches are needed to evaluate future business opportunities, as traditional ones cannot meet the demands of the modern environment that is shaped and characterized by low nominal interest rates and high uncertainty. These

210

P. E. PETRAKIS

evaluation tools need to be based on the concept of strategic thinking (Moon, 2013; Pagani & Otto, 2013) which is the process whereby managers recognize the competitive advantage and seek to maintain that advantage in the future. In this way, a creative analysis is developed of the strategic scenarios thinking (Petrakis & Konstantakopoulou, 2015; Petrakis, Kostis, & Kafka, 2015) which outperforms simple-to-use scripts. In conditions of high uncertainty and low nominal returns, creativity is called upon to discover the limited entrepreneurial opportunities and contribute to their successful implementation.

8.10

Entrepreneurship and Creativity

Creativity is considered a concept intrinsic to entrepreneurship (Schumpeter, 1934 [1911]; Gilad 1984; Whiting, 1988; Nystrom, 1993; Lee, Florida, & Acs, 2004) although in the past, the two were thought of as distinct (Stein, 1974). It is perhaps the most important source of business ideas necessary for successfully launching an enterprise, while its importance is crucial both in starting a new business and in the decisions to be made throughout the business’ running cycle. In times that are dominated by conditions of extreme uncertainty and low nominal returns, the creative cognitive function plays an important role, as it seeks out limited entrepreneurial opportunities and contributes to their successful realization. Creative people are the ones who bring about a productive change in the system. Creativity is considered as a manifestation of human expression for which there may be a charge, although its effect on the real economy cannot precisely be defined. Therefore, in addition to having an appropriate business climate, entrepreneurship requires an environment in which creativity and innovation can flourish. Innovation (Ward, 1994) is applied creativity. Therefore, creativity is not the same as innovation and is considered to bring together all intelligent ideas and devise ways of doing so, in the broadest sense. Creativity is a key source of innovation and can lead to the creation of new businesses and the improvement of existing products, so that businesses become more efficient and competitive. The concept of entrepreneurial creativity is perceived as one of the most important business skills in starting and running a business, and, also, a factor that promotes higher levels of business efficiency and competitiveness and shapes business strategy and incentives for employees. The companies and organizations that seem to deliver the

8

ENTREPRENEURSHIP

211

highest level of long-term performance are those which are the most creative and innovative. Factors that have a positive influence on creativity, which in turn affect business activity and, thus, economic growth (Petrakis & Kafka, 2016), are: 1. Knowledge and education: Efficient knowledge management leads to a competitive advantage, as a business (or organization) becomes more creative and innovative and, as such, more competitive and sustainable. Cognitive skills are basic intellectual models which individuals use to organize and process the information received. How the level of education affects the level of creativity differs between individuals, as the role of each person’s general environment in relation to the level of knowledge is particularly important, resulting in differences in people’s perception as regards the discovery, invention, and creation of new innovations (Petrakis & Kostis, 2013; Petrakis, Kostis, & Valsamis, 2014). 2. Disrupting technologies7 : Technology and innovation are a crucial source of economic growth and standard of living. A series of empirical studies (Dean, Brown, & Bamford, 1998; Dean & Meyer, 1992; Eckhardt & Shane, 2011) have concluded that there is a strong link between the application of scientific and technological creative implementations and entrepreneurial creativity (McMullan & Kenworthy, 2015). However, concerns have been expressed that overly “smart” and advanced technology kills creativity. These positions argue that future generations who aspire to innovate will be faced with educational and cognitive encumbrances. 3. The diffusion of creativity: The magnitude of the impact of creativity on economic growth depends on the tendency for creative capital to spread. The availability of creative capital does not lead per se to economic growth, but entrepreneurship facilitates the diffusion and commercialization of those ideas. 4. The cultural background and personal characteristics of individuals: A variety of cultural traits also stimulates creativity. The ability of businesses to tackle different cultural aspects in order to achieve better results is a critical issue. Diverse cultural characteristics help the group to adopt new views as opposed to groups with homogeneous characteristics. Cultures which reward creativity and encourage their members to achieve individual achievements, tend

212

P. E. PETRAKIS

to achieve better innovation outcomes. Also, different cultural behaviors have been observed when it comes to the creation of new businesses. 5. The incentives: A main source of stimulation of an individual’s creativity is their personal motivation. In particular, endogenous incentives associated with creativity, well-being and spontaneity. 6. The existence of and access to resources: The existence of resources is a crucial element for engendering the creative capital in a business, organization, or community. Apart from the existence of the necessary resources, it is very important that they be properly managed. In the literature, some researchers argue that the existence of abundant resources is an essential ingredient for the development of creativity, while some suggest that limited resources promote creativity, as the difficulty in resolving the various processes requires a higher level of creativity. 7. Economic and political institutions: The institutional environment (economic, political, social) influences business creativity, either as an obstacle or as a support (McMullan & Kenworthy, 2015; Shane, 2003). More specifically, the economic environment influences creativity, mainly through wealth, economic stability, capital, and taxation (Audretsch & Acs, 1994; Bruce & Mohsin, 2006; Djankov, Ganser, McLiesh, Ramalho, & Shleifer, 2010), while the political environment, through political freedom and will, and the degree of centralization of power (Roll & Talbott, 2003; Weymouth & Broz, 2013). Finally, one of the most critical factors affecting the level of creativity is the immediate social environment of the individual, which, if favorable, fosters the development of creativity.

8.11

Entrepreneurship and Innovation

Through the intense competition in the international economic environment, companies, in their quest to achieve higher profits and more significant market share, are forced to switch to innovative ideas. Through innovation, businesses are driven to create products, services, and production processes that respond to the changing demand. Innovation is an integral part of entrepreneurship. Developing and implementing an innovative idea leads initially to conquering a greater market share and increasing customer satisfaction. Moreover, it creates value in the new

8

ENTREPRENEURSHIP

213

or improved product or service, generates wealth, improves business adaptation, and increases productivity. Schumpeter (1921, 1939) distinguishes three types of research leading to innovation: Basic research that is usually carried out in universities or large research laboratories, resulting in inventions.8 Applied research, where innovation is created. Innovation, therefore, is the process of converting an invention into a product to be placed on the market, or into a new production process. The diffusion of innovation to other businesses. Other companies apply the successful product or the successful production process obtained through innovation. He argues that only large companies can create innovations because, in addition to large sums of money, specialized research teams are needed, and the results of these efforts are never certain because the risk of failure is quite real. The entrepreneur, in his attempt to make a profit, organizes the factors of production in a new way that will make his products stand out from their competitors’. Indeed, the emphasis is characteristic which Schumpeter places on the role of the entrepreneur as the first to implement innovation—the “revolutionary” who changes the state of stagnation in the market. Innovation brings profits to the entrepreneur who implements it. On the other hand, however, the potential for profits also generates the interest of other entrepreneurs for the specific innovation in question. The latter will attempt to imitate it and bring new products to the market. Innovation can take many forms. The two most important are related to aggressive and defensive innovations, followed by imitative and subordinate ones. • Aggressive innovations make intensive use of research and the development of new technologies and require laborious and long-term research efforts, specialized scientific teams, huge funds, as well as the ability of the business to take the risk that all of the above may not lead to a good commercial idea. For this reason, very large companies are mostly the ones who promote aggressive innovations. • Defensive innovations are the response of other entrepreneurs to aggressive innovation. They also require the intensive use of new technology research and development mechanisms, as well as the other factors used in the case of aggressive innovation. • In mimetic innovation, entrepreneurs merely imitate the successful products that emerged from the forms of innovation above, without

214

P. E. PETRAKIS

trying to improve or change their features. This is precisely the kind of innovation which pioneering entrepreneurs try to prevent, using the means offered by patents and copyright protection. Imitative innovation allows other entrepreneurs to share the profits which pioneers generate, without themselves having to contribute to the costs involved in the innovation. The result of their action is to reduce the profits of the sum total of companies in the market. • Dependent innovations are a particular category of innovation, not related to the application of the innovation by the company that created it, but to the obligation of its application by another company which is dependent on the company that first created it. The dependency relationship is defined as the unequal relationship between two companies in the product manufacturing process. The dependent innovation has a positive impact on the business which imposes it, though it is not certain that it will have the same impact on the business which accepts and implements it. Internal factors that shape the enterprise’s innovation capacity, include the education level of the entrepreneur or founder, as well as his experience, the qualifications skills, and training of the workforce, continuous technological efforts and business costs for formal and informal research and development, etc. On the other hand, external factors include good networking, geographical proximity, and institutional support. Moreover, Yoo, Sawyerr, and Wee-Liang (2015) point out that the decision to outsource is determined both by factors that are extrinsic and others that are endogenous to the company. Exogenous factors, such as the market, technological change, and the intensity of competition, push a company to outsource innovation for the sake of innovation, while endogenous factors such as avoiding ambiguity, organizational inactivity, and low assimilation capacity, can suspend the supply of external knowledge. For entrepreneurship to achieve its goal to a significant extent, it must be knowledge-intensive, i.e., it must utilize research results and ideas from professional and business practice. To this end, spin-off companies are established, created either by individual employees in an organization, university or research center, or because of technology transfer from one organization to another. They represent the transfer of technological innovation to a new business venture or company that is established based on that innovation. The spin-off can be either corporate—new companies created to exploit commercially innovative research results

8

ENTREPRENEURSHIP

215

developed within a company or organization—or academic—set up to commercialize an intellectual property that has been produced within the academic community. They contribute to national competitiveness, create jobs locally and also provide input to the academic community. Academic spin-offs are externalities that are marketed by businesses for which the university is the source of diffusion. Universities create secondary technological spill-over effects that are exploited by start-ups (Shane, 2001a, 2001b). Note that the role of innovation in economic growth, whether introduced externally—from the external environment to business—or an endogenous product–through business structures—has preoccupied economists (see below) since virtually the very beginning of economic science. Concerning innovative activity worldwide, we observe some clustering of countries in terms of innovative performance, mainly based on their geographical location, although the overall level of economic growth and the standard of living of the economies seem to play a more significant role. In essence, there is an “innovation gap“ that divides the developed from the developing countries of the world. The global picture presented by innovation is described in Table 8.3. North America has the highest overall score in terms of their innovative performance, followed by Europe, Asia and Oceania, Latin America and the Caribbean and, finally, Africa. Of the North American countries, the United States and Canada are particularly high in world ranking (4th and 17th, respectively) in the global innovation index. However, although the United States occupies one of the first places in world ranking in the institutional environment and the general conditions favoring innovation (placed among the best 4–11 economies), they occupy a much lower position in the index that expresses the size of innovation outputs which a given country is assigned for its inputs (22nd position). In Europe the UK and Germany stand out (5th and 9th, respectively, among 128 countries in the Global Innovation Index), while countries such as Spain and Italy show poorer innovation activity (29th and 30th, respectively) though quite high in relation to the world level. Despite the rise of international competitors, such as the United States and China, European economies are showing significant innovation performance, as evidenced by the fact that 14 of the 25 most innovative economies on the

216

P. E. PETRAKIS

Table 8.3 The picture of innovation Global Innovation Innovation outflow subIndex indicator

North America USA 61.73 (4) Canada 53.88 (17) Europe Germany 58.19 (9) Italy 46.30 (30) Spain 47.85 (29) United 61.30 (5) Kingdom Asia and Oceania China 54.82 (14) India 36.58 (52) Korea 56.55 (11) Australia 50.34 (22) Latin America and the Argentina 31.95 (73) Brazil 33.82 (66) Africa Egypt 27.47 (92) South 34.04 (63) Africa

Innovation inflow subindicator

Research Reason and for innovation development efficiency

Innovation links

Creating knowledge

52.61 (6) 41.36 (22)

70.85 (3) 66.40 (9)

0.74 0.62

77.9 (3) 59.5 (15)

54.3 (9) 48.4 (15)

72.3 (3) 50.5 (13)

51.10 37.87 38.42 54.38

(9) (29) (28) (4)

65.28 54.74 57.29 68.22

(12) (30) (25) (6)

0.78 0.69 0.67 0.80

73.4 45.5 45.5 67.8

(7) (22) (21) (9)

53.9 37.6 26.5 50.1

(10) (34) (60) (13)

66.6 38.0 34.2 66.9

(6) (23) (25) (5)

52.75 (5) 28.49 (51) 47.15 (13) 36.33 (31) Caribbean 21.56 (75) 22.93 (67)

56.88 44.66 65.95 64.35

(26) (61) (10) (15)

0.92 0.63 0.71 0.56

58.8 34.2 89.3 61.4

(17) (35) (1) (14)

27.2 33.6 46.1 34.6

(58) (41) (18) (39)

68.1 20.9 63.1 38.0

(4) (42) (8) (21)

42.34 (72) 44.71 (60)

0.50 0.51

28.6 (38) 35.6 (32)

18.0 (106) 13.2 (60) 25.0 (66) 19.8 (47)

21.62 (74) 22.34 (68)

33.32 (106) 45.74 (51)

0.64 0.48

10.7 (55) 25.8 (43)

17.5 (110) 11.1 (66) 29.9 (48) 19.3 (48)

Notes 1. Scores for each variable can receive a minimum of 0 and a maximum of 100 2. The brackets show the ranking of each economy among 128 economies 3. The overall score on the Global Innovation Index is the simple average of the Inflow and Outflow Sub-index 4. The Innovation Outflow Sub-Index provides information on outputs that are the result of innovative activities within the economy. There are two outflow pillars: Knowledge and technology outflows and Creative outflows 5. The Innovation Inflow Sub-Index consists of five input pillars that capture the elements of the national economy, which enable innovative activities: (a) Institutions (b) Human capital and research (c) Infrastructure (d) Market sophistication, and (e) Business sophistication 6. The Innovation Performance Ratio is the ratio of the Outflow Sub-Index to the Sub-Index score. It shows how many outflows of innovation a given country receives for its inflows 7. Research & Development (R&D) assesses the level and quality of R&D actions, with indicators for researchers, gross expenditure, R&D costs of the world’s leading R&D investors, and quality of scientific and research institutions, such as these are ranked on the basis of the average scores of the top three universities in the 2015 QS Universities Ranking

8

ENTREPRENEURSHIP

217

8. The innovation linkages sub-pillar derives qualitative and quantitative data on business/university collaboration in R&D, well-developed and deep cluster domination, the level of gross foreign-funded R&D spending, the number of consortium agreements and strategic partnerships and the total number of patent applications lodged by residents in at least two regional offices under the Patent Cooperation Treaty (PCT) 9. Knowledge creation includes five indicators that are the result of inventive and innovative activities: patent applications at the national patent office and internationally through the PCT, utility templates submitted by residents at the national office, scientifically and technically published articles in evaluation papers and number of articles on an economy which have collected a minimum of references Source Global Innovation Index (2019) and author’s own creation

planet are European, while in the 10 most innovative economies globally are included: Switzerland (1st place), Sweden (2nd), Netherlands (3rd), Finland (6th), Denmark (7th), and Germany (9th). Europe has the comparative advantage of very strong institutions and well-developed infrastructures, while there is room for improvement in business culture, research and development, high-tech exports, and international patents. Korea (11th in the 128 countries) and China (14th in the ranking) stand out from the Asian continent, while India is significantly lower (52nd in the world rankings). It should be noted that the Chinese economy ranks 26th in the world in terms of the number of innovations a given country receives for its inputs, even though it does not have the best possible environment for promoting innovation (institutions, human capital and research, infrastructure, market sophistication, and business sophistication), nor enough innovation links (ranked 58th in the world). Australia ranks high (22nd in the world rankings), mainly due to the favorable environment for promoting innovation and the level and quality of R&D activities. The level of innovation is low in the countries of Latin America and the Caribbean, with typical examples being Brazil (66th in the world rankings) and Argentina (73rd in the world rankings), as it is in African countries, with typical examples South Africa (63rd) in the world rankings) and Egypt (92nd in the world rankings). These countries do not have a favorable environment for promoting innovation, resulting in low quality and quantity of innovation outputs while, at the same time, lacking appropriate innovation links and adequate knowledge creation.

218

P. E. PETRAKIS

Notes 1. The termination of the operation of an undertaking describes as failures those businesses that were sold by their owners for profit. We can say that shutting down a business may be a sign that it has failed, but we must not miss causes such as the owner’s illness or finding a new business opportunity. Bankruptcy, after all, is a very narrow concept. An undertaking is declared insolvent at the request of creditors who cannot repay it. Creditors are more likely to pursue a business in bankruptcy when the amounts owed to them are relatively large and the company owed them a large amount of assets. Therefore, we expect bankruptcy data to apply more to larger companies and so they don’t give a good picture of the failure of new startups, which are probably small. Finally, the bankruptcy criterion does not characterize those businesses that were closed to avoid losses as unsuccessful. 2. Economies experience periods of prosperity and recession, one after another. This phenomenon is called “business cycle.” 3. Here, the entrepreneur is understood as the person who is engaging in business in the broadest sense, in all areas of social and economic activity. 4. It is about risk-taking (such as the Schwartz dimension where individuals are separated by the degree to which they take risks), community service (such as active membership or self-help groups and groups), mutual assistance (whether in sports or leisure organizations), and creativity (such as the Schwartz dimension in which individuals are separated by the degree to which they are creative and imaginative), etc. 5. The cognitive structures are basic intellectual models of mental function that individuals use to organize and process the information they receive (Wright and Stigliani, 2012). The cognitive structures attempt, through human thinking, to create a set of rules that will apply universally to a multitude of different situations. Their contribution to the process of looking for entrepreneurial opportunities is critical as it helps to exploit the information available and highlight opportunities. 6. The use of traditional methods of assessing high uncertainty in trying to steer future entrepreneurship, can, in the best of cases lead to a marginal contribution to successful decision-making and implementation of strategic decisions or to enormous risk at worst (Courtney, Kirkland, & Viguerie, 1997). The main reason behind the failure of traditional methods of estimating uncertain situations is that they direct entrepreneurs and business executives to think about and deal with uncertainty in a “binary” way. In particular, they may assume either that the world is known with certainty and, therefore, accurate predictions can be made, or they may assume that the future is completely unknown and, as such, is entirely unpredictable. When the uncertainty factor is underestimated, then entrepreneurs and

8

ENTREPRENEURSHIP

219

business executives are led to strategies for making decisions that cannot protect the business from threats, nor to identify opportunities arising from their activity at a higher level of uncertainty. In such a case, then, businesses become adrift on an uncertain future and they risk not only gaining competitive advantages but, on the contrary, endangering their very existence. The assessment of investments using traditional methods is based on discounting cash flows. The basic premise of these models is that they do not share the flexibility of managers in the decision-making process. In particular, when new information is available, managers are deprived of the ability to vary their initial choices. At the same time, the concept of uncertainty has a limited impact on decision-making, as new information available in each period fails to be incorporated into the analysis. In this context, in an environment of high uncertainty, discounting an investment at a specific rate in the long run fundamentally fails to incorporate the particular features of each period. That is, the discount rate is unable to respond to real conditions, as it does not fully integrate the available market information. At the same time, economic agents form rational expectations for the projected interest rates. In addition to the discount rate, other problems concern the estimation of future cash flows and the expected business life of the assets. Another major problem of traditional assessment methods is the inability to recognize the business environment and the ability to strategically flex. If the expected cash flows are predetermined, then the model assumes that there are no fluctuations that could change the value of a project. If managers have the opportunity to diversify their initial plans, then there is value in flexibility. 7. New technologies that represent a rapid change in capabilities or terms of price/performance of substitutes and competing products, or related to developments that lead to accelerated change rates or discontinuous capacity improvements, have been termed “disrupting technologies ” (McKinsey, 2013). 8. An invention is defined as a new idea or a new design that can lead to a new product or to an improvement of an existing product.

References Acs, Z., & Szerb, L. (2010). The Global Entrepreneurship Index (GEINDEX). Foundations and Trends in Entrepreneurship, 5(5), 341–435. Audretsch, D. B., & Acs, Z. J. (1994). Small business economics. Small Business Economics, 6(6), 439–449. Beugelsdijk, S. (2007). Entrepreneurial culture, regional innovativeness and economic growth. Journal of Evolutionary Economics, 17 (2), 187–210.

220

P. E. PETRAKIS

Braunerhjelm, P., Acs, Z. J., Audretsch, D. A., & Carlsson, B. (2010). The missing link: Knowledge diffusion and entrepreneurship in endogenous growth. Small Business Economics, 34(2), 105–125. Bruce, D., & Mohsin, M. (2006). Tax policy and entrepreneurship: New time series evidence. Small Business Economics, 26(5), 409–425. Bruno, A. V., & Leidecker, J. K. (1988). Causes of new venture failure: 1960’s vs. 1980’s. Business Horizons, 31(6), 51–57. Companys, Y. E., & McMullen, J. S. (2007). Strategic entrepreneurs at work the nature, discovery and exploitation of entrepreneurial opportunities. Small Business Economics, 28, 301–322. Courtney, H., Kirkland, J., & Viguerie, P. (1997). Strategy under uncertainty. Harvard Business Review, 75(6), 67–79. Dean, T. J., Brown, R. L., & Bamford, C. (1998). Differences in large and small firm responses to environmental context: Strategic implications from a comparative analysis of business formations. Strategic Manage Journal, 19, 709–728. Dean, T. J., & Meyer, G. D. (1992). New venture formations in manufacturing industries: A conceptual and empirical analysis. In N. Churchill, S. Birley, W. Bygrave, D. Muzyka, C. Wahlbin, & W. Wetzel (Eds.), Frontiers of entrepreneurship research (pp. 173–187). Babson Park: Babson College. DiMaggio, P. J. (1988). Interest and agency in institutional theory. In L. Zucker (Ed.), Institutional patterns and organizations (pp. 3–22). Cambridge, MA: Ballinger. Djankov, S., Ganser, T., McLiesh, C., Ramalho, R., & Shleifer, A. (2010). The effect of corporate taxes on investment and entrepreneurship. American Economic Journal: Macroeconomics, 2(3), 31–64. Eckhardt, J. T., & Shane, S. A. (2011). Industry changes in technology and complementary assets and the creation of high-growth firms. Journal of Business Venturing, 26(4), 412–430. Ekanem, I., & Wyer, P. (2007). A fresh start and the learning experience of ethnic minority entrepreneurs. International Journal of Consumer Studies, 31(2), 144–151. Gaskill, L., Van Auken, H., & Manning, R. (1993). A factor analytic study of the perceived causes of small business failure. Journal of Small Business Management, 31(4), 18. GEM. (2019). 2018/2019 global report. Retrieved from https://www.gemcon sortium.org/file/open?fileId=50443. Gilad, B. (1984). Entrepreneurship: The issue of creativity in the market place. The Journal of Creative Behavior, 18, 151–161. https://doi.org/10.1002/j. 2162-6057.1984.tb00379.x. Global Innovation Index. (2019). The Global Innovation Index (2019). Winning with Global Innovation.

8

ENTREPRENEURSHIP

221

Greif, A. (1994). Cultural beliefs and the organization of society. Journal of Political Economy, 102(5), 912–950. Hofstede, G. (1980). Culture’s consequences: International differences in workrelated values. Beverly Hills, CA: Sage. Hofstede, G., Hofstede, G. J., & Minkov, M. (2010). Cultures and organizations: Software of the mind. New York: McGraw-Hill (Rev. 3rd ed.). Inglehart, R., Haerpfer, C., Moreno, A., Welzel, C., Kizilova, K., Diez-Medrano, J., Lagos, M., Norris, P., Ponarin, E., & Puranen, B., et al. (Eds.). (2014). World values survey: Round six-country-pooled datafile 2010–2014. Madrid: JD Systems Institute. http://www.worldvaluessurvey.org/WVSDocumentatio nWV6.jsp. Kirzner, I. M. (1973). Competition and entrepreneurship. Chicago: University of Chicago Press. Kirzner, I. M. (1997). Entrepreneurial discovery and the competitive market process: An Austrian approach. Journal of Economic Literature, 35, 60–85. Lee, S. Y., Florida, R. L., & Acs, Z. J. (2004). Creativity and entrepreneurship: A regional analysis of new firm formation. Regional Studies, 38, 879–891. Leibenstein, H. (1968). Entrepreneurship and development. American Economic Review, 58, 72–83. Lucas, R. E. (1978). On the size distribution of business firms. The Bell Journal of Economics, 9, 508–523. Lynn, R. (1991). The secret of the miracle economy: Different national attitudes to competitiveness and money. London: The Social Affairs Unit. McKinsey, J. (2013). Disruptive technologies: Advances that will transform life, business, and the global economy. New York: McKinsey Global Institute. McMullan, W. E., & Kenworthy, T. P. (2015). Creativity and entrepreneurial performance: A general scientific theory. Springer. https://doi.org/10.1007/ 978-3-319-04726-3. Metzger, G. (2006). Once bitten, twice shy? The performance of entrepreneurial restarts. Center for European Economic Research, 06(083), 1–20. Moon, B. J. (2013). Antecedents and outcomes of strategic thinking. Journal of Business Research, 66, 1698. Nystrom, H. (1993). Creativity and entrepreneurship. Creativity and Innovation Management, 2(4), 237–242. Pagani, M., & Otto, P. (2013). Integrating strategic thinking and simulation into marketing strategy: Seeing the whole system. Journal of Business Research, 66(9), 1568–1575. Petrakis, P. E., & Kafka, K. I. (2016). Entrepreneurial creativity and growth. In M. Franco (Ed.), Entrepreneurship. London: Intech. Petrakis, P. E., & Konstantakopoulou, D. (2015). Uncertainty in the entrepreneurial decision making: The competitive advantage of strategic creativity. New York, NY, USA: Palgrave Macmillan.

222

P. E. PETRAKIS

Petrakis, P. E., & Kostis, P. C. (2013). The effects of cultural background, and knowledge creation and impact on self-employment and entry density rates. Review of Economics and Finance, 3(2), 18–32. Petrakis, P. E., Kostis, P. C., & Valsamis, D. G. (2014). Innovation and competitiveness: Culture as a long-term strategic instrument, culture on innovation and competitiveness during the European Great Recession. Journal of Business Research, 68(7), 1436–1438. Petrakis, P. E., Kostis, P. C., & Kafka, K. I. (2015). Secular stagnation, faltering innovation, and high uncertainty: New-era entrepreneurship appraisal using knowledge-based thinking. Journal of Business Research. https://doi.org/10. 1016/j.jbusres.2015.10.078. Petrakis, P. E., Valsamis, D. G., & Kafka, K. I. (2016). From an optimal to a stagnated growth prototype: The role of institutions and culture. Journal of Innovation & Knowledge. Retrieved from https://doi.org/10.1016/j.jik. 2016.01.011. Porter, M., Sachs, J., & McArthur, J. (2002). Executive summary: Competitiveness and stages of economic development. In M. Porter, J. Sachs, P. Cornelius, J. McArthur, & K. Schwab (Eds.), The global competitiveness report 2001–2002. New York: Oxford University Press. Praag, C. M. (1996). Determinants of successful entrepreneurship. Amsterdam: Thesis Publishers. Ricardo, D. (1817). The principles of political economy and taxation. London: John Murray. Roll, R., & Talbott, J. (2003). Political freedom, economic liberty, and prosperity. Journal of Democracy, 14(3), 75–89. Rostow, W. (1960). The stages of economic growth. Cambridge: Cambridge University Press. Schror, H. (2006). The profile of the successful entrepreneur: Results of the survey ‘Factors of Business Success’. Statistics in focus (Eurostat). Schmitz, J. A. (1989). Imitation, entrepreneurship, and long-run growth. Journal of Political Economy, 97 (3), 721–739. Schumpeter, J. A. (1921). The theory of economic development. Cambridge: Harvard University Press. Schumpeter, J. A. (1934 [1911])). The theory of economic development. Oxford: Oxford University Press. Schumpeter, J. A. (1939). Business cycles: A theoretical, historical and statistical analysis of capitalist process. New York: McGraw-Hill. Schumpeter, J. A. (1942). Capitalism, socialism and democracy. New York: Harper & Row. Shane, S. (2001a). Technological opportunities and new firm creation. Management Science, 47 , 205–220.

8

ENTREPRENEURSHIP

223

Shane, S. (2001b). Technology regimes and new firm formation. Management Science, 47 , 1173–1190. Shane, S. (2003). A general theory of entrepreneurship: The individual-opportunity nexus. Cheltenham: Edward Elgar. Shane, S., & Venkataraman, S. (2000). The promise of entrepreneurship as a field of research. Academy of Management Review, 25(1), 217–226. Smith, A. (1981 [1776]). An inquiry into the nature and causes of the wealth of nations. In R. H. Campbell & A. S. Skinner (Eds.), The Glasgow edition of the works of Adam Smith, 2. Indianapolis: Liberty Fund. Spence, J. T. (1985). Achievement American style: The rewards and costs of individualism. American Psychologist, 40, 1285–1295. Stein, M. I. (1974). Stimulating creativity. London: Academic Press Inc. Ucbasarana, D., Westhead, P., Wright, M., & Flores, M. (2009). The nature of entrepreneurial experience, business failure and comparative optimism. Journal of Business Venturing, 25, 541–555. Ulmer, M., & Nielsen, A. (1947). Business turn-over and causes of failure. Survey of Current Business, 27 , 10–16. Ward, T. B. (1994). Structured imagination: The role of conceptual structure in exemplar generation. Cognitive Psychology, 27, 1–40. Weymouth, S., & Broz, J. L. (2013). Government partisanship and property rights: Cross-country firm level evidence. Economics & Politics, 25(2), 229– 256. Whiting, B. G. (1988). Creativity and entrepreneurship: How do they relate? Journal of Creative Behavior, 22, 178–183. Wright, M., & Stigliani, I. (2012). Entrepreneurship and growth. International Small Business Journal, 31(1), 3–22. https://doi.org/10.1177/026624261 2467359. Yoo, S.-J., Sawyerr, O. O., & Wee-Liang, T. (2015). The impact of exogenous and endogenous factors on external knowledge sourcing for innovation: The dual effects of the external environment. The Journal of High Technology Management Research, 26(1). https://doi.org/10.1016/j.hitech. 2015.04.002.

PART III

Growth Sources in Economic Thought

CHAPTER 9

The Evolution of Economy and Economic Thought

9.1

Introduction

Theoretical thinking is developed on the basis of the real issues to be resolved and the way the human mind perceives them. Thus, developments in the real economic field trigger corresponding theoretical pursuits, which have their own dynamics. Therefore, the existence of real economic problems to be solved is a necessary, though not sufficient, condition for theoretical economic research. In the following chapters, we will search for the sources of economic growth as economic thought evolves. The search for growth sources has been an issue of concern for economic thinkers since the period of Enlightenment. Classical economics, from the eighteenth to the early nineteenth century, attempted to provide a comprehensive, structured conceptual framework for the generation and distribution of wealth. Ever since then, the evolution of economic thought has been constantly expanding. The search for the sources of economic growth as economic thought evolves will be presented later in this book, based on both the chronological and thematic evolution of economic science. This will allow us to monitor its maturation. That is, we will be following the evolution of that part of economic thought which will subsequently identify the sources of general and integrated growth. This complex presentation methodology was deemed necessary for a number of reasons: © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_9

227

228

P. E. PETRAKIS

1. The departure point of all the economic theories and viewpoints of classical economics was unitary in character. Similarly, the great neoclassical economists who followed, such as Marshall and Walras, established general conceptual approaches, such as that of general equilibrium. The same was the case with Veblen’s ideas of evolution. 2. The emergence of scientific subfields took place only in the aftermath of Keynes’ era, and mainly after the war. The scientific subfields on which we will focus are the theory of growth and development, international economics and international trade, microeconomics and macroeconomics. At the same time, adjacent sciences such as history, anthropology, and others will feature in the analysis. 3. It is extremely difficult to draw clear dividing lines between scientific subfields. Besides, it is rare for the effects of an intellectual contribution to be confined to a single scientific field. In most cases, the effects of theoretical contributions are diffused vertically (over-time effect) and horizontally (between scientific subfields), as the same source of growth (e.g., increasing returns) may appear in several scientific subfields, such as in international trade and macroeconomic perspective.

9.2

Economy and Evolution of Economic Thought

The fathers of economic science wrote their works in the wake of completing a specific picture of economic reality, first in its static and later, in its dynamic version. This is the period of the birth of economic theory by the classical economists prior to its later maturation, from 1720 to 1930. The world of that time was characterized by a much smaller amount of circulating information and fewer communication channels, but it was not a simple one. Indeed, comparing the level of development of analytical tools with the cataclysmic events of the Industrial Revolution and the formulation of Darwin’s laws of variation, we can claim the exact opposite: that world was becoming complex at a rapidly accelerating rate. The Classical Economists, as well as their immediate successors (1880– 1930), especially the Neoclassicals and the Evolutionarists, understood

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

229

the economy as a whole, first in the form of political economy, then, in terms of the general laws of evolution and, later, in the form of general equilibrium. In these two centuries, almost all sources of economic growth that we have known since then were scientifically determined (with the debate already begun by the ancient Greeks1 ). What has changed so far is the analytical and summarizing ability of economists, and ultimately, the dominance of some of the sources of growth at different periods. Over the years, however, the picture of growth sources has been primarily enriched through their specialization. The key contributions and themes of the joint evolution of economy and economics are presented in Table 9.1. In the chapters that follow in Part C the literature references presented in this table are analyzed, in terms of their contribution to the sources of growth. These sources are also the point of reference for economic theories. This allows readers to focus on the basic literature references of each economic theory and school of thought, and then, if they so wish, to deepen their study. Table 9.1 can be read in many ways. It sets out economic thought in five major periods. The first period includes the sub-periods of the basic infrastructures for economic theory, which are: The period of Classical Economics (1720–1880) with the birth of economic theory and preparing the ground for the New Era (1880–1840) with the emergence of the Neoclassicals and the Evolutionarists up until the end of the Great Depression (1929–1940), when John Maynard Keynes emerges. Over the next four periods (1940 to date), economic thought has been evolving in terms of the extent and in depth of its analysis. At the same time, we observe the emergence of the subfields of development economics and growth economics, international economics and trade, microeconomics and macroeconomics, while influences from adjacent sciences, such as history, sociology, etc., also appear. These are the periods after the Great Depression, which was characterized by strong growth and low inflation (1940–1970), the period of low growth and high inflation (1970–1980), the period from the Great Moderation to the Great Recession of 2008 (1980–2008) and finally, the period of structural changes in world economy after the Great Recession (2008 to date).

230

P. E. PETRAKIS

Table 9.1 The key theoretical contributions to economics

(continued)

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

231

Table 9.1 (continued)

Source Author’s own creation

9.3

From the Birth of Economics to the Great Global Economic Depression (1720–1940)

During the period up to the great global economic depression, Watt’s steam engine, in the 1780s,2 boosted the integration of machines into production, increasing productivity and signaling the start of the Industrial Revolution (1780–1810). The period of the Industrial Revolution was a period of rapid changes, both technological and social, leading to

232

P. E. PETRAKIS

industrialization, first in Great Britain and then in the USA and other European countries. The use of the steam engine was predominant in mines and rail transport until the proliferation of the internal combustion engine. In the 1840s, the expansion of the rail network accelerated significantly, facilitating communications and economic development. In fact, the railway revolutionized transport and, consequently, the production process chain, by reducing transport costs, eliminating distances, and providing access to new markets. At the same time, this period was characterized by the creation of new markets and the maturation of existing ones. A particular aspect of the Industrial Revolution is the “Market Revolution,” which refers to the economic transformation that took place in America during the first half of the nineteenth century. Improved means of transport gave impetus to trade and increased the rate of industrialization resulting from the Industrial Revolution. “Electrification,” which started in Britain and the USA in the mid1880s and continued until 1950, was a breakthrough achievement of the period. The transition from locomotives and hydraulic power to electric motors contributed to a series of changes in both transport and production. During the nineteenth century and the first half of the twentieth century, the main forms of energy had been coal and oil. However, not all countries were equally rich in mineral wealth, while the cost of mining created further problems in the production process. Electricity came to solve the above fundamental problems by changing the map of energy supply in the first half of the twentieth century. As a result, countries deficient in energy were now able to feed fuel their production. In addition to electricity, the use of chemicals contributed to the production of new products that met new needs, and to increased production. The synthesizing of chemicals and their use in the production process contributed to several new inventions by replacing many smallscale operations with lower-cost controllable processes. In this great economic-historical era, the evolution of economic theory has two distinct periods: setting the foundations of classical economics (1720–1880) and preparing the ground for the new era with the Neoclassicals and the Evolutionarists (1880–1929). The foundation of classical economics (1720–1880) as the beginning of economic theory was of paramount importance for the future evolution

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

233

of economic science. Classical economics, with Adam Smith (1723– 1790), David Ricardo (1722–1823), and Thomas Malthus (1766–1834) as their main exponents, attempted to provide a conceptual framework for the generation and distribution of wealth. In The Wealth of Nations, Adam Smith, in 1776, puts forward the view, for the first time, that the wealth of nations derives from the role of international trade, a concept also used by Ricardo (1817) to develop his theory about comparative and absolute advantage. Malthus (1798) also introduced the concept of population containment in the process of growth in a negative way. In addition, John Stuart Mill (1806–1873) closed the period of classical economics by formulating a “classical” theory of economic growth based on the law of diminishing returns and the limited incentive to invest. For Adam Smith, productivity of labor depends on the division of labor as a critical source of growth. Although the division of labor has been a source of conflict—as it entails the transformation of the labor force from the agricultural to the industrial sector and, subsequently, labor in the commercial sector—both Karl Marx (1818–1883) and Adam Smith recognized its role in economic growth. In the New Era, a series of heterogeneous approaches appear which provide economic theory with new insights for its subsequent evolution. When Darwin published his book The Origin of Species (1859), consideration of the principles of change, which are at the core of the growth process, was already afoot. Nevertheless, the theoretical controversy had been intense as to whether change is the result of a pre-existing law or development trend or an evolutionary shift in reality. Thorstein Veblen (1898), quoting from Darwin and others the imperative that the causal origin of all evolved phenomena had to be explained, sees the future evolution of society and the economy as a result of the collective change of society and institutions, rather than the result of a change at the individual level. In terms of the evolution of economic theory, neoclassical economics and the models of general equilibrium in particular, are at the center of attention during this period. Walras (1874) developed a model of general equilibrium regarding the microeconomic foundations of price formation. The basic assumption of perfect competition, coupled with the Pareto optimal allocation of resources in the Walrasian Paradigm and in the neoclassical model in general (Marshall, 1890; Pigou, 1912), provides a specific framework of behavior and preferences. At the same time, under

234

P. E. PETRAKIS

conditions of perfect information, markets are cleared, with no transaction costs due to the assumption of complete contracting. In his book Principles of Economics (1890), Alfred Marshall, as an exponent of neoclassical analysis, brings together the ideas of supply and demand, marginal utility, and production costs into a coherent whole. Marshall was the first to develop the supply and demand law, presenting a series of key elements in supply and demand, including supply and demand curves, market equilibrium, the relationship between quantity and price regarding supply and demand, the law of marginal utility, the law of diminishing returns, and the ideas of consumer surplus and producer surplus. The Great Depression and World War II raised the issue of recovering the damages to workforce (unemployment) and to infrastructures, alongside the ideological dominance of Keynesian ideas, which focused on managing macroeconomic demand as a source of growth, mainly by using fiscal policy (until 1970). The Great Depression was a particularly severe global economic crisis, which began in most countries in 1929 and lasted until the end of 1930. The Great Depression started from the US stock market in early September 1929 and became known worldwide with the stock market crash of October 29, 1929. The depth of the crisis at the global level was such that, for the period 1929–1932, the global GDP declined by 15%. Some economies began to recover from the mid-1930s onwards, while in many others the negative effects of the Great Depression lasted until the beginning of World War II. The turmoil created new economic realities and disrupted entire industries. Even in the worst of times, however, some well-run businesses not only survived the crisis preserving their good condition, but flourished in the aftermath of the crisis. There is no more spectacular example than the US car industry, which built then the foundation for four decades of future success. In addition, the use of oil during this period had been increasing, giving the oil industry significant power to help achieve high economic growth. In the 1930s, Austrian economists Ludwig Von Mises, Schumpeter, and Hayek make their presence felt. Subjective human choice plays an essential role in theoretical thinking. Hayek (1935) developed the theory of business cycles, based on the impact of money on relative prices. Schumpeter (1934) saw economic development as a dynamic process, as opposed to Walras’ static general equilibrium approach. The entrepreneur plays a key role, causing imbalance and change in the functioning

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

235

of the economic system. This change is endogenous. The individualism of the Austrian school helped Schumpeter to bring out the personality of the entrepreneur. In the field of trade theory, a further development of Ricardo’s theory is the Factor Endowment Theory of Heckscher (1919) and Ohlin (1933) which, building on neoclassical logic, formulated the theory that international trade will grow between two different countries even if they have the same technology, but differ in their portfolio of production factors (land, labor, capital). This period is complemented by the significant contribution of one of the major economists, Irving Fisher (1867–1947), to the formation of neoclassical utility theory and monetary economics (quantitative theory of money). Dealing with the crisis of 1929, he raised the issue of the effects of the burst of the credit bubble in a way that became relevant once again, after 2008.

9.4 The Outburst of Economic Thought: After the Great Depression and Until the Period of High Growth and Low Inflation (1940–1970) The period after the Great Depression and World War II until the time of the Bretton Woods Agreement3 (1944–1971) is an interesting historical period for many reasons. First of all, we may consider it as the “golden age of capitalism,” thanks to the extraordinary growth rates. It is also characterized as a period of moderate inflation rates. In addition, it is considered a period that has been an exception in the Western world economic history: significant exchange rate stability, very low real interest rates, and a high level of convergence of national performances. The car industry started in the United States in the 1890s—the United States retained the title of the largest carmaker until the 1980s, when Japan conquered it. At the beginning of the century, cars entered the transportation market as the “toy of the rich,” However, they became increasingly popular worldwide as they allow anyone to travel whenever and wherever they wished. As a result, in North America and Europe, cars became much more accessible to the middle class. The popularity of cars was steadily evolving along with the economy. It increased during the boom period after World War I and sharply decreased during the Great Depression of 1929, when unemployment was high. During World

236

P. E. PETRAKIS

War II, there was a significant increase in public transport due to the high employment and the comparative scarcity of cars. In addition to the immediate economic value of this change, oil was to become an integral part of many key economic sectors, such as car manufacturing and car sales, which would become important factors in the business world after World War II. The immediate post-war period of Keynesian economics saw the development of the neoclassical synthesis based on Hicks, Modigliani, Solow, Tobin, and Samuelson. They gave a more specific form to the way markets are balanced and human decisions are made. The result was the development of general equilibrium models, based on Keynesian and classical principles (Arrow & Debreu, 1954) and later, models of macroeconomic imbalances, such as those of Clower (1965) and Leijonhufvud (1968) and finally, of Barro and Crossman (1971). Another important group of prominent economists relied on Keynesian thinking. These are the Keynesians who, trying to interpret the fluctuations of the economy, developed various models based on effective demand and capital accumulation. A typical example of such a model is the one developed by Harrod (1939) and Domar (1946), also called the Harrod-Domar. The contribution of G. Myrdal to economic theory, with his work Political Element in the Development of Economic Theory (1953), seems to have been slightly ahead of John Maynard Keynes (at least concerning savings and investments, the role of the state and strengthening of economic activity). From the group of early Keynesian economists, we can single out the works of Kaldor (1957, 1961), which contributed to the formulation of certain critical ideas regarding growth models. In the decade of 1950–1960, a set of growth ideas developed which shaped what we know today as growth theory. Rosenstein-Rodan (1943), with his monumental work, formulated his argument for coordinated investment, Big Push, as a means of escaping the growth trap. Herein are present the assumptions of economies of scale and the existence of a dualistic economy (agriculture, unemployment) which can release labor force. Thus, the contribution of the less developed sector in growth (Lewis, 1954) is directly introduced as a growth factor, through the transfer of manpower to more developed sectors. In this period, we note, among others, the contribution of Hirschman, who occasioned the theoretical elaboration of the function of Leontief’s input–output tables (1951, 1966) which describe the interconnections of an economy. Gerschenkron

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

237

(1962) with the Backwardness model, argued that it is possible for a relatively well-established economy to evolve toward industrial development, mainly based on the catching up argument. Gershenkron’s model can be considered to some degree similar to that of Rostow (1960) who argued that economies, in the course of growth, go through successive quantitative stages of growth. At the same time, the neo-Marxist theories of political economy and international economic relations are developed, whose perspective of growth is quite different from that of mainstream economics. Baran’s contribution to the political economy of growth (1952, 1957) is associated to the concept of surplus value, which is directly related to growth performance. The concept of the Development of Underdevelopment was further elaborated by Frank (1966), who also promoted the theory of dependence in a different version to that of S. Amin (1976) i.e., in the form of uneven development. At the same time, the dimension of dependent development also takes the form of a substantial contrast between the so-called developed center and the less developed region, an issue first taken up in the work of Prebisch (1968) and Singer (1950). At this time, neoclassical economics emphasized the role of international trade, focusing on factor price equalization (Samuelson, 1948). Leontief’s paradox in economics is that the country with the world’s highest capital per worker has a lower ratio of capital to labor in exports than imports. This econometric finding was the result of Leontief’s attempt to empirically test the theory of Heckscher–Ohlin. Of particular interest is the theory of foreign exchange rates and optimal monetary area. These theories relate to the possibilities presented to economic policy and in particular, to conditions of growth, employment, etc, by floating or fixed interest rates, combined with the size of economies and their degree of exposure to international trade (Friedman, 1953; Mundell, 1961). In the field of finance, the works of Markowitz (1952) and Modigliani and Miller (1958) served as a reference point, contributing to the argument about growth sources. At the same time, this period provided a fertile ground for the development of monetary economics, with Friedman (1956) and Friedman and Schwartz (1963) as their main exponents, whose analysis focused on money supply and the contribution of rational expectations. In this period, there is also an attempt to highlight political action as an endogenous influence on economic development with two important manifestations: public choice and public regulation.

238

P. E. PETRAKIS

Samuelson (1954) published his work, a pure theory of public expenditure for collective consumption goods, which was the launching point for an entire sector. Public goods now play a vital role in many theories. His work is typically regarded as the foundation of modern public goods theory. Wicksell (1896) introduced the concepts of equity and efficiency in public finance decisions and thus linked public revenue decisions with public expenditure decisions. The key tool by which interventions affect the processes of producing and redistributing growth products is related to rent seeking. The idea of rent seeking was developed by Tullock (1967) and then, by Krueger (1974). Marshall’s development of the neoclassical synthesis, in which he described how the economic system functions to achieve optimal production and optimal price-setting under conditions of full competition or/and monopoly, provided impetus to the thought of Coase (1960) and John Kenneth Galbraith (1958) to acknowledge the analysis of certain aspects of the institutional framework of the functioning of the economy. Coase introduced the “neoclassical” concept of institutions. Around the same time, Galbraith (1958), with his overall strong criticism of American capitalism and influenced mainly by Veblen, expanded their thinking to include the ways in which society is organized. The model of Arrow and Debreu (1954) was the most essential theoretical reference to the theory of general equilibrium in its modern form, after Walras’s original contribution (1874). This model defines a society that interacts through a system of interconnected markets, whereby prices and quantities of equilibrium are formed. The general equilibrium model is a milestone in the theory of the functioning of the real economy, as any deviation from the equilibrium point leads to conditions of imperfect markets. Such models, assuming that businesses and households are price recipients and that prices are linear, adopt a Walrasian-type equilibrium. Nash’s equilibrium (1949), on the contrary, results from the strategic decisions of economic actors. In the Nash equilibrium, market players, rather than being price recipients, are the ones who set the prices, based on the information they have about the other players. Strategic decisions are the result of the expectations of economic actors. Finally, game theory, as a neoclassical approach to decision-making at the microeconomic level, has been at the heart of the theoretical contribution of the period of strong growth and low inflation. Game theory

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

239

provides a theoretical approach to determining how actors make decisions, based on the strategies they develop, the information available, and rational choice. The work of Von Neumann and Morgenstern, Theory of Games and Economic Behavior (1944) is considered a classic book which created the field of game theory research.

9.5

Economy with Increasing Prices (1970–1980)

The perception that education can provide benefits, including economic benefits, is certainly not new. However, the use of human capital to reflect the economic effects of education and training began to develop mainly from the late 1950s onwards. Becker’s research formed the basis for the concept of human capital, expounded in his work Human Capital (1964). Becker (1975) also treated the calculation of the return rate of the investment in human capital. In the decade of 1970–1980, trade theory was enriched with elements deriving from the field of development of strategic advantage at the enterprise level and of the development of a business strategy with international horizons. Two main approaches that have played a significant role in the above evolution: the first concerns the product’s life cycle (Vernon, 1970) and the second, the national comparative advantage (Porter, 1980). Porter’s (1980) theory of national comparative advantage is a far more sophisticated view of the interpretation of international trade trends than the classical and neoclassical concepts of comparative advantage. The new theory of trade, developed mainly by Krugman (1979), focused on multinational enterprises and their efforts to develop a comparative advantage over other similar global enterprises. High inflation from the mid-1960s to the mid-1980s (the period of the Great Inflation) gave rise to questions about the effectiveness of economic policy as it had been exercised in the 1970s. The increase in oil price led to higher inflation and was mostly beyond the control of monetary policy. Monetary policy pursued during the 1970s followed the Taylor rule,4 based on the prevailing outlook on the course of inflation and unemployment. In conjunction with the economies’ dependence on oil, inflation followed the course of oil prices. During the 1970s, monetary policy was particularly expansive, whereas a tight monetary policy would have resulted in a lower growth, in terms of total nominal demand and, consequently, a lower inflation. The empirical refutation of the Phillips curve played an important role, while stagflation

240

P. E. PETRAKIS

appeared with low growth rate και high inflation and, later, the view of monetary policy under low inflation conditions was adopted. The theories that have been developed to interpret the high inflation of this period are divided into three categories: 1. theories that focus on “bad luck” because the inflation coincided with the increase in oil price; 2. theories that focus on wrong policies on the part of the Central Banks; and 3. theories that combine the two preceding approaches. A particular approach to price increase is based on the hypothesis to which Orphanides (2003) refers as the “mismeasurement of the potential output,” which economy is ready to undertake over full employment, an approach which distances itself from views on how the economic model and cost inflation function. During the period of high inflation and low growth (1970–1980), in response to the failure of the Keynesian economics and as an explanation for stagflation, the New Classical economics emerged and rapidly became mainstream. Their main feature is the determination of the analysis of the general equilibrium and, in particular, of the clearing of prices and the market, based on rational expectations. Lucas’s critique (1976) necessitated the revision of Keynesian economics, enhancing the introduction of microeconomic principles into macroeconomic models. In his text, Econometric Policy Evaluation: A Critique (1976), Lucas argues against the effectiveness of economic policy because the latter changes the structure of the economic system. Across the spectrum from them, New Keynesian economics emerged. The New Keynesian economics is a school of macroeconomic thinking that seeks to align Keynesian economics with microeconomic baselines, market imperfections, and nominal wage rigidities. The emergence of the New Keynesian economics in the 1980s came as a result of the strong criticism of new classical economists on many aspects of the Keynesian approach. I. Fischer (1977) was one of the first to contribute to New Keynesian economics, focusing on nominal rigidities due to the existence of contracts in the labor market. He studied the role of monetary policy

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

241

which may influence the behavior of the actual GDP. Fischer (1977) and Taylor (1980) argue that labor market contracts are a factor of wage rigidity. An important dimension of the microeconomic thinking of this period concerns how the economic and institutional frameworks function together between economic actors. Three situations have been particularly analyzed: adverse selection (Akerlof, 1970), moral hazard, and signaling. Williamson’s (1975) contribution is also relevant: the lower the transaction cost for the sake of improving market efficiency, the lesser the loss of prosperity in the economy and the more resources become available so as to accumulate capital and take steps to achieve growth. Finally, during this period there is an active incursion into economics of psychology which had disappeared from economic debate by the middle of the twentieth century. Behavioral economics, rather than explaining economy through a rigid and predetermined view of human rationality, attempts to study it without such prior assumptions, while seeking the assistance of other social sciences, such as Psychology or Sociology. Perhaps the most critical views in the field of behavioral economics and finance during the 1970–1980 period were formulated by Tversky and Kahneman (1974) and Kahneman and Tversky (1979), where cognitive psychology techniques were used to explain various documented abnormalities in the rational decision-making process.

9.6 The Economy from the Period of Great Moderation to the Period of Great Recession (1980–2008) The period from the mid-1980s to the emergence of the Great Recession in 2008, known as the period of Great Moderation, was a period of unusual macroeconomic stability for world economy. The lack of sharp fluctuations in the business cycle and the economic progress of the developed and emerging economies were defining features of this period. When GDP volatility declined (after 1980) and the evolution of economies was normalized, emphasis on growth theories sought and promoted innovation, while at the same time, Information Technology and biotechnology revolutions created new data in the real economy. Research focused on short-term fluctuations by incorporating rational expectations in the Real Business Cycle (RBC) Theory. These abstractions

242

P. E. PETRAKIS

of a macroeconomic type focused on the mechanism of economic cycles and the countercyclical effects of monetary and fiscal policies. New Keynesians, as well as supporters of the real business cycles now turned their attention to the way that prosperity in the economy could be preserved and expanded. This is the period when central bank interdependence and global economic policy coordination structures are formed. At the same time, the degree of financialization of economies and the expansion of the influence of the financial sector play a significant role in expanding citizens’ prosperity. At the core of the Real Business Cycles (RBC) are the microeconomictype foundation and the decisions of economic actors shaping the upward and downward course of the economy. In their influential work, Kydland and Prescott (1977, 1982) introduce a RBC theory by providing a methodology for exploring business cycles. In a sense, RBC models are the descendants of the models of Lucas (1975) and Barro (1976), founded on microeconomic-type bases of the ArrowDebreu general equilibrium. So, analytic Dynamic Stochastic General Equilibrium Models—DSGE Models (Rotemberg & Woodford, 1997) appear that follow the structure of RBC models while, however, assume non-competitive markets where prices are adjusted at no cost. In an attempt to rebuild Keynes’ main ideas, the Post-Keynesian school of thought emerged. This school focuses mainly on the study of financial markets. It also focuses on the behavior and functioning of the real economy, downgrading monetary and financial effects, as well as uncertainty. The Post-Keynesians’ theoretical background is based on the principle of active demand. According to Davidson (1984), one of the most important representatives of Post-Keynesian economists, market clearing is not the result of an autonomous process of changing the relative prices that can bring the economy into balance. On the contrary, the behavior of households and businesses is determined by many factors other than relative prices. In the field of finance, another prominent representative of Post-Keynesian economists, Minsky (1986), focuses on financial crises and proposes the concept of financial market fragility. This contribution became widely known as the “Minsky moment,” where long periods of speculation lead to a deep crisis. The Financial Instability Hypothesis—FIH aimed to interpret volatility in financial markets as a result of the normal functioning of a capitalist economy (Minsky, 1985).

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

243

In this period, the full attention of growth analysis is focused on compensating for diminishing capital returns. The theory of endogenous growth (Acemoglu, 2009; Aghion & Howitt, 1988, 1992, 2009; Barro & Sala-i-Martin, 2003; Mankiw, Romer & Weil, 1992) was expressed in two main conceptions: AK models, where diminishing returns disappear because the model incorporates both the natural and human capital, and innovation-driven growth models (Lucas, 1988, 1990; Romer, 1986, 1990) with two parallel subcategories: Romer’s product varieties, where the degree of product variety neutralizes all of the diminishing returns, and Schumpeter’s quality improvement, which also eliminates diminishing returns. In the field of evolutionary theory, new approaches emerge with Neo-Darwinism (also known as modern evolutionary synthesis) which encompasses the basic principles of natural selection, with culture functioning in this process as a transmission mechanism. A key element in evolutionary theory is the role of research and development, which emphasizes the costs of accumulating knowledge and developing knowhow, factors that increase the chances of businesses to survive within intense competition and also be able to develop further.

9.7

Structural Changes in Global Economy in the Aftermath of the Great Recession (2008 to Date) The period of the Great Moderation ends with the emergence of the Great Recession of 2008, which is a longlasting crisis. During the Great Recession, central banks keep inflation stable by controlling interest rates, while simultaneously trying to stabilize demand. At the same time, the fiscal policy pursued imposed discipline on public sector deficits, thus addressing—indirectly—the level of public debt (Allsopp & Vines, 2015). Monetary policy assisted by fiscal policy worked effectively to stabilize the economy. So, what we now call New Consensus Assignment between fiscal and monetary policy was formed. Monetary policy could stabilize the economy by controlling inflation, while fiscal policy would be responsible for controlling fiscal deficits and debt sustainability. The emergence, however, of the Great Recession in 2008 was accompanied by the need to deleverage the private sector and maintain zero interest rates, resulting in monetary policy no longer being able to serve

244

P. E. PETRAKIS

the targets pursued by policymakers. In addition, product output was reduced sharply, tax revenues were reduced and public debt followed an upward trajectory, while the private sector followed a persistent deleveraging process. Fiscal policy could restore the economy to an environment of full employment if there were fiscal space to assist growth recovery. However, the high deficits of the heavily indebted countries (i.e., countries at the Eurozone periphery) did not allow for an expansive fiscal policy to be implemented. On the contrary, the austerity policies implemented after the Great Recession in Europe to curtail public debt, delayed the recovery of economies. The majority of researchers agree that, toward the end of the Great Moderation, the imbalances accumulated from 1980 onwards led to the Great Recession. The overconfidence of economic actors and excessive leverage made the global economy vulnerable to even a small shock (Brunnermeier, Eisenbach, & Sannikov, 2013; Brunnermeier & Sannikov, 2013). As a result of the change in the way expectations were formed, the Great Recession created a lack of confidence making it impossible to return to a stable structure, such as the one prevailing during the Great Moderation. Major economies, mainly the United States and the United Kingdom, did not return to satisfactory growth rates, despite signs of recovery they gave after the Great Recession. The dilemma for policymakers was great: whether to respond to low growth by maintaining zero interest rates, thereby jeopardizing the continued increase in asset prices or to use fiscal policy to increase the supply of products and services. Neither option was particularly pleasing (Allsopp & Vines, 2015), because both involved costs. The performance of individual economies and those within the more generalized clusters (developed/developing) were quite divergent. The most significant differences are observed between the EU-28 countries and the United States with the United Kingdom. The transatlantic growth rate gap is attributed to differences in the components of GDP growth. The main reason for the difference in GDP growth between the United States and the Eurozone lies with private consumption, which increased in the United States but decreased in the Eurozone and especially so in the periphery. However, the difference in investment is not enough. Public expenditure in the Eurozone has remained de facto fairly stable in recent years, and has declined significantly in the United States. However, the

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

245

long-term trend of low growth rates is accompanied by low-productivity rates. The Great Recession affected the diversification of performance between different groups of countries (developed versus emerging) due to: 1. the specific characteristics of the onset of the financial crisis—and of subprimes in the western developed countries; 2. the more specific characteristics of its diffusion; and 3. the differential effectiveness of the policies to tackle it. Worldwide, there is now a sharp and voluntary instances of monetary devaluation, with the aim of exerting pressure to increase exports and reduce imports so as to restore growth. Specifically, these are currency wars (or competitive devaluation wars) in which economies that devaluate their currency aim to make their products shipped to foreign countries relatively less expensive. Supply-side arguments, which first emerged in the 1970s, have been a critical theoretical core in finding solutions to exit the Great Recession of 2008 (Dullien & Guérot, 2012; Sachs, 2012a, 2012b; Wolff 2012). At the same time, however, begins the development of a different approach to how economists perceive the functioning of the economic system by focusing on complex systems (Foster & Pyka, 2014). Borrowing the concept of complexity from physics, economic science begins to realize that the relationships formed between participants in the economic system are not as simple as it once thought. The dominant view on the implementation of fiscal consolidation policies and the widespread need to reduce the debt burden of the heavily indebted countries in the aftermath of the Great Recession, came from the scientific work of Reinhart and Rogoff (2010). They even identified a critical level, where the debt-to-GDP ratio exceeds 90%, which is crucial for the relationship between the two figures. Reinhart’s and Rogoff’s research, of course, received much criticism as it provided no evidence of the direction of causality between high debt and growth. The need to reduce public debt was accompanied by wider deleveraging in the economy, giving rise to the theoretical debate on Balance Sheet Recession and deleveraging. Initially in his work, Koo (2008) introduces the concept

246

P. E. PETRAKIS

of Balance Sheet Recession and Krugman (2009), based on it, will later develop a theoretical approach addressing that issue. At the same level as the debate on fiscal consolidation is the debate on fiscal multipliers (Blanchard & Leigh, 2012). The size of fiscal multipliers proves to be particularly critical, given that its effects on GDP, caused by an external change in fiscal deficit, depend on these multipliers. However, a great debate has arisen as to whether the negative short-term effects of fiscal consolidation were more significant than those expected, given that the importance of fiscal multipliers was downgraded. Up until the onset of the 2008 economic crisis, financial markets valued Eurozone country bonds at almost the same risk premium. The Eurozone crisis is a story of a systematic incorrect definition of public debt costs, leading to macroeconomic instability and multi-equilibrium conditions (Blanchard, 2011; De Grauwe, 2011; Wyplosz, 2010). In a state of multi-equilibrium, markets show their preference for low-interest-rate government bonds, reflecting the belief that the default rate is low. On the other hand, they show their aversion by selling bonds of other countries, increasing the latter’s borrowing costs. In this case, default is more likely as these countries, in the manner of a self-fulfilling prophecy, are pushed to bad equilibrium (Calvo, 1988; Corsetti & Dedola, 2011; Gros, 2011, 2012). The existence of many equilibrium points in public debt cost triggers confidence crises, and thus, leads to panic due to fiscal and monetary crisis. Monetary policy issues in zero lower bound conditions occupy a special position during this period (Woodford, 2011). This includes organizing expectations through the Central Banks’ forward guidance policy and their orientation toward quantitative easing. The global economic crisis of 2008 and its transformation into a debt crisis in the Eurozone countries have brought to light an important aspect of the crisis: the possibility of contagion and spillover in other European countries (ECB, 2013). The challenge faced by the ECB in 2008 resulted in the widespread use of monetary instruments (BIS, 2016) with the aim of limiting the negative impact of the heavily indebted economies of the European periphery. In this period, attention was drawn to the question of whether the conditions of secular stagnation that were created will prevail or whether the long-term post-recession stagnation tendencies are due to the large cycle of over-indebtedness which was formed. In essence, this is a different perspective on the causes of the next crisis, contrasting to the exponents of

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

247

the view of the exhausted use of monetary instruments (BIS, 2016). One definition of secular stagnation is that negative interest rates are necessary to equalize savings and investments with full employment, while the primary concern is that secular stagnation makes it even more difficult to achieve full employment with low inflation and zero interest rates (zero lower bound) (Teulings & Baldwin, 2014). The fear that has now arisen is that, if the existence of secular stagnation conditions with real interest rates remaining low or negative for a long time is confirmed, then, the classic monetary policy tools may not be sufficient (Wolff, 2014).

Notes 1. The ancient Greeks’ engagement with economic issues and phenomena reportedly begins mainly in the Classical Era, although earlier writers, such as Hesiod and Democritus, had been selectively engaged. Xenophon (430– 355 BC) is the first to use the title “Economic” in a related work to indicate the proper management of the house. Plato (427–347 BC) analyzed the key factors and institutions that should govern social relations by identifying various economic phenomena and functions. Aristotle (384–322 BC) dealt with the purposes of economic activity, the value and price of goods, money and its function, as well as private property. 2. In 1776, he presented the first improved low pressure steam engine and in 1782, the first steam engine with dual steam action on piston movement. Since 1787, a universal engine has been available with high and constant power and remarkable for its time performance rating. 3. The Bretton Woods system of monetary management established the rules of commercial and financial relations between the USA, Canada, Western Europe, Australia, and Japan in the mid-twentieth century. The Bretton Woods system was the first example of a monetary order following full negotiations for governing monetary relations between independent nationstates. 4. The Central Bank uses the Taylor rule (Taylor, 1993) as a tool for monetary policy operations on prices. The Taylor rule is a simple monetary policy rule that defines how a central bank should adjust its policy tool as regards interest rate in a systematic way that responds to inflation and macroeconomic stability developments (Orphanides, 2007). The rule is a function of inflation and unemployment and the unemployment gap resulting from the difference between the real and the natural rate of unemployment. According to Rudebusch (2010), interest rate policy should respond to deviations of inflation from its targets and deviations of unemployment from the natural rate. In other words, what causes a deceleration or

248

P. E. PETRAKIS

acceleration of inflation is the unemployment rate.   Target Rate = 1 + (1.5 ∗ Inflation)− 1 ∗ Unemployment Gap , where unemployment rate is the difference between the real and the natural rate of unemployment.

References Acemoglu, D. (2009). Introduction to modern economic growth. Princeton, NJ: Princeton University Press. Aghion, P., & Howitt, P. (1988). Growth and cycles through creative destruction (Unpublished). University of Western Ontario. Aghion, P., & Howitt, P. (1992). A model of growth through creative destruction. Econometrica, 60, 323–351. Aghion, P., & Howitt, P. (2009). The economics of growth. Cambridge, MA: MIT Press. Akerlof, G. A. (1970). The market for “lemons”: Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84(3), 488–500. Allsopp, C., & Vines, D. (2015). Monetary and fiscal policy in the Great Moderation and the Great Recession. Oxford Review of Economic Policy, 31(2), 134–167. https://doi.org/10.1093/oxrep/grv022. Amin, S. (1976). Unequal development. New York: Monthly Review Press. Arrow, K. J., & Debreu, G. (1954). Existence of an equilibrium for a competitive economy. Econometrica, 22(3), 265–290. Baran, P. A. (1952). On the political economy of backwardness. The Manchester School, 20(1), 66–84. Baran, P. A. (1957). The political economy of growth. New York: Monthly Review Press. Barro, R. J. (1976). Rational expectations and the role of monetary policy. Journal of Monetary Economics, 2, 1–32. Barro, R. J., & Crossman, H. (1971). A general disequilibrium model of income and employment. American Economic Review, 62, 82–93. Barro, R. J., & Sala-i-Martin, X. (2003). Economic growth. Cambridge, MA: MIT Press. Becker, G. (1964). Human capital. New York Columbia University Press. Becker, G. (1975). Human capital: A theoretical and empirical analysis, with special reference to education (2nd ed.). New York: Columbia University Press for NBER. BIS. (2016). Unconventional monetary policies: A re-appraisal (BIS Working Papers 570). Bank for International Settlements.

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

249

Blanchard, O. J. (2011). Blanchard on 2011’s four hard truths. (VOX, CEPR Policy Portal). Blanchard, O. J., & Leigh, D. (2012). Growth forecast errors and fiscal multipliers (NBER Working Papers 18779). National Bureau of Economic Research, Inc. Brunnermeier, M. K., Eisenbach, T., & Sannikov, Y. (2013). Macroeconomics with financial frictions: A survey. Advances in Economics and Econometrics. Cambridge: Cambridge University Press and New York: Tenth World Congress of the Econometric Society. Brunnermeier, M. K., & Sannikov, Y. (2013). Redistributive monetary policy. Jackson Hole Symposium 2013331-384. Calvo, G. (1988). Servicing the public debt: The role of expectations. American Economic Review, 78(4), 647–661. Clower, R. (1965). The Keynesian counter-revolution: A theoretical appraisal. In F. H. Hahn & F. P. R. Brechling (Eds.), The theory of interest rates. London: Macmillan. Coase, H. R. (1960). The problem of social cost. Journal of Law and Economics, 3, 1–44. Corsetti, G. C., & Dedola, L. (2011). Fiscal crises, confidence and default: A bare-bones model with lessons for the Euro area (Unpublished). Cambridge. Darwin, C. (1859). On the origin of species by means of natural selection, or the preservation of favoured races in the struggle for life. London: John Murray, Albemarle Street. Davidson, P. (1984). Reviving Keynes’s revolution. Journal of Post Keynesian Economics, 6, 561–575. De Grauwe, P. (2011). The governance of a fragile Eurozone, economic policy (CEPS Working Documents). Domar, D. E. (1946). Capital expansion, rate of growth and employment. Econometrica, 14, 137–147. Dullien, S., & Guérot, U. (2012). The long shadow of Ordoliberalism: Germany’s approach to the Euro crisis (European Council on Foreign Relations, ECFR/49). ECB. (2013). The dynamics of spillover effects during the European sovereign debt turmoil (Working Paper Series, NO 1558/June). Fischer, S. (1977). Long-term contracts, rational expectations, and the optimal money supply rule. Journal of Political Economy, 85(1), 191–205. Foster, J., & Pyka, A. (2014). Introduction: Co-evolution and complex adaptive systems in evolutionary economics. Journal of Evolutionary Economics, 24(2), 205–207. Frank, G. (1966). The development of underdevelopment. Monthly Review, 18(4), 17–31. Friedman, M. (1953). The case for flexible exchange rates. In M. Friedman (Ed.), Essays in positive economics (pp. 157–203). Chicago: University of Chicago Press.

250

P. E. PETRAKIS

Friedman, M. (1956). The quantity theory of money—A restatement. In M. Friedman (Ed.), Studies in the quantity theory of money (pp. 3–21). Chicago: University of Chicago Press. Friedman, M., & Schwartz, A. J. (1963). A monetary history of the United States, 1867–1960. Princeton: Princeton University Press. Galbraith, J. K. (1958). The affluent society. New York: Houghton Mifflin Company. Gerschenkron, A. (1962). Economic backwardness in historical perspective. Cambridge: Belknap Press. Gros, D. (2011). A simple model of multiple equilibria and default mimeo (CEPS Working Document, No. 366). Gros, D. (2012). A simple model of multiple equilibria and default. (CEPS Working Document, No. 366). Harrod, R. (1939). An essay in dynamic theory. Economic Journal, 49, 14–33. Hayek, F. A. (1935). Prices and production. London: Routledge. Heckscher, E. (1919). The effect of foreign trade on the distribution of income. Ekonomisk Tidskrift, 21, 497–512. Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47 (2), 263–292. Kaldor, N. (1957). A model of economic growth. Economic Journal, 67 (268), 591–624. Kaldor, N. (1961). Capital accumulation and economic growth. In F. A. Lutz & D. C. Hague (Eds.), The theory of capital (pp. 177–222). London: Macmillan. Koo, R. C. (2008). The holy grail of macroeconomics: Lessons from Japan’s Great Recession. Hoboken, NJ: Wiley. Krugman, P. R. (1979). Increasing returns, monopolistic competition and international trade. Journal of International Economics, 9, 469–479. Krugman, P. R. (2009). The Great Recession versus the Great Depression. Retrieved from http://krugman.blogs.nytimes.com/2009/03/20/the-great-recessionversus-the-great-depression. Krueger, A. (1974). The political economy of the rent seeking society. American Economic Review, 64, 291–303. Kydland, F. E., & Prescott, E. C. (1977). Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy, 85, 473–491. Kydland, F. E., & Prescott, E. C. (1982). Time to build and aggregate fluctuations. Econometrica, 50(6), 1345–1370. Leijonhufvud, A. (1968). On Keynesian economics and the economics of Keynes. Oxford: Oxford University Press. Leontief, W. (1951). Les tendances futures éventuelles des relations économiques internationales des Etats-Unis. Revue Économique, Programme National Persée, 2(3), 271–278.

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

251

Leontief, W. (1966). Input—Output economics. New York: Oxford University Press. Lewis, W. A. (1954). Economic development with unlimited supplies of labor. Manchester School of Economic and Social Studies, 22, 139–191. Lucas, R. E. (1975). An equilibrium model of the business cycle. Journal of Political Economy, 83(6), 1113–1144. https://doi.org/10.1086/260386. Lucas, R. E. (1976). Econometric policy evaluation: A critique. CarnegieRochester Conference Series on Public Policy, 1(1), 19–46. Lucas, R. E. (1988). On the mechanisms of economic development. Journal of Monetary Economics, 22, 3–42. Lucas, R. E. (1990). Why doesn’t capital flow from rich to poor countries? American Economic Review, 80(2), 92–96. Malthus, T. R. (1798). An essay on the principle of population, as it affects the future improvement of society, with remarks on the speculations of Mr. Godwin, M. Condorcet, and other Writers, J. Johnson, London. Mankiw, N. G., Romer, D., & Weil, D. (1992). A contribution to the empirics of economic growth. Quarterly Journal of Economics, 107, 407–437. Markowitz, H. (1952). Portfolio selection. The Journal of Finance, 7 (1), 77–91. Marshall, A. (1890). Principles of economics (1st ed.). London: Macmillan. Minsky, H. P. (1985). The financial instability hypothesis: A restatement. In P. Arestis & T. Skouras (Eds.), Post Keynesian economic theory. Brighton, UK: Wheatsheaf. Minsky, H. P. (1986). Stabilizing an unstable economy. New Haven and London: Yale University Press. Modigliani, F., & Miller, M. (1958). The cost of capital, corporation finance, and the theory of investment. American Economic Review, 48(3), 261–297. Mundell, R. A. (1961). A theory of optimum currency areas. American Economic Review, 53, 657–665. Myrda, G. (2004 [1953]). The political element in the development of economic theory. New Brunswick, NJ: Transaction Publishers. Nash, J. F. (1949). Equilibrium points in N-person games. Mathematics, 36(1), 48–49. https://doi.org/10.1073/pnas.36.1.48. Ohlin, B. (1933). Interregional and international trade. Cambridge, MA: Harvard University Press. Orphanides, A. (2003). The quest for prosperity without inflation. Journal of Monetary Economics, 50(3), 633–663. Orphanides, A. (2007). Taylor rules. Finance and Economics Discussion Series 18. (U.S.). Board of Governors of the Federal Reserve System. Pareto, V. (1906). Manuale di Economia Politica, con una Introduzione alla Scienza Sociale. The Economic Journal, 16(64), 553–557. Pareto, V. (1935). The mind and society. In A. Livingston (Ed.), (A. Bongiorno & A. Livingston, trans.). New York: Harcourt, Brace & Company.

252

P. E. PETRAKIS

Pigou, A. C. (1912). Wealth and welfare. London: Macmillan. Porter, M. E. (1980). Competitive strategy. New York: Free Press. Prebisch, R. (1968). A new strategy for development. Journal of Economic Studies, 3, 1–14. Reinhart, C. M., & Rogoff, K. R. (2010). Growth in a time of debt (American Economic Review, NBER Working Paper 15639). Ricardo, D. (1817). The principles of political economy and taxation. Kitchener: Batoche Books. Romer, P. (1986). Increasing returns and long run growth. Journal of Political Economy, 94, 1002–1037. Romer P. (1990). Endogenous technological change. Journal of Political Economy, 98(5), S71. Rosenstein-Rodan, P. N. (1943). Problems of industrialization of eastern and south-eastern Europe. The Economic Journal, 53, 202–211. Rostow, W. W. (1960). The stages of economic growth. Cambridge: Cambridge University Press. Rotemberg, J. J., & Woodford, M. (1997). An optimization-based econometric framework for the evaluation of monetary policy. NBER Macroeconomics Annual, 12, 297–346. Rudebusch, G. D. (2010). The Fed’s exit strategy for monetary policy. FRBSF Economic Letter, 18, 14. Sachs, G. (2012a, March 15). Achieving fiscal and external balance (Part 1): The price adjustment rewired for external sustainability. European Economics Analyst (12/01). Sachs, G. (2012b, May 10). Can the Euro area adjust? European Economics Analyst (12/08). Samuelson, P. (1948). Economics: An introductory analysis. New York: McGrawHill. Samuelson, P. (1954). The pure theory of public expenditure. The Review of Economics and Statistics, 36(4), 387–389. Schumpeter, J. A. (1934 [1911]). The theory of economic development. New York: Oxford University Press. Singer, H. W. (1950). The distribution of gains between investing and borrowing countries. American Economic Review, 40(2), 473–485. Smith, A. (1981 [1776]). An inquiry into the nature and causes of the wealth of nations, Volumes I and II. In R. H. Campbell & A. S. Skinner (Eds.), Liberty Fund: Indianopolis. Taylor, J. B. (1980). Aggregate dynamics and staggered contracts. Journal of Political Economy, 88, 1–23. Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195–214.

9

THE EVOLUTION OF ECONOMY AND ECONOMIC THOUGHT

253

Tullock, G. (1967). The welfare costs of tariffs, monopolies, and theft. Western Economic Journal, 5, 224–232. Teulings, C., & Baldwin, R. (2014). Secular stagnation: Facts, causes, and cures. In C. Teulings and R. Baldwin (Eds.), A VoxEU.org Book. London: CEPR Press. Tversky, A. M., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science, 185(1124), 31. Veblen, T. (1898). Why is economics not an evolutionary science? The Quarterly Journal of Economics, 12(4), 373–397. Vernon, R. (1970). Creativity: Selected readings. London: Penguin Books. Von Mises, L. (1912). The theory of money and credit. New Haven: Yale University Press. Von Mises, L. (1996 [1949]). Human action: A treatise on economics. Fox & Wilkes, ISBN 0930073185. Von Neumann, J., & Morgenstern, O. (1944). Theory of games and economic behavior. Princeton: Princeton University Press. Walras, L. (1874). Principe d’une théorie mathématique de l’échange. Journal des économistes, 34, 5–21. Wicksell, K. (1958 [1896]). Finanztheoretische Untersuchungen. Jena: Gustav Fischer (English trans.: A new principle of just taxation). In R. Musgrave & A. T. Peacock (Eds.), Classics in the theory of public finance (pp. 72–118) New York: St. Martin’s Press. Williamson, O. (1975). Markets and hierarchies: Analysis and antitrust implications. New York: Free Press. Wolff, G. B. (2012). Arithmetic is absolute: Euro-area adjustment. (Bruegel Policy Contribution, 2012/09). Wolff, G. B. (2014). Monetary policy cannot solve secular stagnation alone. In C. Teulings & R. Baldwin (Eds.), Secular stagnation: Facts, causes, and cures (pp. 143–150). A VoxEU.org Book. London: CEPR Press. Woodford, M. (2011). Simple analytics of the government expenditure multiplier. American Economic Journal, Macroeconomics, 3(1), 1–35. Wyplosz, C. (2010). The Eurozone debt crisis, facts and myths. VoxEU.org.

CHAPTER 10

The Sources of Growth from the Birth of Economics to the Rise of the New Era

10.1

Introduction

Research regarding the sources of growth, either direct or indirect, was an issue that had preoccupied the theorists of political philosophy and economic thought since the Enlightenment. The period from the Birth of Economics (1720–1880) to the emergence of the New Era (1880–1940) is characterized by the delineation of the core of economic thought by Classical economics and subsequently, by Neoclassical economics. Classical economics, developed in the late eighteenth and early nineteenth century, with Adam Smith, David Ricardo, and Thomas Malthus as its main exponents, attempted to provide a conceptual framework for the production and distribution of wealth. In Adam Smith’s 1776 opus, The Wealth of Nations, for the first time the wealth of nations derives from the role of international trade, a concept which was also used by David Ricardo, to develop his theory of comparative advantage. To the classics also belong Darwin, with the evolutionary revolution he brought to scientific thought and Karl Marx with the fundamental laws of economic development. The contribution of the classics to economic thought has been fundamental to its later development. After the classics laid the foundations, their successors, the Neoclassical economists played a significant role in the enrichment of economics until today. Neoclassical economics is the stream of economic science where, through the mechanism of supply and © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_10

255

256

P. E. PETRAKIS

demand, the quantity of goods and services is determined, as well as the distribution of income. Their main exponents were, among others, Alfred Marshall (1842–1924), Pigou (1912), and Vilfredo Pareto (1906). This chapter identifies the presence of sources of growth in the evolution of economics from 1720 to 1940.

10.2 Division of Labor, Population Change, and the Fundamental Laws of Capitalism 10.2.1

Adam Smith (1723–1790)

In his work The Wealth of Nations Adam Smith brought together the economic ideas and theories of previous and contemporary thinkers of his time, adopted some of them and modified others, clarified and analyzed some of the primary sources of growth, and thereby laid out the fundamental laws of capitalism. He was the founder of the concept of growth. Adam Smith’s main contribution was to link the division of labor with economic growth and market size. He considers that the process of growth is based on microeconomic foundations driven by the interaction of individual interests, the establishment of institutions (property rights), and ultimately the specialization and division of labor. He identifies three advantages from the division of labor: 1. increase in the skills of each employee 2. time saving 3. better use of capital equipment. Labor productivity depends on the division of labor as the main source of growth. Productivity gains can occur through job specialization, as each employee is engaged in what they can be most efficient. Smith’s theory of economic growth is characterized by increasing economies of scale which stem from the division of labor. The division of labor, however, is different in each sector of the economy, with the craft sector reaching more advanced stages. The growth in Smith’s theory is seen in an endogenous process in which progress in period t-1 creates the conditions for further growth.

10

10.2.2

THE SOURCES OF GROWTH …

257

Thomas Robert Malthus (1766–1834)

Thomas Robert Malthus developed a different approach to growth and capital accumulation. In his work on population evolution, titled An Essay on the Principle of Population (1798), he introduced the concept of restricting population in the process of growth in a negative way, explaining population growth as a long-term variable. He therefore considered population change as an endogenous variable. He considered that, due to the human instinct of propagation, the population is growing at a geometric progression, while food is growing at a rate of arithmetic progression, inevitably leading to a stagnation in the rate of population growth. Also, Malthus pointed out that the agriculture (from where food is derived) operates under decreasing returns to scale thus leading to a reduction of the marginal product of labor and, therefore, to a reduction of the real wage in terms of food products. So, he arrived at the formulation of the Malthusian equilibrium, where there is zero population growth. 10.2.3

Jeremy Bentham (1748–1832)

Bentham (1787), having well understood the role of the entrepreneur as an exceptional person and an actor of economic progress, expounded the role of innovation as a guiding force of growth. He described management as a creator of value and trade, with the role of discovering new markets and improving existing products or reducing production costs. 10.2.4

David Ricardo (1772–1823)

David Ricardo developed along with Thomas Malthus the central idea of decreasing returns to scale. An important factor is the diminishing productivity of agriculture which has an impact on real wages. Based on the theory of value of Adam Smith,1 he considers that the value of goods is proportional to the labor required for their production, while the value-in-use is not the measure of their value-in-exchange. The Ricardian methodological approach based on the Theory of Value includes some dynamic aspects of economic growth. These aspects describe the long-term development process and were based on:

258

P. E. PETRAKIS

1. the Malthusian principle of the population growth rate 2. the principle of diminishing returns (in agriculture), 3. the relationship between wages and productivity under the influence of innovation. Therefore, under the prism of Ricardo, these three sources of growth played a vital role in growth. 10.2.5

John Stuart Mill (1806–1873)

John Stuart Mill completed the pantheon of classical economics by creating a “classic” theory of economic development based on: 1. the law of diminishing returns; and 2. a declining incentive to invest. Therefore, the concepts of the accumulation of capital, population change, and technology were already present. At that time, the Industrial Revolution was already in motion, so it was relevant to highlight the importance of economies of scale along with Smith’s division of labor. These were the two main sources of growth that Mill used in his thesis. 10.2.6

Edwin Chadwick (1800–1890)

Edwin Chadwick is considered by Ekelund and Edward (2012) the “single most brilliant social and economic reformer of the century.” He indeed was the first to understand the importance of introducing general education systems so as to increase the quality of human capital. He, therefore, highlighted the role of accumulation of human capital and the role of institutions and preferences (economic incentives). 10.2.7

Karl Marx (1818–1883)

Karl Marx (1818–1883), like Adam Smith, acknowledged the role of division of labor in economic development. Marx gives a social dimension to the concept of division of labor by differentiating it from Adam Smith’s approach, who focuses on its economic dimension. He considered that

10

THE SOURCES OF GROWTH …

259

the division of labor was a source of conflict, as it meant the transformation of the labor force from the agricultural sector to the industrial and thence, to commercial labor. Rising conflicts create a new situation where conflicting interests are trying to prevail for their own benefit. Therefore, a whole historical, economic, and social context for political economy is emerging. The division of labor is creating increasingly less skilled workers. The more the work task becomes specialized, the less training is required, and the workforce has fewer competences and skills than when a single person did all the work. Due to technical necessity, it is necessary to allocate certain forms of work, although, in most cases the division stems from social factors and hierarchies. According to Marx, the original division of labor was the starting point, while the technological change was the catalyst that set in motion the four basic rules of the dynamics and the evolution of capitalism, which are: 1. the law of accumulation and the tendency of the rate of profit to fall 2. the law of increasing concentration and the concentration of industry 3. the law of a raising reserve army of labor and the law of the increasing wretchedness of the proletariat 4. the law of crisis and recessions, because of the overproduction of capital. Therefore, the development of technology holds back the surplus value derived from labor in the capitalist process and leads to recurring capitalist crises. 10.2.8

Charles Darwin (1809–1882)

Charles Darwin developed the theory of biological evolution (1859) according to which the populations of various organisms that exist in nature tend to evolve from generation to generation. Darwin’s theory, also known as Darwinism (Huxley, 1918), initially included the general concepts of species mutation or evolution, but, subsequently, referred to specific concepts of natural selection. Darwinism soon developed and became the bedrock for a whole range of evolutionary philosophies with applications in biology and society. According to Darwin’s theory, more powerful organisms survive and reproduce as they are better adapt to their environment (natural selection). All species of all organisms come about

260

P. E. PETRAKIS

and evolve through the natural selection of small, hereditary variations which increase the individual’s ability to compete, survive, and reproduce. Box 10.1 Malthusian Growth The central characteristics of Malthusian growth are that: 1. There is no long-term trend of growth in real wages, 2. Improvements in production potential are absorbed by population growth 3. Population growth is regulated by preventive fertility control and mortality control, in order to maintain a homeostatic balance. Malthus’s view of economic growth (1798) is based on a natural process resulting from the laws of economic theory. Malthus (1798) stressed that the increase and employment of the population in the low-productivity agricultural sector would reduce the supply of agricultural products per capita and thus reduce the population due to malnutrition. In order to increase the supply of agricultural products, given the low productivity of labor in the agricultural sector, all people should be employed in it, driving the economy in the Malthusian trap. Thus, while overall income could increase, it was almost certain that per capita income would remain stable. The diminishing marginal product of capital is the key point of Malthusian theory. While the production increases with a decreasing rate because of diminishing marginal product of capital, the population increases exponentially and, as a result, it cannot be sustained by the limited production capacity of the economy.

10.3

Absolute and Comparative Advantage

The productivity dimension as a source of growth is derived from the Ricardian theory of comparative advantage.2 Ricardo in his work (1817) Principles of Political Economy and Taxation, described a model in which international trade between two countries can be beneficial (for both countries), if each country exports the products in which it has a comparative advantage, which refers to the different labor productivity of each country.

10

THE SOURCES OF GROWTH …

261

The basic idea behind comparative advantage is that every economy, regardless of how advanced it is in terms of labor productivity compared with other economies, is in a position to exercise a beneficial trade with other economies. The Ricardian model contains a factor of production, work, and is based on the comparative advantage of countries, which determines the international division of labor. Under this model, international trade leads to growth (increasing global production), as each country specializes in producing the goods in which it has a comparative advantage. Hence, for products of the same quality a country has a comparative advantage, if the relative opportunity cost of producing this product, in terms of production costs (i.e., labor costs), is lower than that of the other country. So, then, if this country produces more and consumes less of this product, given the existence of external demand (since other countries are willing to trade with her), it would achieve the improvement of its production, i.e., development. Finally, the pattern of international trade depends on differences in labor productivity. The concept of comparative advantage was developed as opposed to the absolute advantage of Smith (1776). According to absolute advantage, international trade takes place when one country exports products in which it has higher labor productivity to another which simply has lower labor productivity, that is, not in comparison to its trading partner. So, in a single world with a production factor that is lagging behind in terms of labor productivity, there should be no external trade. It should be noted that Ricardo’s theory of comparative advantage has been, from its creation until today, an essential tool of the intellectual toolkit of every economist. Although it has been 200 years since the emergence of this theory, sophisticated models of international trade (Dornbusch, Fischer, & Samuelson, 1977; Eaton & Kortum, 2002) are significantly influenced by the underlying framework of the comparative advantage theory, as it is designed in a very well structured way and the knowledge it imparts is timeless. In more recent works, the Ricardian model extends to the case of many goods (Deardorff, 2007; Dornbusch et al., 1977; Wilson, 1980). In its new version the Ricardian model continues to examine the case of the open economy and the benefits of trade for both countries involved.

262

P. E. PETRAKIS

Box 10.2 Comparative Advantage (Ricardian Model) The basic assumptions: • There are two countries, country H and one foreign country, F, using the vector symbolism c = (H, F) Each country produces two goods (usually when explaining the model. The two goods are considered unrelated, e.g., steel and cotton) which we here denote as X and Y . Therefore, we can say that g = (X, Y ) • The economy uses only one factor, which is labor • Technology affects Constant Returns to Scale (CRS) (i.e., technology is assumed to be linear). • Markets are fully competitive. The symbol (*) as an exponent indicates the foreign country. • Demand is determined by a utility function for each country, U c =  U c C Xc , CYc , where C represents the level of consumption • Representative consumers want to maximize utility with given financial constraints • Utility functions are homothetic and similar in each country. Concerning the  hypothesis that technology has CRS and assuming that  a = a XH , aYH are the constant unit of labor requirements for country H   and a ∗ = a XF , aYF for country F, the CRS indicate that a fixed amount of labor is needed to produce a unit of product. Moreover, since the only cost of production is the competitive wage, the hypothesis of competing markets leads to the conclusion that  pricesare determined by the simple equation pgc = w · a, where w = w H , w F represents the wage in every country. Suppose competitive markets mean that, in the long run, profits are zero in each sector and that there is one sector for each commodity produced under the basic hypotheses we made above. Therefore, we assume that we have branch 1 producing commodity X and branch 2 producing commodity Y or otherwise i = (1, 2). Because of perfect competition (long-term profits are zero in  each sector), using the symbols mentioned above, the profit function is ic = pi yi − wL = 0, where pi is the price of commodities g while y denotes the product produced. To get

10

THE SOURCES OF GROWTH …

263

the cost per unit, we can divide y by the above profit function. In doing so, we have. pi = w

L . yi

Based on the assumptions of the model, the term yLi denotes the work used per unit of product, and using the symbols introduced so far, it should be understood that it represents the labor requirements a. In a closed economy (case of self-sufficiency) it is understood that both goods should be produced in each country separately. The prices for each good are determined by the equation above. CRSs’ imply a linear limit of production capacity and act as an economic constraint for consumers (Fig. 10.1).

Fig. 10.1 Ricardian model in a closed economy (Source Author’s own creation) Based on the given symbols, we assume that country H has a comparative advantage over commodity X if

a∗ p∗ pX aX < X∗ so < X aY aY pY pY∗

264

P. E. PETRAKIS

meaning that country H “specializes” in producing X , and therefore costs less in country H to produce X than it does in country F. Using the complementary assumptions, and assuming a positive substitution elasticity, then the relative production quantities for the commodity in which country H is specialized will be greater than that of country F and vice versa.

10.4

Factor Endowment Theory

During the period from the Birth of Economics to the Emergence of the New Era, the role of international trade was made very clear as a critical component in the process of economic growth and development. The Ricardian model of comparative advantage was based solely on productivity differences due to different technologies. On the basis of these differences, international trade develops. A further evolution of Ricardo’s theory, which does not necessarily include technology difference, is the Factor Endowment Theory (see also Box 10.3) by Heckscher (1919) and Ohlin (1933). Utilizing neoclassical logic, they have formed the theory that international trade will be developed between two different countries, even if they have the same technology, but differ in the portfolio of production factors (land, labor, capital) available to them. The portfolio is a new form of comparative advantage, since the country will produce goods which require inputs that are available in relative abundance. Essentially, to the extent that, the Heckscher–Ohlin model, produces the comparative advantage based on the existing (within the economy) difference in the portfolio of factors of production, it shapes the conditions of an endogenous growth model for the development of foreign trade. The Heckscher–Ohlin model differs from the Ricardian model in two respects. 1. First, it adopts a more realistic framework compared to the Ricardian model, allowing a second production factor in the form of capital. This innovation of the model shows that the production capacity threshold will be concave and will therefore result in an increase in opportunity costs. Therefore, full specialization, as in the Ricardian

10

THE SOURCES OF GROWTH …

265

model, is not particularly likely. Furthermore, trade will result in a redistribution of income between labor and capital. 2. Second, in the Heckscher–Ohlin model, the comparative advantage is determined by differences in the ratios of production factors between countries and not in the differences in technology (as in the Ricardian model). In the Heckscher–Ohlin model, countries have the same production technologies. This innovation of the model shows that a country will export goods using intensively that factor which is available in abundance.

Box 10.3 Heckscher–Ohlin Model The Heckscher–Ohlin Model (H–O model) is a general mathematical equilibrium model for international trade. The model goes a step further than Ricardo’s model for trade. Heckscher and Ohlin define a trade environment for two separate countries. The original H–O model assumes that the only difference between the two countries is their relative abundance of labor and capital. As there are two (homogeneous) production factors, this model is sometimes called the Model “2 × 2 × 2” (2 Countries, 2 commodities, 2 coefficients). The model assumes that countries do not have the same ratios of factors to each other—highly developed countries have a higher ratio of capital to labor compared to developing countries. Thus, the developed country has plenty of capital in relation to the developing country which has plenty of labor in relation to the developed country. With this single difference, Ohlin was able to examine the new mechanism of comparative advantage using only two goods and two technologies for their production. One technology would be a capital-intensive industry and the other a laborintensive business. The theoretical assumptions of the model are: 1. The production functions for good X and Y have Constant Returns to Scale (CRS) 2. The production functions, which are the same in both countries, differ in the intensity of each factor. We assume that X is labor-intensive while Y is capital-intensive.

266

P. E. PETRAKIS

3. There is a constant ratio of labor and capital, which is homogeneous and there is perfect mobility between sectors within each country. However, there is no substitution of labor and capital between countries. 4. There are no market distortions such as imperfect competition, taxes, duties, etc. 5. The preferences are identical and homogeneous. 6. Countries differ by the available relative ratios of factors. Thus, Heckscher and Ohlin (1991), on the basis of the assumptions they made, suggested the H–O theorem: A country exports goods produced intensively using the factor of the country which is relatively abundant (and, therefore, it imports the commodity which requires the relatively rare factor of the country) (Fig. 10.2).

Fig. 10.2 Heckscher–Ohlin Model (Source Author’s own creation) From the Production Possibility Frontier (PPF) curve, one can understand capital-intensive goods and labor-intensive goods (as well as which country has an abundance of which factor, respectively). In a closed economy, a balance of self-sufficiency is achieved, however, to meet demand—as both economies consume indifference curves outside the PPF—countries will need to get involved in the trade process. Then,

10

THE SOURCES OF GROWTH …

267

country H buys the commodity that requires labor-intensive production and so does country F. Therefore, this shift in demand results in a change in commodity prices, as do national production structures. At the new equilibrium point (as prices have shifted in each economy, p H decreases and p F increases), a new equilibrium is achieved and, while assumptions remain, commodity prices are equated p ∗ = p H = p F and the production curves are similar. Further, for an international equilibrium, the product market needs to be cleared (the surplus of demand of country H responds to the surplus of supply in country F and vice versa). As demand for both countries is not within the PPF, there appear to be positive benefits from trade.

Notes 1. Adam Smith points out that there is a “value-in-use” and a “value-inexchange” for goods, but often they do not appear to coincide, creating the “paradox of value.” Smith did not attempt to solve the paradox of value, but attempted to explain how “value-in-exchange” is being determined. 2. The term comparative is used to analyze the reasons for labor productivity between two countries.

References Bentham, J. (1787). Defence of usury. London: Payne and Foss. Darwin, C. (1859). On the origin of species by means of natural selection, or the preservation of favoured races in the struggle for life. London, Albemarle Street: John Murray. Deardorff, A. (2007). The Ricardian model. Ann Arbor: mimeo University of Michigan. Dornbusch, R., Fischer, S., & Samuelson, P. A. (1977). Comparative advantage, trade, and payments in a Ricardian model with a continuum of goods. American Economic Review, 67, 823–839. Eaton, J., & Kortum, S. (2002). Technology, geography, and trade. Econometrica, 70, 1741–1779. Ekelund, B. R., Jr., & Edward, O. P., III. (2012). The economics of Edwin Chadwick: Incentives matter. Cheltenham, UK: Edward Elgar. Heckscher, E. (1919). The effect of foreign trade on the distribution of income. Ekonomisk Tidskrift, 21, 497–512.

268

P. E. PETRAKIS

Heckscher, E. F., & Ohlin, B. (1991). Heckscher-Ohlin trade theory (Harry Flam & M. June Flanders, Translated, Edited, and Introduced). Cambridge, MA: MIT Press. Huxley, L. (1918). Life and letters of Sir Joseph Dalton Hooker OM. GCSI, 2(I), 522–525. Malthus, T. R. (1798). An essay on the principle of population, as it affects the future improvement of society, with remarks on the speculations of Mr. Godwin, M. Condorcet, and other writers. London: J. Johnson. Ohlin, B. (1933). Interregional and international trade. Cambridge, MA: Harvard University Press. Pareto, V. (1906). Manuale di Economia Politica, con una Introduzione alla Scienza Sociale. The Economic Journal, 16(64), 553–557. Ricardo, D. (1817). The principles of political economy and taxation. Kitchener: Batoche books. Smith, A. (1981 [1776]). An inquiry into the nature and causes of the wealth of nations. In R. H. Campbell & A. S. Skinner (Eds.), The Glasgow edition of the works of Adam Smith (Vol. 2). Indianapolis: Liberty Fund. Wilson, C. A. (1980). On the general structure of Ricardian models with a continuum of gsoods. Econometrica, 48, 1675–1702.

CHAPTER 11

The Sources of Growth from the Beginning of Economics to the Emergence of the New Era: Equilibrium, Evolutionary Development, Schumpeter and Keynes

11.1

Introduction

At the core of the analysis of the Neoclassical approach was the concept of general equilibrium, on which the edifice of the prevailing economic thinking was subsequently based up to the present. Another issue that preoccupied economic theory, during the period leading up to the new era, was evolutionary development, based on Darwin’s approach. The relevant debate focuses on the principles of transformation that are at the heart of the growth process. The contribution of Keynes’ General Theory through demand, expectations, and uncertainty, was able to provide convincing explanations regarding the concerns of the period following the Great Crisis of 1929.

11.2 Innovation, Diminishing Returns, and General Equilibrium in the Neoclassical Economists The role of innovation in economic development has preoccupied economists since virtually the first steps of the science of economics. Some argue that innovation is introduced externally—from the external © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_11

269

270

P. E. PETRAKIS

environment to the enterprises—and some that innovation is generated endogenously through the structures the enterprise possesses. Adam Smith (1981 [1776]) spoke of the crucial role of technological progress in increasing the wealth of societies and economic development. David Ricardo and Thomas Robert Malthus, while based on Smith’s theory, added the link between technological progress and employment. John Stuart Mill, in agreement with Ricardo and Malthus, saw innovation as exogenous to the economic growth model. However, the view of technology as an external dimension puts the relationship between technology and growth outside the scope of analysis. Accordingly, the theory of Joseph Alois Schumpeter (1921, 1939) relates to an economy static at its base, so that innovation enters his models exogenously, since it originates with the entrepreneur. On the contrary, Karl Marx sees innovation as an endogenous process. He considers that it is an internal dimension which is integral to the process of capitalist accumulation, namely, that it is both cause and effect and main source of growth of the social productive power of labor. Neoclassical economics after Cournot and Dupuit, became more emphatically oriented toward microeconomics. Thus, these theorists’ focus was mainly on diminishing returns and entrepreneurship. Entrepreneurship is based on innovation, institutions, and critical ability. However, Carl Menger (1840–1921), the founder of the Austrian School of Economics, and Friedrich Von Wieser (1851–1926) made a concerted effort to integrate institutions into economic analysis. Once the institutions were incorporated, they have defined the constraints on individuals’ decision-making. The entrepreneur defines the operation of the economic process, acting as a “certainty provider” at a certain cost with profit as a reward Von Thunen (1783–1850) develops the character of the riskbearing, innovative entrepreneur into the character of the problem-solver, in accordance with the motto “necessity is the mother of invention.” These were the first steps in the theory developed later by Schumpeter, who placed the entrepreneur at the heart of the growth process. John Bates Clark (1847–1938) initially introduced a static concept of economic analysis, placing great emphasis on institutions and the context of economy preferences: private property, individual freedom, individual incentives, and needs. But, even in this static environment, the initial conditions are changed: population growth, change of needs, technological change, etc. Thus, the foundations were laid for the necessity

11

THE SOURCES OF GROWTH …

271

of institutional change as anti-paradigm, since Clark as a marginalist neoclassical economist was opposed to institutional theorization. Alfred Marshall (1842–1924), like his predecessors, accepts the natural origin of diminishing returns as a result of increased use of labor and capital in a given order of efficiency. Hence, the principle of diminishing returns and the effects of innovation is therefore present. In addition, he developed the concept that external1 economies compared to internal economies, are backed by better information, skills, and specialized equipment. Once he accepted the influence of accumulated human capital and external surrounding influences, he introduced elements of economic analysis which were later identified as sources of growth. In addition, it was Marshall who established that the concept of demand allows for the emergence of issues of taste, preference, and restrictions. These concepts were necessary in order to elaborate the complex concept of development. Of greater interest is his definition of the concept of labor supply, as he observed that long-term, wages were above the level that would allow the elements of a theory of human capital to enter the analysis. The complex skills that are necessary for the entrepreneur to survive in the competitive market, made Marshall focus on the role of the entrepreneur. In the wake of Darwin, Marshall argued that professional business managers emerge as a particular form of development of the evolutionary process, driven by specialization and division of labor. Leon Walras (1834–1910), with the general equilibrium approach, introduces the idea of interdependencies, according to which all markets are interrelated (see Box 11.1). Such a methodological approach to the way economy is analyzed, significantly promotes the requirements of an overview of how economy functions, creating a framework for the forces of equilibrium which lead to a search not only for market interconnections but, also for the interconnections between markets and behaviors, economics, and politics. Walras’ model rejects interaction relationships between actors. The price mechanism is unable to incorporate the available information. Also, the role of entrepreneurship and innovation in the Walras model is very weak. There are conflicting views on the role of the entrepreneur in this model. Walras did refer to the role of the entrepreneur in several cases, but the lack of uncertainty in his whole conception of the economy is by implication not compatible with the function of the entrepreneur. Nevertheless, there is also the view that Schumpeter’s conception of the entrepreneur has its roots in the way Walras described his role (Walker, 1986).

272

P. E. PETRAKIS

Vilfredo Pareto (1906) adopted the general equilibrium framework of Walras and enriching it with the grid of exchange and production, established the conditions of maximization of prosperity: for all individuals who consume two products, the marginal substitution factor between any two goods must be the same. This is an optimal Pareto solution. If this is the case, the level is improved through exchange without anyone’s position getting worse.2 In organizing production and exchange, the framework of Walras and Pareto does not lead to any dynamic descriptions of the way the economy develops, but, rather, it is more static, aiming mainly to describe the system’s function. Still, the substitution factor and the technical substitution factor lead the first to the introduction of preferences, and the latter to the introduction of technology and productivity as factors of economic growth. Irving Fisher (1867–1947) made an excellent contribution to the formation of the neoclassical theory of utility and to economics dealing with monetary policy (quantitative theory of money—monetary economics). Dealing with the crisis of 1929, he raised the issue of the impact of “deflated” excessive credit expansion. This issue has reemerged during the crisis of 2008 making it significant as an interpretative framework for the developments that characterize the economic recovery process: it is known as Fischer’s debt-deflation theory (1932). According to Fisher, the deflated credit bubble releases some negative effects on the economy, such as debt liquidation and underpressure sale, money supply contraction and the like. These positions were primarily adopted by the New Keynesians and Post-Keynesians. Box 11.1 Walras: General Equilibrium Model Walrasian Paradigm (Walras, 1874) is used as a basic model to describe, but also to establish, the raison d’être of the free market. The process of balancing prices and quantities is determined by market transactions based on interdependencies between markets. It is the price mechanism that determines the balance. As the economic system is interrelated, a change in the price of a good will have further effects on other markets. The main assumptions underlying the Walrasian paradigm are: 1. the existence of perfect competition, 2. optimal allocation of resources,

11

THE SOURCES OF GROWTH …

273

3. the existence of institutions that enhance economic growth, 4. the absence of systemic risk 5. the preferences of individuals and businesses for development (those dimensions of the cultural background that are oriented toward development) are non-idiosyncratic. The main assumption of perfect competition and optimal allocation of resources, ensures a specific set of behaviors and preferences, shaping the way economic institutions operate. At the same time, under conditions of perfect information, markets are cleared and there is no transaction cost due to the assumption of full contractualization. It is considered an economy with I economic actors, i ∈ I = {1, . . . , I } and commodities L l ∈ L = {1, . . . , L}. A commodity bunch is a vector L . Each operator i has an endowment ei ∈ R L κt and a utility x ∈ R+ + L → R. These are the archetypes of the exchange economy, function u i : R+    Economic actors accept market prices for so we write E = u i , ei i∈x

commodities as given. We denote the vector of the market prices as p ∈ L ; that is, all prices are non-negative. Each player chooses consumption R+ to maximize utility with a given income constraint. Therefore, for factor i the solution is: max u i (x) s.t. p · x ≤ p · ei

L x∈R+

The income constraint differs slightly from the usual price theory. Let us remember that the common income constraint is p · x ≤ w, where w is the initial wealth of the consumer. Here the “wealth” of the consumer is. p · ei , the amount that he would receive if he sold the total of his stock. We can write the sum of the budget as:   B i ( p) = x : p · x ≤ p · ei Walrasian equilibrium is a vector of prices and a consumption bundle for each player, so that: each entity’s consumption maximizes its utility with fixed prices and markets clearing: the aggregate demand for each commodity    equals the cumulative stock. Walrasian equilibrium is a vector p, x i

i∈x

as:

274

P. E. PETRAKIS

1. Entities to maximize their utility: for all i ∈ I : x i ∈ argmax u i (x) x∈B i ( p)

2. Markets to be cleared: for all l ∈ L ,   xli = eli i∈I

11.3

i∈I

The Growth Approach According to Veblen

When Darwin published his book On the Origin of Species (1859) a debate was already under way regarding the principles of change at the heart of the process of growth. In particular, there was intense theoretical controversy about whether change is the result of a pre-existing law or a trend of evolution or an evolutionary alteration of reality. The evolutionary economic theory aims to interpret and limit the weaknesses of mainstream economics, i.e., mostly Neoclassical synthesis and analysis, in terms of how the economic system is formed through business development and strategic decision-making under conditions of uncertainty. As Veblen said: “evolutionary economics must be the theory of a process of cultural development, a theory of the cumulative sequence of economic institutions stated in terms of the process itself…”. Veblen’s criticism focuses on classical economists and stresses that it is impossible to account for changes in the economy or society by using a static model. Furthermore, he criticizes the great majority of economists of his era, who ruled out any causal relationship between factors associated with economic change, and which “invariably consist, as a last resort, in a change of habits of thinking.” Thorstein Veblen (1857–1929), drawing from Darwin and others the urgent need to provide a causal explanation of the origin of all evolutionary phenomena, treats the future development of society and the economy as the result of a collective change of society and its institutions, rather than as the result of change at the individual level. He rejects the Classics’ concept of balance and favors an evolutionary aspect of economic science, whereby the system can be driven to any state, without this being necessarily good or bad in terms of social well-being.3

11

THE SOURCES OF GROWTH …

275

In Veblen, the explanation of economic phenomena ought not to rely on the hedonistic behavior of maximization but, rather, the interpretation of the continuity of cause and effect in any given historical and cultural period of humanity. Veblen considers the process of growth4 and development a “process of cultural growth,” specifying that this development is not necessarily qualitatively better than the previous state of things. Decisions made by the individual can lead to an evolutionary process. However, it is a matter of perspective whether the outcome of his actions is legitimate or not. It identifies change as a consequence of change in socio-economic context rather than at the individual level. Any fact or situation which leads the system to deviate is considered a “factor of disturbance,” something which Veblen designated as a standpoint of ceremonial adequacy. He treated human beings as complex organisms characterized by instinctive behavior and habits, i.e., his emphasis was on the concept of culture.5 There is extensive reference in his work to the relationship between culture and institutions. The environment, including technology, influences culture. Thus, cultural factors shape institutions and vice versa, in a continuous process. Veblen considers that there are two kinds of institutions: technological and ceremonial. The two types of institutions arise as the outcome of culture and historical evolution. Although institutions are static, Veblen considers that technological institutions (inventions, production methods, technology, etc.) have a dynamic character that can lead to changes. Ceremonial institutions can limit the evolution of technological ones creating long-lasting conflict between them. Therefore, Veblen brought to light a possible anti-development process, that of the asynchronous evolution of technological and ceremonial institutions.6 This asynchronous nature of the two types of institutions can lead to a parallel evolution with the diversification of preferences. His theory of institutional change is central to the evolution of capitalism by producing economic cycles. It is an endogenous process due to the failings of human nature. In this light, Veblen’s views are an attempt to describe the capitalist process where a standpoint is adopted similar to that of Marx on general laws. Among other things, Veblen’s commentary on economic rationality is important—a concept still central to economic science and the theories that have been developed around it. As he points out, societies made up of rational individuals cannot be changed and developed. For Veblen (1898), the rational person is associated with hedonistic psychology.7

276

P. E. PETRAKIS

The main difference between economics and evolutionary sciences arises from the fact that the advocates of the theory of evolution refused to follow any particular path toward equilibrium by using concepts that are difficult to quantify. Economists consider that the economy follows a “natural law” behavior that leads it to a point of a normal evolution of things.

11.4

Relative Prices and the Entrepreneurs for Austrians and Schumpeter

The contributions to economic science of Austrian economists Ludwig von Mises (1881–1973), Schumpeter (1934 [1911]), and Hayek (1935) share some general characteristics, where subjective human choice plays a significant role. Therefore, expectations, alertness, knowledge, and error determine human decisions and lead to methodological individualism. Friedrich Hayek (1935) developed his theory of business cycles based on the effect of money on relative prices, which decision-makers observe. The relative prices change because of technology, time preference, and also because of monetary policy which can variously influence investment returns. Here, the manner and quality of the signals produced in the market shapes human behavior. Hayek therefore attributed to changes in relative prices, resulting from either technology change, preference, or monetary policy, a reason for short-term growth disruptions. A crucial contribution by the Austrian school of thought concerns the role of the entrepreneur in development models. The relationship of entrepreneurship and profit had already been presented by Frank Knight (1921), with profit appearing as a reward for sound business decisions, since the entrepreneur lives in an uncertain environment without being able to calculate the risks. Thus, the entrepreneur is obliged to assess risks as effectively as possible, hedging against uncertainty, in order to ensure against the calculated risk, and be compensated, through the profits, for the uncertainty. So, then, uncertainty is a source of growth provided the entrepreneur makes the right decisions. Gains through uncertainty may be influenced by many factors (prices, innovation, technology, government policy, etc.). Schumpeter (see Box 11.2) in his analysis considers the entrepreneur as the main source of change and disturbances in the functioning of the economic system. The entrepreneur is a key person causing

11

THE SOURCES OF GROWTH …

277

imbalance and a change in the functioning of the economic system. This change is endogenous. Schumpeter specifically highlighted the role of the entrepreneur perceiving economic development as a dynamic process that should be correlated with Walras’ static approach to general equilibrium. The individualism 8 of the Austrian school helped him highlight the personality of the entrepreneur not as manager but as protagonist-innovator. Schumpeter borrowed from Marx the concept of endogenous change, though without leading the economic system to a specific outcome. The central issue in this theory is the process of Creative Destruction, namely, the destruction and regeneration of the economic structure rather than not the ultimate destination of the economic system. 1. The dynamic entrepreneur creates innovation, which should not be confused with invention. The two may or may not coincide. Innovation can be: 2. The introduction of a new good or the improvement of an existing one 3. The introduction of a new method of production 4. Opening a new market 5. The introduction of a new source of raw materials 6. The creation of a new kind of industrial organization. Despite Schumpeter’s significant contribution to the theory of economic development, through the emergence of the role of the entrepreneur, the traditional sources of development of the Classics, whose focus was on specialization and the division of Labor, maintained their force in conventional economic theories. It took many years for there to be a revival of interest in the role of entrepreneurship, mainly on the basis of evolutionary theory, and the need to identify the determinants of innovation as a driving force of growth. Box 11.2 Schumpeter about Growth and Entrepreneurship The basic idea about the nature of economic growth and entrepreneurship is based on the fact that every process of development has as a consequence a quantitative change at the microeconomic and at the

278

P. E. PETRAKIS

macroeconomic level. This change could be described as a creative destruction, whose powers are as follows: 1. the introduction of a new good or a significant improvement in the quality of a good that already exists, 2. the introduction of a new production method, 3. opening a new market, 4. the acquisition of a new source of supply of raw materials or semifinished goods; and 5. the creation of a new kind of industrial organization. This creative destruction does not necessarily lead to a new equilibrium point. As a result, the analysis of such a process should include the study of the sources and consequences of the disturbances unavoidable after a quantitative change. Te Velde (2004) summarizes Schumpeter’s thinking about how the economy works. Schumpeter initially assumes the existence of a perfectly competitive economy, which is in a static equilibrium. In this perfectly competitive equilibrium no profits are made and there are no interest rates, no savings, no investment, and no involuntary unemployment. Under these conditions, the equilibrium condition is repeated each year, as the same products are produced each year, in the same way, therefore creating a “circular flow.” In other words, he argues that changes in the economy are disappearing or that the factors causing the changes are not taken into account. However, the concept of economic growth comes from a spontaneous and discontinuous change in this “circular flow,” which leads to a disruption of the equilibrium which is altered forever. A key feature of the capitalist economy is the fact that it never stagnates. Innovation is the element that causes imbalance and, at the same time, causes the economy to move forward. The reason he uses the concept of general equilibrium is to show the contrast and explain economic development, when a change takes place, through the introduction of innovation in existing routines of companies. Equilibrium is for Schumpeter a theoretical measure introduced to explain the imbalance caused by innovation. With innovation, the economic system moves away from equilibrium and, as the effects of innovation “fade,” it returns to a new equilibrium. Moreover, he highlights the importance of innovations in the production process and attributes to the economic growth, which he disassociates from the increase in production factors. He argues that the introduction of innovations allows entrepreneurs to create, in the short term, monopolistic

11

THE SOURCES OF GROWTH …

279

situations, which enable them to hoard considerable amounts of money to recoup the funds they invested, even though, gradually, the entrance of new competitors diminishes profits. Innovations are applied from one sector to another, giving birth to new innovations, as they tend to be “concentrated” (clustered) in certain industries and periods, while this “concentration” more than likely contributes to the creation of business cycles in the global economy. It is obvious that, in the context of this process, there are many risks, since the chances of the success of an innovation are not predictable.

11.5 Demand, Expectations, and Uncertainty in General Theory The work of John Maynard Keynes (1936) General Theory of Employment, Interest, and Money is the fruit of the spiritual turmoil among economists caused by the Great Depression of 1929. It attempts to answer questions of economic policy by giving convincing explanations to the concerns of the time. At its core is the question of whether it would be possible for price adjustment to balance demand and supply. As the crisis in the United States and the United Kingdom lasted for years, the elimination of high levels of unemployment through wage adjustment was difficult. General Theory largely sought to highlight the weaknesses of the equilibrium theory, in order to cope with the Great Depression. Keynesian economics flourished, becoming the dominant economic theory until the 1960s. The increased trust of economists in the Keynesian model was accompanied by the stable and prosperous economy of the 1950s and 1960s. In the early 1970s, however, Keynesian thinking began to be drastically curtailed, due to the poor predictive performance of Keynesian econometric models, to an increasing recognition of supply-side factors as drivers of fluctuations, and to a weakening of the inverse relationship between inflation and unemployment through the Phillips curve. Keynes attempted to analyze the economy from the demand side, the variations of which create economic crises, by contrast to classical economics, which is based on the logic of scarcity of resources. In the period of classical economics, the available resources were limited in relation to the needs of the population. Thus, its analysis does not incorporate

280

P. E. PETRAKIS

the lack of demand, implying that demand is limited only by supply. Classical economics ignored the lack of overall demand in its assumptions and confined itself to shifting demand between different sectors of the economy. In Keynesian economics, the invisible hand of Adam Smith has been replaced by the invisible thread of convention, shaping the economic result, while at the same time the parameters are specified of the rational behavior of the individual, thus providing a more realistic framework of human behavior, in relation to the “ideal” behavior model of classical economics. Keynes criticizes Say’s law 9 with an emphasis on the causal link between production and expenditure. He believed that it is not production that drives demand but spending decisions create demand which drives production to follow demand. The fluctuations in effective demand and in levels of employment are due to the uncertainty that prompts people to prefer holding onto money, to restrict consumption, and to avoid investment. The lack of demand is due to the decreasing propensity to consumption and the cost of money (interest). As a result, in a capitalist economy, achieving full employment can only happen with appropriate state interventions. State intervention stimulates demand, creates income, increases savings, and facilitates investment financing. Over a short period, the income of an economy is determined by the expenditure of households, the state, and enterprises. Thus, the problem during a recession is the result of insufficient demand. He argued that there are rigidities (oligopolies, monopolies, trade unions) and stiffness (of prices, wages and interest rates) which impede the equilibrium mechanism of the economy. The change in interest rates has a negligible impact on investment, contrary to the monetarist view. The rigidities in prices and wages cause deviations from the equilibrium of full employment: if nominal wages decrease, because the prices will be reduced due to a drop in demand, ultimately, real wages will not decrease. So, adjusting monetary wages is not enough to balance the economy, which can easily result in an “unemployment balance,” hence it is necessary to manage overall demand. The balance of the equilibrium for Keynes comes from the state of expectations, not from the fundamental forces of productivity. Keynesian economists denies that markets alone can achieve equilibrium and full employment. Economic life is characterized by a certain degree of recurrent movement. Despite Knight’s view of the uniqueness of each economic situation, in economics we recognize the reappearance of particular elements.

11

THE SOURCES OF GROWTH …

281

The key question is: “can fluctuations in the size of the economy in the short- and medium-term be characterized as periodicity?” A negative answer to this question stems from the inability to provide a reasonable interpretation based on the fundamental variables, without giving proper consideration to the more imponderable variables associated with markets, with the confidence of economic agents and with the rotation of the mood and attitude of individuals. All this is summarized in what Keynes called Animal Spirit.10 By the term Animal Spirit Keynes attempted to describe the exogenous and possibly self-fulfilling waves of optimism and pessimism on a state of the economy, which motivate individuals to choose between investment and consumption. This is the imponderable factor which sums up people’s long-term expectations and inevitably leads to disequilibrium and business cycles. So, if human behavior and, by extension, the functioning of the economic system are possessed by animal spirit, then there is a problem as to stability and the avoidance of economic cycles. Expectations are introduced in the analysis of Keynes, as he considered that the equality between savings and investment depends not only on the change of interest rates, but is also influenced by expected future returns, which, in turn, determine the marginal efficiency of capital. Expectations11 are only a manifestation of the cultural background and, as has been mentioned, they play an important role in investment and income. In addition, they are an essential component of at least two of Keynes’ three core principles in his analysis of total demand: 1. The level of investment depends on the cost of money and the discount rate, which is determined by the expected income of the investment. 2. The preference for holding money depends on the individual’s expectations about the future course of interest rates, i.e., whether he expects capital gains or losses. 3. The consumption function depends not only on disposable income, but also on expected future income and future capital gains. He separates expectations into short-term and long-term and, indeed, this distinction relates to the extent that they can be predicted with accuracy. In the short term, forecasts can be made with relative accuracy, while

282

P. E. PETRAKIS

in the long term, the complexity of the economic system makes it impossible to accurately predict future conditions based on what is happening today. The expectations, both long term and short term, are approached from the side of investment, while changes in the quantity of money can destabilize business expectations (Keynes, 1923).12 While in the short term, the concept of uncertainty and risk quantification may have some value, Keynes places particular emphasis on uncertainty as to long-term expectations. Changes in long-term expectations determine the level of investment through marginal yield and interest rate through liquidity preferences, and they may even affect consumption. Short-term equilibrium for Keynes is brought about by rebalancing short-term expectations.13 On the demand side for goods and services, the function of overall demand establishes a correlation between the degree of employment and employees’ expectations of their future earnings. The intersection of the aggregate demand curve and the total supply curve, i.e., actual demand, is the “…point [at which] the entrepreneur’s expectations for profits will be maximized” (Keynes, 1936). At the point of balance, enterprises have no incentive to change the scale of return or employment. Although the real demand point determines the short-term balance, it is long-term expectations that ultimately determine the level of overall long-term economic demand. The changes in long-term expectations are those governing the changing levels of investment, through the marginal effectiveness of capital and the interest rate through liquidity preferences. For Keynes, expectations are not unique. In the short term, economic agents make decisions through a range of possibilities, or their expectations. In the long term, however, they cannot be dealt with in the same way. Even if expectations are equivalent to certainty, they cannot be certain because of the low significance of the data on which they are formed. The absence of significant elements, contractual, or arbitrary rules, as well as psychological factors determine expectations and choices. For Keynes long-term expectations, i.e., investments, are extremely precarious. The accumulation of capital can only be explained in terms of the confidence of entrepreneurs. The slightest change in the prevailing conditions can significantly affect individuals’ expectations for the future. However, Keynes denies that long-term expectations depend only on irrational expectations. The fluctuations in expectations resulting from the existence of an uncertain

11

Uncertainty

ExpectaƟons

THE SOURCES OF GROWTH …

Decision making

Total demand Liquidity preference

283

Economic outcome/ output

Fig. 11.1 Expectations and economic outcome (Source Author’s own creation)

world affect the economic outcome through total demand and liquidity preferences (Fig. 11.1). Therefore, fluctuations in the economy as perceived by Keynes are determined by the expectations of the individual. The imbalances of the economy are derived from expectations, which are a factor in determining overall demand and the preference of society to hold money, as a means of managing uncertainty. In conclusion, the fact that demand levels do not remain stable, but are the result of individual choices, directly affects the levels of total employment, investment, and imbalances in the economy. Box 11.3 Keynes and Aggregate Demand According to General Theory, the level of employment depends on the level of aggregate demand. The balance is reached when consumers expect to buy exactly the available product at a profitable price, so as to justify that the company employs the particular number of workers needed to produce the product in question. The intersection point of the two curves shows the actual demand. The difference between Keynes and classical economics is that real demand does not necessarily determine the point of full employment for the economy. Aggregate demand, for Keynes, consists of two elements: demand for consumption and demand for investment. In the short term, the momentum for consumption is relatively stable as a percentage of current income—fluctuations are minimal. This is because consumer habits are stable reflecting established habits, as opposed to investments, which depend on expectations. When income increases, consumption increases less than income, while when income decreases, consumption decreases. Inequality of consumption for changes in income is also the source of the economic problem. As the consumption propensity is less than the unit, the difference between production and consumption should be covered by the investments. Classical economists assume that savings are always geared to interest rate investments. Keynes’ innovation was to distinguish

284

P. E. PETRAKIS

between the treatment of savings and consumption. This gives rise to the “paradox of thrift” which causes a fallacy. If society prefers to save rather than consume, businesses will reduce their sales and product output will decrease unless the incentive to invest increases to expand aggregate demand. The level of investment depends on what Keynes calls “marginal efficiency of capital,” i.e., the return on capital that exceeds the “rental” cost of capital. If the marginal return on capital is higher than the cost of borrowing, investment will increase, while if lower, investment will decline. The momentum for consumption and the impetus for investment determine the level of employment.

Notes 1. Marshall’s ideas on externalities opened the way for the institutional economics of the twentieth century. 2. This logic can be extended to the direction of production inputs with the marginal substitution factor being replaced by the introduction of the marginal technical rate of substitution, where one input can be replaced by another without changing the production level. 3. Based on the perspective of Smith on the “invisible hand” and the view that the economy is moving toward equilibrium, he detects the “difference of spiritual attitude or opinion,” by analogy with the science of taxonomy of animal or plant species, assuming “a system of economic taxonomy,” and considers that the equilibrium provides an overview on how reality is, but does not provide any information on the process of change. The “economic taxonomy system” can be addressed as a result of the economic process in technological terms. 4. Veblen seems to be using the word growth, not in the sense we use it today, but to express change without implying any progress in cultural terms. It is also interesting that he does not make any reference to quantitative growth, does not, that is, take into account, the idea that economic growth is an end in itself. 5. Culture: Derived from the Latin word culture which means cultivation and, in turn, comes from the verb colo-ui,-ultum-ere, which means to grow. It is the deep cultivation of a human being’s mental abilities combined with his psychological and moral cultivation. Let it be noted that the word was used later inappropriately in the sense of a higher spiritual culture to be enjoyed by a privileged class of people.

11

THE SOURCES OF GROWTH …

285

6. “As a case of use of this rule of ceremonial knowledge we can cite ‘circumstantial history’ which plays such a large part in the classical view of economic institutions, such as the settlement of accounts at the beginning of trading in the transactions of the hypothetical hunter, fisherman and shipbuilder, or of the man with the wooden slab and two joists or of the two men with the basket of apples and the basket of nuts” Veblen (1898). 7. “In all received formulations of economic theory … the human material with which research is concerned, is framed in hedonistic terms… The psychological and anthropological biases of economists are those accepted by the science of psychology and the social sciences some generations earlier. The hedonistic notion of man is that he is a bright computer of pleasure and pain, which oscillates like a homogeneous sphere in pursuit of happiness, under the influence of stimuli which move it around, but leave it intact. There is no precedent or antecedent. This is an isolated, definitive human datum, in steady equilibrium, with the exception of the vibrations of the annoying forces which displace it in one direction or another …” Veblen (1898). 8. A philosophical theory according to which the individual must play a more important part or have a greater value than the whole. It is based on the confrontation of personality with the group and the subjugation of social interests to individual interests. The ideologists of this theory believe that individualism has its roots in “unchanging human nature” which is selfish and can but serve its self-interest. It’s mainly a creation of bourgeois philosophy and is closely connected with the consolidation and expansion of proprietary right which, in turn, fuelled the take-off of the capitalist system. In physics, it was originally a theory of Lefkippus and Demokritus who argued that things consist of little indivisible structural elements or particles. It was initially accepted by Epicurus and in modern times it was revisited by Gassendi, while the English physicist R. Boyle posited it as the basis of chemistry. 9. Say’s Law of Markets (1803), is the law, according to which, total production necessarily creates an equal amount of total demand. In this way, the concept of macroeconomic shocks was understood, due to the lack of demand, which J.-B. Say defined. 10. “Most probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirit – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities” (Keynes, 1936, The General Theory of Employment, Interest, and Money, chapter12). 11. Keynes himself did not specify how expectations were formed, but even up until when they were theoretically replaced by rational expectations (Muth, 1961) it was accepted that people form their expectations about

286

P. E. PETRAKIS

what will happen in the future, based on their experiences of what happened in the past. 12. In General Theory, Keynes writes: “Our knowledge of the factors that govern the return on investment a few years later is usually very small and often negligible. If we are to be honest, we have to admit that the knowledge base we have in order to evaluate the performance in ten years’ time of a railroad, a copper mine, a textile plant or a patent for a drug or a building in the city of London, amounts to minimal, sometimes negligible knowledge, even after five years.” 13. “The level of the total supply for the output of a given level of employment is the expectation of returns that will simply make entrepreneurs deliver that employment, because it will be worth it” (Keynes, 1936).

References Darwin, C. (1859). On the origin of species by means of natural selection, or the preservation of favoured races in the struggle for life. London, Albemarle Street: John Murray. Fisher, I. (1932). Booms and depressions. New York: Adelphi Company. Hayek, F. A. (1935). Prices and production. London: Routledge. Keynes, J. M. (1923). A tract on monetary reform. London: Macmillan. Keynes, J. M. (1936). The general theory of employment, interest and money. London: Macmillan. Knight, F. H. (1921). Risk, uncertainty and profit. New York: Harper. Muth, F. J. (1961). Rational expectations and the theory of price movements. Econometrica, 29, 315–335. Pareto, V. (1906). Manuale di Economia Politica, con una Introduzione alla Scienza Sociale. The Economic Journal, 16(64), 553–557. Say, J. (1803). A treatise on political economy: Or the production, distribution and consumption of wealth. New York: Augustus M. Kelley. Schumpeter, J. A. (1921). The theory of economic development. Cambridge: Harvard University Press. Schumpeter, J. A. (1934 [1911]). The theory of economic development. New York: Oxford University Pres. Schumpeter, J. A. (1939). Business cycles, a theoretical, historical and statistical analysis of capitalist process. New York: McGraw-Hill. Smith, A. (1981 [1776]). An Inquiry into the nature and causes of the wealth of nations. In R. H. Campbell & A. S. Skinner (Eds.), The Glasgow edition of the works of Adam Smith (Vol. 2). Indianapolis: Liberty Fund. Te Velde, R. (2004). Schumpeter’s theory of economic development revisited. In T. E. Brown & J. Ulijn (Eds.), Innovation entrepreneurship and culture,

11

THE SOURCES OF GROWTH …

287

the interaction between technology, progress and economic growth. Cheltenham, UK: Edward Elgar. Veblen, T. (1898). Why is economics not an evolutionary science? The Quarterly Journal of Economics, 12(4), 373–397. Walker, D. (1986). Melting equilibrium in multicomponent systems and liquidus/ solidus convergence in mantle peridotite. Contributions Mineralogy Petrology, 92, 303–307. Walras, L. (1874). Principe d’une théorie mathématique de l’échange. Journal des économistes, 34, 418–423.

CHAPTER 12

Neoclassical Synthesis and Keynesian Development

12.1

Introduction

Keynes’ ideas and his approach to the way economy operates, laid the foundation for modern economic thought. The debate over Keynesian theory has led to the emergence of new economic theories. In this chapter, we look at the emergence of sources of growth and the attention they received in the upsurge of economic thought following the Great Depression of 1929. These are the issues raised during the period of strong growth and low inflation which persisted until about 1970. It is a time of numerous new economic ideas. The combination of the advent of the Great Depression and the emergence of Keynes, produced an extremely fertile environment for the creation of new ideas and the delineation of new fields and syntheses that gave rise to new debates concerning the sources of growth. World War II added to this environment with two main effects: on the one hand, with the onset of the war, the need to mobilize the production machine was created and, on the other hand, it was imperative to meet the needs of the period that followed in the wake of great disasters. At the same time, new geographical areas, with emerging economies, raising the question of the start of a global process of development. These events once again ushered the issues of development and stimulated economic thought so that it led to the emergence of the scientific subfields of economics: Developmental Theory and, later, Theory of © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_12

289

290

P. E. PETRAKIS

Growth, International Economics and Economics of International Trade, Microeconomics, Macroeconomics. NeoKeynesian economics1 arose in the post-war period, mainly from a group of economists (Hicks, Modigliani, Solow, Tobin, Samuelson) who sought to exploit Keynes’ writings and synthesize them with neoclassical models of economics. This is how the Neoclassical Synthesis came about, which created the models from which the basic ideas of Neoclassical and Neokeynesian economics derived. These ideas dominated the post-war period, shaping the dominant macroeconomic thinking of the 1950s, 1960s, and 1970s. The Keynesians developed Keynes’ thoughts on many issues of development and growth by introducing some basic concepts that are directly related to the particular subject of analyzing the sources of growth.

12.2

The Neoclassical Synthesis

Neoclassical Synthesis is a conception of economic theory that emerged in the United States in the early 1940s and remained the dominant model until the late 1960s—and shortly thereafter—when the Monetarists’ economic thinking came to light. It is essentially a synthesis of Neoclassical ideas and Keynes’ theory. The term Neoclassical Synthesis seems to have been coined by Samuelson (1955) to suggest a more general view of macroeconomic theory. Its main exponents were Hicks (1904–1989), Modigliani (1884–1920), Solow (born 1924), and Tobin (1918–2002). They gave a more specific form to the way markets are balanced and to the taking of human decisions thus defining expectations (adaptive expectations). As a result general equilibrium models were developed based on Keynesian and Classical principles (Arrow & Debreu, 1954) and, later, on macroeconomic imbalance models, such as those of Clower (1965), Leijonhufvud (1968), and Barro and Grossman (1971). The Neoclassical Synthesis observes the peculiar phenomenon, at the microeconomic level, of a Walras equilibrium, in which economic actors are fully informed and act rationally in competitive markets, while at the macroeconomic level the state intervenes by exercising fiscal and monetary policies, with a view to achieving aggregate demand at the full employment level, without expecting a free market balance. At the macro level, a Keynesian-type imbalance prevails.2 The existence of involuntary unemployment in the long run reveals something contradictory, namely, that at the microeconomic level, individuals do not succeed in maximizing

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

291

their utility and benefits. But how do individuals fail to act rationally when the neoclassical synthesis is supposedly compatible with the Walras equilibrium at the microeconomic level? How is it possible for these hypotheses, which are made at the microeconomic level, to be compatible with the macroeconomic imbalance? The answer to this incompatibility is given by dividing the analysis into a short- and a long-term period, as well as by assuming imperfections in the price mechanism in the short term. Thus, money is considered neutral in the long run and not neutral in the short run. It is argued that price rigidity is responsible for the lack of the self-regulation of markets, while Say’s law does not apply. Therefore, the Neoclassical Synthesis can be described as “Keynesian” in the short run and as “Neoclassical” in the long run. 12.2.1

The Contribution of Hicks

Central to the Neoclassical-Keynesian synthesis is the IS-LM model by Hicks (1937), based on the critical elements of Keynesian thought, which was later expanded by Modigliani (1944). According to this model, prices are stable, and the economy is not in a full employment status, while the level of production and employment is determined by aggregate demand. Also, consumption expenditure is a positive function of the disposable income and the economic system exogenously determines public expenditure on the basis of government decisions. Private investment is a negative function of interest rates, while interest rates are determined by the interaction of product and money markets. Money supply is considered to be exogenously determined by the monetary authorities. One of the key weaknesses of the IS-LM model was that it failed to achieve the Keynesian result of an “unemployment equilibrium” but tended to approach the Neoclassical model of “full employment.” As a result, to create an “unemployment equilibrium” as a solution to the IS-LM equation system, New Keynesian economists introduced fixed wages, inelastic investment demand, inelastic demand for money and/or some other defects in this system. For Hicks, equilibrium can only come from correct predictions and expectations about the future. However, this is not easy. The emergence of imbalances in the markets is nothing but wrong predictions and, therefore, balancing markets is a far cry from reality. As he typically notes: “The real economy is always in imbalance.” Changes in certain parameters of the economy may be responsible for the imbalance in prices.

292

P. E. PETRAKIS

The most general effect on prices, according to Hicks, concerns interest rates and the value of money. Hicks (1939) introduced the concept of “temporary equilibrium” in order to establish the mechanism of economic dynamics. He thus considers that the balance, which can be brought to the economy, is temporary, because of the uncertainty involved in human decision-making. Accepting the stable equilibrium hypothesis implies equating current and future values. However, if the stable equilibrium hypothesis is rejected, it is not possible to calculate future prices based on current prices. As a future period can be subdivided into sub-periods, the attempt to determine prices, which equate supply and demand in each sub-period, should be based on the forecasts of individuals. One of Hicks’s key hypotheses is the existence of a higher level of interest rates, on the left-hand side of the LM curve, as the key differentiation between Keynes and Classical finance. Hicks’s analysis in his book Value and Capital (1939) is based on dividing interest rates into shortand long-term. The long-term interest rate is shaped by expectations for the future evolution of short-term interest rates. The current interest rate is determined based on risk and uncertainty about its future prices. At the same time, unlike Keynes, he believes that the interest rate is not just a monetary measure but is influenced by real forces such as savings and investment. The term elasticity of expectations 3 introduces into the model the role of expectations to determine the effect of real prices on price expectations. The participants in the production system make their decisions based on current and future prices which, unlike in the case of stable equilibrium (the equilibrium of an economy in which there is no net saving), cannot be identified as the decision-making process involves the factor of risk, as Knight (1921) has identified it. On the money market, Hicks notes that withholding money acts as a means of safeguarding uncertainty about future payments. If the need for money in the future is predetermined with certainty, then one could use their money in a more profitable way (e.g., borrowing). Therefore, the money market cannot be in equilibrium, as the individual prefers to hold onto cash, due to uncertainty, while sacrificing the benefit of maximizing value. Hicks (1981) typically stated that “when the risk factor is present, it plays a particularly critical role in how the individual manages his or her assets.”

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

293

The notion of confidence dominates Hicks’s analysis as he attempts to interpret the fluctuations in the economy. Increased confidence leads the person to distribute their assets into less accessible forms, while a disturbance of confidence increases the disposition to retain assets that can be readily liquidated. In times of recession, when confidence has reached the lowest levels, there is an observable gap between long-term and short-term interest rates. This is because investor behavior in terms of the allocation of assets has changed during the recession. As longterm interest rates are high, lending becomes difficult for businesses, and prospects for recovery are limited. However, the recovery may come from an external shock or through lower interest rates due to increased savings. The increase in savings is in line with periods of stability in the economic cycle, although extended stability may prove dangerous for the economy as the preference for less liquid assets increases. Expectations4 of rising prices will lead to higher interest rates, while the inability of entrepreneurs to understand the evolution of interest rates is a critical factor in making the wrong investments. This situation, according to Hicks, “leads to a loss of confidence and a shift of assets in the opposite direction.” Box 12.1 The IS–LM Model (Hicks, 1937) The IS–LM model developed by Hicks in 1937, also known as the Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates and the assets market. The intersection of the investment–savings curve [IS] and the liquidity–money preference curve [LM] is an example of the “general equilibrium,” where the assumed equilibrium occurs at the same time in interest rates and commodity markets. However, two equivalent interpretations are possible: first, the IS–LM model explains the changes in national income, when the price level is set in the short term, and second, the IS–LM model shows the factors that lead to shifts in the aggregate demand curve. The IS curve expresses the combinations of interest rate and the real GDP that correspond to the equilibrium of the product market. The negative slope of the curve between the interest rate and the equilibrium product indicates that a higher interest rate reduces private investment spending. The steeper the slope of the IS, the higher the sensitivity of consumption and investment to interest rate changes and the higher the multiplier. Factors affecting IS (shifting the whole curve) are fiscal policy (public spending, taxes, etc.), business expectations (animal spirits, etc.),

294

P. E. PETRAKIS

household wealth (fluctuations in assets, equities, bonds) as well as the current account balance (domestic product, foreign product, real exchange rate, when considering the case of an open economy). The LM curve shows that the money market equilibrium indicates a positive relationship between GDP and interest rate. This curve is the combination of income and interest rates in which the money market is in equilibrium, given the price level and exogenous variables. It is all the more vertical, the more sensitive the demand for money is to the product and the less sensitive it is to the interest rate. Factors affecting LM (shifting the whole curve) are the actual money supply (e.g., nominal money supply increases and price level is assumed constant, so actual supply increases and LM shifts to the right) and the transaction cost (Fig. 12.1).

Fig. 12.1 The IS-LM Model (Source Author’s own creation) Expansionary fiscal policy shifts the IS curve to the right. This increases the equilibrium interest rate and national income. Shifts of the IS curve to the right also result from exogenous increases in investment expenditure, consumer spending, and export expenditure, as well as exogenous reductions in import expenditure (when considering an open economy). Consequently, they also increase the equilibrium income and the equilibrium interest rate. Changes in these variables in the opposite direction, correspondingly shift the IS curve in that direction.

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

295

Expansionary monetary policy shifts the LM curve down or to the right, lowering interest rates by increasing equilibrium income. Furthermore, exogenous reductions in the preference for liquidity, possibly due to improved trading technologies, lead to downward shifts in the LM curve, and thus, lead to income increases and interest rate reductions. Again, changes in these variables in the opposite direction shift the LM curve in the opposite direction. The simultaneous balance between the market for products and services and the money market is where IS intersects with LM. This applies to specific cases: here, the Keynesian approach comes to a halt, as it recognizes that prices change over time but does not address this question. The classical approach which rejects the rigid pricing hypothesis, argues that firms ought not to adapt supply to demand. They will do so only if necessary. On the basis of the classical approach, prices “intervene.”

12.2.2

The Contribution of F. Modigliani

F. Modigliani (1944), in his article Liquidity Preferences and the Theory of Interest and Money, based on Hicks’s assumption that the elasticity of expectations is always unitary,5 revises the role of interest and money. The role of expectations in Modigliani’s model lies in determining the money market equilibrium through interest rates and dividing them into shortand long-term interest rates. His demand-side model6 is based exclusively on Hicks’s article, Mr. Keynes and the Classics (1937), while from the supply-side, it is based on a price level that would be equal to the marginal cost of the level of production determined by effective demand. Building on the Hicksian elasticity of expectations, Modigliani attempts to define the relationship between current and expected interest rates. If expectations for future interest rates are based on current short-term interest rates, then the elasticity of expectations tend to be unitary and the interest rate nexus is fully matched. However, if there are rigid expectations based on different data, the elasticity of expectations will be low and a change in short-term interest rates will affect longer-term interest rates only to the extent that some of the interest rates change (Modigliani, 1944). In his article, Modigliani (1944) treats the model as a type of general equilibrium, by distinguishing two specific cases:

296

P. E. PETRAKIS

1. The first is the Keynesian case, where the demand for money and the LM curve become infinitely elastic at a low “r” interest rate. The Keynesian case applies when the full employment equilibrium interest rate is less than “r.” Increasing the money supply cannot increase employment because of the impact on interest rates. The IS curve determines real income and employment. 2. The second is the Classic case, which exists when the interest rate is so high that the demand for money is virtually zero. Any changes in interest rates leave the demand for money unchanged, but only a change in the demand for money can change the output and employment. A shift in saving and investing behavior can only affect the interest rate. Modigliani in his analysis of determining the equilibrium point in the short run, makes no distinction between interest rates, believing that long- and short-term interest rates are the same.7 In the short run, money market equilibrium is determined by the supply of money for holding and the demand for money for holding, i.e., income. In the long run, the money market equilibrium occurs when the interest rate and quantity (i.e., demand and supply) are not expected to change further. To achieve long-term equilibrium, the interest rate should not change from one period to another, which can only be achieved if the money stock remains stable over time. However, at any given period, the individual constantly changes the money supply for holding, either by increasing it through savings or by reducing it through borrowing. If the net savings exceed net lending, then the money supply will rise above the level of the last period. However, at the interest rate of the previous period, the individual will not want to keep the additional offer and will want to buy securities, thus lowering the interest rate. On the other hand, if one wants to borrow at the interest rate of the previous period, then lenders should be motivated to reduce the demand for money by raising the interest rate. Only when all savings are equal to investments does the interest rate remain unchanged in the long run. Modigliani’s significant differentiation from the Keynesian concerns the labor market. In classical theory, the supply of labor behaves rationally and depends on relative prices. Thus, the supply of labor is taken into account so that it depends not on the money wage rate but the real wage (Modigliani, 1944). In Keynesian economics, labor supply is assumed to be perfectly elastic to the historically prevailing wage level. For

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

297

given wage levels and price levels, there is a maximum employment level. If the demand for labor is lower than supply, then the wage level remains stable. However, wages may show an upward trend if, for a given level of wages and prices, those who wish to find employment have already found it. The supply of labor will only increase if the level of wage increases more than the price level. 12.2.3

The Contribution of J. Tobin

Tobin (1958), motivated by one of the key relationships in the Keynesian model, liquidity preferences, attempted to provide a microfoundation for the downward slope of total liquidity preferences. He argued that overall liquidity preferences arise from some basic assumptions when making decisions. Thus, he presented two groups of cases which, in his view, can create liquidity preferences in line with Keynes’ “speculative motive” for demand for money: • Inelastic expectations of interest rates, and • The fact that expectations about future interest rates vary between individuals. Tobin in his analysis uses two different kinds of assets: cash and consols.8 The composition of the portfolio is based on the expected returns from holding both of these assets. While each investor owns an undiversified portfolio, cumulatively, a pool of investors who have a different view on future interest rates, creates a downward slope of overall liquidity preferences. The concept of uncertainty is introduced in Tobin’s analysis by dividing investors according to their degree of risk aversion. The composition of the portfolio depends on the investor’s utility function—which reflects its degree of risk aversion—and the perception of a compromise between risk and return. A possible increase in the yields of consols will increase the opportunity cost of cash. A typical risk-averse investor will want to gain more cash consols for a given level of wealth, creating an inverse relationship between interest rate and demand for cash. Through risk aversion behavior, Tobin extracts the downward slope of liquidity preferences at the microeconomic level. If all investors avoided the risk, overall liquidity preferences would have a downward slope, provided that there were heterogeneous preferences and inelastic expectations of interest rates.

298

P. E. PETRAKIS

As for Tobin’s theory of risk aversion behavior, it departs from the Keynesian approach by assuming that expectations of future interest rates are independent of the current rate. Tobin’s model initially assumes that the average value of expected capital gain in consols is zero, that is, diverging views about future interest rates play no role in the model, and it also assumes that expectations are not evaluated. 12.2.4 The Contribution of P. Samuelson and R. Solow and the Phillips Curve Samuelson and Solow (1960), while considering the Phillips curve as a good attempt to interpret the relationship between inflation and employment in the economy, still find that its results may be biased.9 Focusing on labor market differences between the United States and the United Kingdom, Samuelson and Solow (1960) refer to geographical, economic and social events, labor mobility and trade unions. At the same time, if the Phillips curve represents a reversible labor supply curve, movements on the curve reflect changes in aggregate demand, while shifting the curve represents institutional changes associated with cost-push theories. In addition, they make an important point about the Phillips curve by giving two “predictions” according to the observation of the curve. These relate only to subsequent years. The Phillips curve shows a short-term, but not a long-term, trade-off between inflation and unemployment. It can be moved up or down in line with expected inflation. Reference is made to the role of expectations since, as they note, “other economists may be more likely to believe that expectations for continued full employment are sufficient to explain the shift in the supply curve” (Samuelson & Solow, 1960). A low-demand policy can either improve the relationship by affecting expectations, or worsen it by creating more structural unemployment. Inflationary expectations can shift the Phillips curve down in the long run. For given inflation levels, employment should be higher. Going one step further, they note that the curve may shift outward as cyclical unemployment becomes structural. Thus, the main point of Samuelson and Solow’s (1960) analysis is the conclusion that the relationship between inflation and unemployment may change, leaving room for economic policy to shift the Phillips curve in any direction.

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

299

12.3 Keynesians, Real Demand, Capital Allocation, and Accumulation Keynes viewed the economy from a macroeconomic perspective, seeing the danger of creating equilibrium points that would include imbalances between labor and capital. In such a situation, the entrepreneur (as J. Schumpeter describes him) can do only a few things and this situation could be addressed only if the government and central economic policy were to intervene. A typical example of Keynesian economic theory is the model developed independently by Harrod (1939) and Domar (1946) also called the Harrod–Domar model (see Box 12.2), and considered a precursor to the AK model. The model was initially designed to explain short-term economic fluctuations, that is, economic cycles, but was later used to describe the functionality of the growth mechanism and the factors that determine it. Savings, marginal product of capital and depreciation are critical factors in the Harrod–Domar’s growth model.10 The growth rate of the product is positively determined by savings, the marginal product of capital and the reduced depreciation rate. Growth depends on labor and capital. Increasing investment which leads to capital accumulation generates economic growth. Keynesian thinking about the model is based on the assumption that the economy does not always find full employment and stability. The model’s structure, as well as its policy proposals, give the model an extrinsic character in terms of how growth in the economy evolves. Box 12.2 The Harrod–Domar Model (1939, 1946) The model was independently proposed and developed by Harrod in 1939 and Domar in 1946 and is considered a precursor to the AK model. This model proposes that product growth rates are affected by savings and depreciation.

300

P. E. PETRAKIS

It is assumed that the product is expressed as a function of the production of capital and labor, and technology is introduced as a coefficient of the elements of the function, which in turn are assumed to be constant. Therefore, we can say that: Y = F(K , L) Stable technological coefficients imply that there will be a surplus or labor surplus, which in turn depends on the economy’s stocks. However, both authors focus more on the most important element of the total production function, capital. In this sense, we can say that: Y = f (K ) = AK In a continuous time, investments will be: I = sY − d K where s is the saving rate and δ is the depreciation rate. Now, by substituting we have ˙ = s f (K ) − δ K = s AK − δ K K ˙ The model implies that growth is given by: g = K K = sA − δ It follows from the foregoing that the rate of growth of the product increases linearly by the rate of saving times the fixed technological coefY minus the ficient, which is the marginal product of capital A = K depreciation rate.

A large group of prominent economists relied on Keynesian thought and dealt extensively with post-war growth issues. These are Myrdal (1953), Robinson (1956), Kaldor (1960), and Kalecki (1968). Myrdal’s contribution to economic theory, found in his work The Political Element in the Development of Economic Theory (1953) seems to have been slightly ahead of Keynes (at least concerning savings and investment, the role of the state, and the strengthening of economic activity). However, Myrdal was overall a supporter of Keynesian ideas. What is important is that he developed a classical integrated understanding of political economy, closely linking psychology (behaviorism), social sciences, political science, economic theory and economic policy, and promoting the idea of interdependence of economic, social and institutional phenomena. It is characteristic that he influenced and promoted both the role of expectations and the role of uncertainty, under the influence of Knight’s work (1921).

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

301

Out of this group of early Keynesian economists, one can distinguish the works of Kaldor (1957, 1961) which made three distinct contributions: 1. He helped shape some critical ideas of growth models. Thus, he was the first to develop the concept of learning by doing which was later incorporated into endogenous growth models as the basis of technical progress. 2. A second particular contribution was his analysis of regional and national divergences. 3. His contribution to the theory of international trade based on the concept of increasing returns was also significant. This contribution was developed within a wider Keynesian context of real demand and limited development. Kaldor also introduced the notion of a positive relationship between total industrial production and productivity leading to an increase in capital accumulation which he thinks is attributes to three reasons.11 Indeed, Kaldor describes static and dynamic returns to scale. The economies of scale that Kaldor has in mind stem from the discovery of new processes, increased diversification, and new subsidiary industries—that is, general industrial expansion, rather than the expansion of a particular company or industry. As growth increases, external demand for the industrial sector will not come from the agricultural sector of the economy but from exports. Thus, the Keynes multiplier is expanded and converted into a foreign trade multiplier (Hicks, 1950). But since the economy needs imports as inputs, then exports need to grow faster than imports. This introduces the notion of export demand elasticity. In Kaldor’s (1957, 1961) view, the flow of trade is determined by: 1. relative prices, 2. elasticities of relative income, 3. relevant position in the international financial system. Therefore, international relations make a difference in each country’ relative position within the international spectrum and within the dynamics of globalization, convergence and divergence. The sources of growth and

302

P. E. PETRAKIS

productivity are not only endogenous (practical learning and increased returns to scale) but also exogenous (inventing or introducing capital goods that incorporate technical progress). There are two major groups of post-Keynesian growth models: one derives from Joan Robinson and the other comes from Kalecki. Both are Keynesian, in that they use an independent investment function and a Kaldor savings function. The difference is that Robinson’s model assumes full productive capacity utilization, compared to Kalecki’s model, which does not accept it. This difference turns out to be crucial. The influence of Robinson (1956) and Kalecki (1968) on the development of Keynesian magnification theories is marked by the emergence of a distinct source of growth, which is income distribution. Since there are independent investment functions and the propensity to save varies between different income groups, the distribution of income between capital and labor plays a critical role. In Robinson’s model, income distribution is an endogenous variable, and higher earnings go hand in hand with faster growth. Kalecki’s model, which has an additional degree of freedom through the variable use of productive capacity, needs to be supplemented by an exogenous income distribution theory where higher wages lead to higher growth. In contrast to neoclassical economics, Keynesian economics regards investment accumulation as the variable that drives the development process. In neoclassical development theory, investment ceases to exist in the long run, passively adjusting relative prices and product growth, and coincides with the offering of savings. On the contrary, in the Keynesian economy, investment is understood as something that is defined independently of savings. This implies that investment is not normally limited by the availability of savings, but by the possibility of credit mobilization. Usually, this analysis of the real sector is complemented by the assumption of a flexible financial system and an endogenous supply of money. Therefore, the structure of the financial system becomes important. By contrast to neoclassical theory, internal and external funding are treated asymmetrically. Especially for small companies, it is often difficult to get credit. Even if the investment function needs to be institutionally specific, Keynesian theory has identified some key factors that can enter into the investment function (Basle, Mazier, & Vidal, 1993). The following factors are most commonly found in the literature:

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

303

1. Earnings as an indicator of future profits 2. Increasing demand, “accelerator” 3. The availability of financing that brings us back to either profits as a source of internal financing or to the structure of the financial system (bank-based versus capital market-based financing) 4. The rates of return on financial investments, which are the alternative to acquiring additional physical capital. 5. Other factors that are sometimes included are pressure from competitors and technological progress. Ekelund, Edvard, Marjo-Riitta, and Dirk (2005) report, by reference to Knight (1921), Chamberlin (1950), and Robinson (1953–1954), that the entrepreneur has now ceased to be the manager and becomes the central catalyst for the operation of the economy as described by Schumpeter. Uncertainty also emerges as a major source of influence on earnings, thus also on investment and the level of economic activity.

12.4 Effective Institutions and Reducing Uncertainty in the Theory of Evolutionism In his great article, Uncertainty, Evolution and Economic Theory (1950), Alchian (1914–2013) contributes mainly to the literature on behavioral economics and the theory of evolutionism, while criticizing the correctness of neoclassical model assumptions. His approach incorporates the principle of biological evolution and natural selection by considering the economic system as an adaptation mechanism which, through the repeated process of profit seeking, develops mechanisms to survive the prevailing conditions. Through natural selection, the economic system selects who survives: on the one hand, there are those who dominate the market and survive and on the other hand, those who are unable to adapt to the environment and perish. Alchian argues that companies, and stakeholders in general, cannot act in a way that maximizes rational profit. That is why in his work he attempts to incorporate incomplete information and uncertainty into the decision-making process. For Alchian (1950), the failure of predictions stems from the existence of uncertainty, which in turn does not provide a good vantage point for determining human behavior. Trying to maximize profits makes no sense in an uncertain environment, where there is a distribution of possible

304

P. E. PETRAKIS

outcomes. In the best-case scenario, from a multitude of feasible outputs, operators can choose the optimal distribution, rather than the optimal output. Alchian’s approach is quite simple, but valuable. He states that it is preferable to assume in our model the existence of complete uncertainty12 and non-motivation, and then add predictive and motivational elements along the process of constructing a detailed model. In essence, he proposes the opposite course to that of the Neoclassical model, by rejecting its basic assumptions. High uncertainty does not always favor decision-makers based on rationale, methodology and an evidence-based approach. On the contrary, chances favor the bold. From this observation, according to Alchian, two issues arise: firstly, the success and overall survival of businesses leads to superiority and secondly, it does not require appropriate incentives for the decision-making process. Among competitors, those who adapt to the particular conditions offered in the economic system could be described as ‘those who survive’. The contribution of Alchian’s work (1950), beyond behavioral economics and critique of Neoclassical economists includes another point. Although not a model of growth, it nevertheless provides information on the deep roots of magnification. At the micro level, companies apply adaptive behaviour and follow an evolutionary process, which through repetition creates learning and knowledge conditions, both of which are critical sources of growth. The way in which those who “survive” are set apart causes a great deal of concern about the way institutions are shaped. High uncertainty can lead to ineffective institutional structures, which in reality act as a deterrent to market efficiency and ultimately to the forces of growth.

12.5

Balanced Dualism and Unbalanced Structural Development

Balanced dualism and unbalanced structural development primarily aimed at resolving the problems of developing countries and in particular the issues of balance of payments, of unemployment and income distribution, and focused on the inability of price system stability mechanisms to promote steady development or a desirable income distribution. Rosenstein-Rodan (1943), in his major work, presented his argument for a Big Push as a means of escaping the trap of growth. The assumptions of economies of scale and the existence of a dual economy (rural/industrial sector) that can free up labor are both present. Thereby,

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

305

the development contribution of the least developed sector comes directly as a growth factor (Lewis, 1954), through the transfer of human resources to more developed sectors. According to W. A. Lewis, in the early stages of development, unlimited supply of labor, coming from the more established sector—with the least productivity—to the more developed sector of the economy, can lead to more growth without market expansion, through growth wages, while on the other hand, there is an increase in returns on capital (Box 12.3). This in turn, leads to a higher level of investments which lead to a higher growth rate. Box 12.3 Lewis (1954): The Two Sector Model Lewis’ model (1954) explains how economic growth begins through structural change—increasing the size of the industrial sector relative to the preservation of the agricultural sector. Lewis dealt with the lack of labor supply in the expanding industrial sector. His contribution was instrumental in laying the foundations for development economics. The Basic Model: • The economy consists of two sectors, the traditional and the modern, which coexist. There is an “economic dualism.” • The traditional sector has surplus labor (MPL = 0). Surplus labor is in the traditional/agricultural sector, much of which is unskilled. • The model focuses on the process of transferring surplus labor and increasing the product in the modern sector. • The model implies that employment will expand, to absorb surplus labor into the modern or industrial sector. Hypotheses: 1. A growing economy has surplus non-productive labor in the agricultural sector. 2. Workers are attracted to the growing manufacturing sector, where higher wages are offered. 3. Wages in the manufacturing sector are more or less stable. 4. Manufacturers make a profit because they charge a price higher than a fixed wage. 5. These profits will be reinvested in the company in the form of fixed capital.

306

P. E. PETRAKIS

6. An advanced manufacturing sector means that the economy has shifted from the traditional to the industrialized economy. The difference between the two sectors, the modern and the traditional, is analytic rather than descriptive. The first analytical difference states that essentially the same type of work has higher productivity in the modern sector than in the traditional sector. Introducing the marginal product (MP of work in the traditional and modern sectors with MPTL and MPML respectively, Lewis’s proposal therefore holds that MPML > MPTL. This inequality implies that the economy can grow through the transfer of labor from the traditional to the modern sector. The hypothesis is that more is saved through the increased output of the modern sector. This is a shift which provides additional capital to the modern sector so as to absorb more work than the traditional sector. This is what basically drives growth in Lewis’s model. The second analytical difference between the two areas concerns distribution. Distribution in the modern sector follows the “marginal productivity rule” of allocation, which leads to profit maximization behavior, so that w M = MPML where w M shows the wage in the modern sector. However, it is considered in the traditional sector wT > MPTL, where wT shows the wage in the traditional sector. This inequality is likely because allocation in this area is governed by a different rule, the “principle of intra-family and /or community allocation,” which results in product maximization behavior rather than profit maximization behavior. It is this output maximization behavior that then pushes the application of labor, in the traditional sector, to very low levels of marginal productivity. On the contrary, the modern sector is characterized by “commercial organization,” which leads it to “profit maximizing behavior” and therefore to compliance with the “marginal productivity of the allocation rule” so that w M = MPML. Overall, a binary economy is characterized by the relationship MPTL < wT < w M = MPML. From the above relation it can be concluded that the modern sector would be expanded by absorbing the work of the traditional sector, without having to increase wages. The shifting of work from the traditional to the modern sector increases MPTL. However, as long as MPTL < wT < w M applies, these increases do not lead to increases of wT , and therefore w M does not need to respond. The modern sector can be expanded with more or less unchanged wages justifying the possibility of “unlimited” or “perfectly elastic” job supply by the traditional sector. Only when the withdrawal of labor pushes MPTL sufficiently upwards

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

307

to bring it closer to wT , does further removal lead to increases of wT , which subsequently creates incremental pressures on w M . That is then that the economy reaches the Turning Point, which is experienced first by wT and then by w M . As the process progresses, equality MPTL = wT = w M = MPML is achieved, the dualism of the economy disappears, and the economy begins to respond to the Neoclassical approach. Figures 12.2 and 12.3 show the above procedures in the form of a graph.

Fig. 12.2 The turning point hypothesis in the Lewis model Author’s own creation)

(Source

Fig. 12.3 Marginal product and wage in the traditional sector (Source Author’s own creation)

308

P. E. PETRAKIS

12.5.1

Unbalanced and Balanced Growth

Unbalanced Growth: The theory of unbalanced growth argues that investments should be made in selected sectors rather than in all sectors of the economy. Hirschman (1958) is seen as the founder of unbalanced growth theory, as he proposed the idea of producing some critical sectors with strong interconnections even if they produce an imbalance because the resulting process will lead to the production of growth. Hirschman pursued the theorization of the operation of Leontief’s input–output Tables (1951, 1966) that describe the interconnections of an economy (Box 12.4). But the issue Hirschman raised was not so much about securing multidirectional interconnections in an economy—this is the descriptive result of his proposals. The crucial issue in his analysis was the creation of new sources of growth as a result of market size and growth economics. Basically, that is, the creation of external economies from the market size, and their interconnection with economies of scale. These external economies may refer to interconnections with subsequent stages of productive activity or to interconnections with earlier stages of productive activity. The former are interconnected through the ability of individual productive sectors to improve the profitability of industries using their products, while the latter through their feature of developing demand for intermediate products, whereby suppliers enjoy the benefits of market size and of the resulting economies of scale. In essence, these views make the question of market structure a key focus of attention. Box 12.4 Leontief (1951): Input–Output Model Leontief (1951) introduced in the field of applied economics the concept of interdependent relations with the Input–Output model. The Input–Output Model consists of the endogenous productive sectors. Final demand is treated as exogenous. The X i j represents the flow from sector i to sector j and X D the flow from sector i to final demand. If we denote with Yi the total output of the sector i, then the total output of each sector Yi should be equal to the total demand of the other sectors of the economy (intermediate demand) plus the final demand for the products of the sector.

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

309

This will lead to: Yi =

m 

Xi j + Xi D

j=1

The most important of the hypothesis underlying the use of the model is that each industry is identified with a single production function. This has the direct consequence that industries producing more than one product pose a serious problem with being classified into a single sector. A second hypothesis relates to the fact that each sector produces only one product, i.e., there are no by-products and no external economies. Finally, it is emphasized that the amount of inputs depends on the level of production through specific technological relationships. These hypotheses preclude changes in technological factors following changes in both relative prices and the availability of product or factors and products. If we define technology ai j as the ratio ai j = X i j /Υi , then it is obvious that the above function can be written as: Yi =

m 

ai j Yi + X i D

j=1

or, as an equivalent: Yi −

m 

ai j Yi = X i D

j=1

For all sectors and with the symbolism of the matrices, the equation is written: (I − A)Y = X D In this equation, the identity matrix is represented with I , the matrix of technological factors with A, the vector of total production with Y , and the vector of final demand with X D . Solving the system results in the only solution: Y = (I − A)−1 X D

310

P. E. PETRAKIS

If we analyze the (I − A)−1 = Z , we end up with the relationship: Y = Z XD Each z i j item in the Z matrix expresses the increase in industry output i needed to meet a unit increase in final demand for industry products j.

Balanced Growth: The theory of balanced growth refers to the simultaneous and coordinated development of many sectors of the economy. Both Ragnar Nurkse (1953) and Rosenstein-Rodan were in favor of balanced growth. Large-scale investment in many sectors simultaneously induces demand complementarity across sectors.13 Therefore, the size of the market is expanding, as is the willingness of the economy to invest. According to Nurkse, market size is determined by several factors in which productivity plays a dominant role. Low productivity reduces real purchasing power, and so Keynesian perceptions of boosting active demand do not have a significant effect, at least in developing economies. By contrast, concepts such as population and geographical area of activity are not as important determinants as are transport costs and non-tariff barriers to trade and the like. An increase in productivity increases the flow of goods and services into the economy, increases consumption, and it increases the rate of growth by increasing the tendency to invest.

12.6 Catching Up Effects and Developmental Stages Gerschenkron (1962) with the Backwardness Model argued that a relatively well-established economy could evolve toward industrial development, mainly based on the Catching Up Argument where the more significant the gap between the level of per capita income of a country that is trailing and the level of per capita income of a leading country at an initial point, the higher the rate of increase in per capita income. Trailing countries import capital goods or receive foreign direct investment. Therefore, they are accumulating investments that integrate the latest generation of technological progress. The ratio of new capital equipment to the old one is higher in the economy of the trailing than that of the leading country, so the rate of increase in output per capita is also

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

311

higher. Over time, as trailing economies fill the gap that separates them from leading economies, the gap between per capita incomes narrows and the two growth rates converge. The Gerschenkron model can be considered complementary to a degree to that of Rostow14 (1959), whose analysis involves overlapping waves of changing economies and societies, covering an extensive range of processes and sources of growth. Specifically, he argues that economies go through five stages of growth, which are: 1. Traditional Society: This is the simplest stage of a traditional rural, hunting, and collecting society, based exclusively on the primary sector, with limited use of technology. 2. Pre-conditions for take-off: These concern a range of conditions, such as increased external demand, the move to more productive activities, the diffusion of technology, and social mobility. 3. Take-off: This includes urbanization, industrialization and technological deepening. 4. Drive to maturity: Here is the diversification of the industrial base, the change in the production structure to meet the demand arising from consumer-type standards, and the implementation of large-scale social infrastructure investment projects. 5. The age of mass-consumption: This involves consuming products that have high income elasticity and consumers who have disposable income greater than what their basic needs require. In addition, concepts are present such as support of certain key sectors and the existence of an institutional framework facilitating growth at the final stage. Rostow organized a theoretical linear evolution of the capitalist process, which was based on the experience of the West (USA, Japan, Europe) and which can be diffused to all countries through the adoption of specific principles of international economic relations (Classical and Neoclassical). Based on his views and on theories of modernization, every country could prosper, provided it followed the five stages of change and increased its savings from 5 to 10% at some point during the take-off phase while at the same time making changes at the level of institutions and culture.

312

P. E. PETRAKIS

12.7 Development Theories and Sources of Growth In the 1950s, a body of development ideas was presented that shaped what we know today as Development Theories. Two important trains of thought have shaped this important scientific trend: 1. The concepts that were based one way or another on Keynesian and Neoclassical influences and go under the general heading The Structuralist Approach to Development Policy (Chenery, 1975) which includes the contribution of Myrdal from the fields of international economics and trade and the contribution of Singer (1950) and Prebisch (1968) in the context of the analysis of dependent development. 2. The group of concepts based on Neo-Marxist thinking and the socalled Dependency Theories. The second group formed a perspective of growth quite different from that of the dominant economic theories. As far as the first set of ideas is concerned, the body of these ideas is full of theoretical references that aim to highlight the significance of sources of growth, which were especially important at that time in human history. Although it is generally believed that, to date, this body of theoretical developmental thinking has not been able to reclaim its place in economic theory, it remains an important source of influence on economic thought. This is especially because in the period we are covering, the fetishism of mathematical economics has diminished a great deal. Thus a major problem, the lack of mathematization from which these economic considerations suffered (Krugman, 1994), has ceased to operate to their detriment. The dimension of dependent development also takes the form of a substantial contrast between the so-called developed centre and the less developed periphery, begun by the work of Prebisch (1968) and Singer (1950). The hypothesis of Singer (1950)—Prebisch (1968) states that the price of primary commodity goods decreases with the price of processed products. The conditions of trade therefore deteriorate to the detriment of the producers of primary goods. This basic concept served as a pillar of

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

313

the theory of dependence for development and the emergence of import substitution policies for industrialization. The Singer-Prebisch theory, developed in the 1950s, raises the issue of how the least developed economies are integrated into the world economy. They fundamentally argue that developing countries will not necessarily experience the same form of evolution as developed countries but will have their own characteristic evolution. The idea of the unfavorable evolution of the terms of trade took a more specific form—that of uneven exchange—by Emmanuel (1972) as the cause of the centre-periphery opposition and the formation of conditions of the periphery’s inability to develop. Emmanouel’s conceptions, at all events, had Neo-Marxist influences. Significant in this regard is the contribution of Vaitsos (1974), who argues that through Transfer Pricing, multinationals transfer a significant portion of their surplus from developing to developed economies. Regarding the second set of concepts, Neo-Marxist theories are primarily concerned with analyzing how new value is created by the productive system (microanalysis) and how values are exchanged in international economic relations, in the presence of geostrategic factors, resulting in certain producers’ prevailing over others, with primary reference to national economies or to groups of economies (centre-periphery, etc.). Baran’s contribution to the political economy of growth (1952, 1957) relates to the concept of Surplus Value15 which is directly related to development performance. Indeed, the distinction he makes between actual economic surplus and the potential economic surplus that can be produced, may highlight the deeper sources of development as he defines it, i.e., as the “increase in time of per capita output of material goods ” (i.e., as an increase in labor productivity). The difference between the two concepts can be zero and therefore the magnification will be improved if the following are eliminated: • • • •

excessive consumption by the middle and upper classes of society, non-productive workers, irrationality and waste in the economy, and unemployment (Edwards, 1957).

314

P. E. PETRAKIS

In relation to the least developed countries, the point is that, although real economic surplus value is usually small, the potential economic surplus value, which could be mobilized through a radical social reorganization, is morally high Baran (1952, 1957) disputed this view by observing that in the backward capitalist countries no such development is visible. On the contrary, he saw with Sweezy (Baran and Sweezy 1966) that these proposals were based on the observation of the European economy and on what was called the “European Miracle” (seventeenth-nineteenth centuries) a main result of Europe’s privileged position in international trade and international relations. But the European Miracle developed those very activities (colonialism) which prevented the societies legging behind from evolving. Thus, the limits of dependency were developed, or the imperialist limits, which destroyed those institutions that could trigger a self-sustaining growth in the least developed economies, thereby perpetuating the development of underdevelopment. The concept of Development of Underdevelopment was promoted by Frank (1966), a German American economist, historian, and socialist who also promoted the theory of dependency in a different version to Amin (1976) in the form of Unequal Development. Influenced by its historical context, however, his work promoted the notion that a country’s economic viability depends heavily on its historical development and geographical features, although it did not accept the Marxist historical interpretation of evolution. In so doing, he reinforced the idiosyncracy of the evolution of the less developed countries, moving away from the common ground described by traditional theorists as “one way for all” for modernized countries. This idiosyncracy was mainly due to the position of these countries in international economic relations characterized by dependency and exploited character. He may be one of the inaugural proponents of evolutionary development analysis. But in the analysis of the Neo-Marxists, the Leninist conception also entered of international dependencies. Thus, were shaped the views about Unequal Exchange in Emmanuel’s (1972) international economic relations and the conceptions of development regionalization.

Notes 1. Neoclassical and Neokeynesians should not be confused with the later New Classicals and New Keynesians, despite affinities between the schools of thought.

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

315

2. This incompatibility was later resolved by the microfoundations of the New Classicals and New Keynesians. 3. Hicks (1939) defined the “elasticity of a person’s expectations of the price of a good X” as the reason for the proportional increase in expected future values of X to the proportional increase in its current price. 4. For the concept of expectations, in particular adaptive expectations, see Chapter 7, sub-section 7.5. 5. The unit elasticity of expectations for a good means that a change in the current price of the good will equal the changes in the expected future value of that good. 6. The relationship between demand and interest rates, which is illustrated by the demand curve for money holding, shows that increasing interest rates reduces demand for money. At the same time, increasing income reduces money supply and increases interest rates. However, from one point onwards, the increase in money supply does not affect the interest rate, while lowering income below one level, also does not change the interest rate. 7. While one might assume that interest rates are moving in the same direction, changes in the money supply may affect interest rates with different maturity, depending on the nature of interest rate expectations. A change in supply will affect the short-term interest rate, but the extent to which it will affect the longer-term interest rates depends on the relationship between the current interest rate and the expected future interest rates (Modigliani, 1944). 8. U.K. fully guaranteed yield bonds, which are considered to prevail over cash in terms of yields (current interest rate). 9. The high unemployment rates (8–10%) required in the US economy to stabilize wages, made them wonder if this type of relationship depends heavily on past experience and claim that this is another way which a past, characterized by rising prices, high unemployment, and mild and short recessions, is likely to create an inflationary tradition. 10. At the heart of the model is the attention it pays to the conditions under which investment and capital accumulation can be increased, and thus the level of savings and productivity of capital. Consequently, there may be a unique rate of increase in investment and income to maintain the level of full employment for a significant period of time (steady growth). Thus, both the Classic supply and the Keynesian demand concepts are taken into account. 11. “First, because the development of manufacturing provides capital goods and therefore technical achievements that are incorporated therein as inputs to other sectors. Second, because the increase in output and manufacturing employment reduces employment in the agricultural sector, but

316

12.

13. 14.

15.

P. E. PETRAKIS

not its output. Thirdly, because greater manufacturing activity increases productivity per worker in the distribution sector” (Targetti, 2005). Even when conditions of high uncertainty and inadequate information prevail, businesses that are better able to adapt to their external environment can be considered to behave rationally. After all, businesses that survive are those that make positive profits, not the maximum profits. Nurkse advocates in favor of balanced growth, both in the agricultural and industrial sectors, to create additional demand across sectors. Rostow’s model, based mainly on the logic of exploiting certain sectors, has selective affinities with Ricardo’s theory and the comparative advantage with the Structuralists and with A. Hirschman, as opposed to the Marxist conception of evolution. Surplus value is the difference between the actual current outflow of a society and the actual current consumption, and is therefore equal to savings and therefore accumulation.

References Alchian, A. A. (1950). Uncertainty, evolution and economic theory. Journal of Political Economy, 58(3), 211–221. Amin, S. (1976). Unequal development. New York: Monthly Review Press. Arrow, K. J., & Debreu, G. (1954). Existence of an equilibrium for a competitive economy. Econometrica, 22(3), 265–290. Baran, P. A. (1952). On the political economy of backwardness. The Manchester School, 20(1), 66–84. Baran, P. A. (1957). The political economy of growth. New York: Monthly Review Press. Baran, P. A., & Sweezy, P. M. (1966). Monopoly capital. New York: Monthly Review Press. Barro, R., & Grossman, H. (1971). A general disequilibrium model of income and employment. American Economic Review, 62, 82–93. Basle, M., Mazier, J., & Vidal, J. F. (1993). Quand Les crises durent (2nd ed.). Paris: Economica. Chamberlin, E. (1950). Product heterogeneity and public policy. American Economic Review, Papers and Proceedings, 40(2), 85–92. Chenery, H. B. (1975). The structuralist approach to development policy. Papers and Proceedings of the A.E.A., 65(2), 310–316. Clower, R. (1965). The Keynesian counter-revolution: A theoretical appraisal. In F. H. Hahn & F. P. R. Brechling (Eds.), The theory of interest rates. London: Macmillan. Domar, D. E. (1946). Capital expansion, rate of growth and employment. Econometrica, 14, 137–147.

12

NEOCLASSICAL SYNTHESIS AND KEYNESIAN DEVELOPMENT

317

Edwards, T. (1957). Paul Baran’s economic study. Chicago, IL: International Socialist Review. Ekelund, J., Edvard J., Marjo-Riitta, J., & Dirk, L. (2005). Self-employment and risk aversion—Evidence from psychological test data. Labour Economics, 12, 649–659. Emmanuel, A. (1972). Unequal exchange: A study of the imperialism of trade. New York and London: The Monthly Review Press. Frank, G. (1966). The development of underdevelopment. Monthly Review, 18(4), 17–31. Gerschenkron, A. (1962). Economic backwardness in historical perspective, a book of essays. Cambridge, MA: Belknap Press of Harvard University Press. Harrod, R. (1939). An essay in dynamic theory. Economic Journal, 49, 14–33. Hicks, J. R. (1937). Mr. Keynes and the “classics”; A suggested interpretation. Econometrica, 5(2), 147–159. Hicks, J. R. (1939). Value and capital. Oxford: Clarendon Press. Hicks, J. R. (1950). A contribution to the trade cycle. Oxford: Clarendon Press. Hicks, J. R. (1981). IS-LM: An explanation. Journal of Post Keynesian Economics, 3(2), 139–154. Hirschman, A. (1958). The strategy of economic development. New Haven: Yale University. Kaldor, N. (1957). A model of economic growth. Economic Journal, 67 (268), 591–624. Kaldor, N. (1960). Essays on value and distribution. Glencoe, IL: The free press of Glencoe. Kaldor, N. (1961). Capital accumulation and economic growth. In F. A. Lutz & D. C. Hague (Eds.), The theory of capital (pp. 177–222). London: Macmillan. Kalecki, M. (1968). Trend and business cycle reconsidered. The Economic Journal, 71(282), 292–299. Knight, F. H. (1921). Risk, uncertainty and profit. New York: Harper. Krugman, P. (1994). The myth of Asia’s miracle. Foreign Affairs, 73(6), 62–78. Leijonhufvud, A. (1968). On Keynesian economics and the economics of Keynes. Oxford: Oxford University Press. Leontief, W. (1951). Les tendances futures éventuelles des relations économiques internationales des Etats-Unis. Revue Économique, Programme National Persée, 2(3), 271–278. Leontief, W. (1966). Input-output economics. New York: Oxford University Press. Lewis, W. A. (1954). Economic development with unlimited supplies of labor. Manchester School of Economic and Social Studies, 22, 139–191. Modigliani, F. (1944). Liquidity preference and the theory of interest and money. Econometrica, 12, 45–88. Myrdal, G. (1953). The political element in the development of economic theory. London: Routledge and Paul (Originally published 1930).

318

P. E. PETRAKIS

Nurkse, R. (1953). Problems of capital formation in underdeveloped countries. Oxford: Oxford University Press. Prebisch, R. (1968). A new strategy for development. Journal of Economic Studies, 3, 3–14. Robinson, J. (1953). The production function and the theory of capital. Review of Economic Studies, 21(2), 81–106. Robinson, J. (1956). The accumulation of capital. London: Macmillan. Rosenstein-Rodan, P. N. (1943). Problems of industrialization of Eastern and South-Eastern Europe. The Economic Journal, 53, 202–211. Rostow, W. W. (1959). The stages of economic growth. UK: Economic History Review. Samuelson, P. A. (1955). Economics (3rd ed.). New York: McGraw-Hill. Samuelson, P. A., & Solow, R. M. (1960). Analytical aspects of anti-inflation policy. American Economic Review, 50(2), 177–194. Singer, H. (1950). The distribution of gains between investing and borrowing countries. American Economic Review, Papers and Proceedings, 40, 473–485. Targetti, F. (2005). Nicholas Kaldor: Key contributions to development economics. Development and Change, 36(6), 1185–1199. Tobin, J. (1958). Liquidity preference as behavior towards risk. Review of Economic Studies, 25, 65–86. Vaitsos, C. V. (1974). Intercountry income distribution and transnational enterprises. Oxford: Clarendon Press.

CHAPTER 13

Solowian Growth and AK Models

13.1

Introduction

This chapter presents the Neoclassical theory of growth in its two successive stages of evolution in the course of which the role of technology is transformed from exogenous to endogenous. The first stage relies mainly on Solow and Swan while reference is also made to the Overlapping Generation Models (OLG Models), which treat technology as an exogenous variable. The second stage centers on AK models, where technology becomes endogenous with the introduction of learning by doing, constituting the first wave of endogenous growth models.

13.2 Exogenous Growth: Savings, Exogenous Technology, Preferences, and Expectations The Neoclassical theory of growth is built on the law of diminishing returns. Models by Solow (1956) and Ramsey (1928) are exogenous growth models and are synonymous with Neoclassical economics. Solow’s model, also known as the Solow-Swan model (Solow, 1956; Swan, 1956), is a dynamic economic equilibrium model that attempts to explain long-term economic growth by focusing on productivity, capital accumulation, population growth, and technological change. The basic microeconomic elements of the model are based on the Cobb–Douglas production function. According to the model, households save a portion © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_13

319

320

P. E. PETRAKIS

of their disposable income which is exogenously determined. The behavioral rule of the fixed saving rate simplifies the determination of the dynamic equilibrium. The percentage of income people save is stable and exogenously affected, for example by the government or central bank announcements. However, the assumption that all households behave in the same way and the fact that savings are not inherent in the model, constitute its weaknesses. It is worth noting that before Solow’s model, the most well-known approach to economic growth through an organized model was that of Harrod (1939) and Domar (1946) which had Keynesian infrastructure. Ramsey’s model or Ramsey–Cass–Koopmans’ model (Cass, 1965; Koopmans, 1965; Ramsey, 1928) differs from Solow’s model in relation to the optimization of individual behavior and to saving practices which it considers endogenous through the influencing of behavioral preferences. Savings, and in particular the depreciation rate, affect the rate of capital accumulation. Households strive to maximize their utility function. The problem with this process is closely related to the diachronic consumption choices. Consumption depends on the discount rate of money, as the individual has to choose between current and future values. The balance is determined by the compromise between investment and consumption, which in turn is determined by the discount rate. A lower discount rate means more savings, as it shows the willingness of households to substitute consumption with savings. The discount rate consists of an intuitive expectation—even though the concept of expectations is not directly defined in the neoclassical model of growth. The existence of uncertainty drives households to diversify their portfolios with less risky assets, such as government bonds. The Ramsey–Cass–Koopmans model is widely used in many areas of macroeconomics, such as fiscal policy, business circles, and monetary policy. Under the neoclassical model, the only way to explain the long-term per capita output growth observed in developed countries is to accept that continuous technological change (productivity growth) outweighs the negative effects of diminishing capital returns. In essence, the tendency to reduce the ratio of production to capital is offset by technological progress. This is so until the economy approaches a steady state, where two forces precisely balance each other, with the balance point being determined by the rate of savings, the depreciation rate and the rate of

13

SOLOWIAN GROWTH AND AK MODELS

321

population change. Savings lead to the accumulation of capital and technological progress which in turn increases the capital per worker and, therefore, the product per worker. High population growth also works as a source of growth. In the long run, the growth rate will revert to the pace of technological progress. Therefore, for specific levels of technological progress, the neoclassical model satisfactorily shows how the level of production, real wages and real interest rates are determined. If all economies had the same technology, then there would be convergence in the long-term. Box 13.1 The Solow Growth Model (1956) Solow’s model of growth is a model of capital accumulation in a purely productive economy: there are no prices, as the emphasis is on the output that equals real income. The “components” of the model are consumers and businesses. It is assumed that individuals work nonstop so there is no free time management option and they also save and invest a fixed part of their income; they are owners of businesses that exist in the economy and thus enjoy all the wage income and profits from the output. At the same time, it is assumed that there is no state intervention, i.e., no taxes and/or transfer payments. It is a closed economy and so, there is no trade. Because there are no prices, there is no need for money and there are no financial markets, etc. Thus, this model captures the net long-term impact of savings = investment, quality of life = per capita income. The variables of the model are: Output = Real income = Yt in period t. Capital Stock = K t Population Size = Nt = Labor Supply (as everyone works nonstop). Consumption = Ct Savings = St Investment = It Lowercase letters refer to the various sizes per capita (divided by population). Population = Labor Supply The population is growing at a steady rate n: n = %ΔNt+1 =

Nt+1 − Nt ⇒ Nt+1 = (1 + n)Nt Nt

322

P. E. PETRAKIS

Business The business produces according to the Cobb-Douglas production function: Total : Yt = AK ta Nt1−a Per capita:

K a N 1−a Yt =A t t Nt Nt

 a K a N 1−a K ta (K a ) Kt yt = A t t = A 1−1+a = A ta = A = Akta Nt (N ) Nt Nt t yt = Akta Consumer: Consumption and Saving The consumer saves part of his or her income s: St = sYt and Ct = (1 − s)Yt thus Yt = Ct + St Note that this reflects the fact that there is no state (no taxation) and no imports and exports (no trade). Balance growth 1. Population If the population starts from one level N0 , then: Nt = (1 + n)Nt−1 = (1 + n)(1 + n)Nt−2 = · · · = (1 + n)t N0 We only need to know the original population N0 and the rate of population growth n in order to find the size of the population at any given time t. 2. Savings and Investments As there is no state, consumers only get everything from businesses. Also, since there are no financial markets, savings are just investments (the only way for consumers to invest their money somewhere is in the businesses themselves) and so: It = St 3. Capital accumulation Total capital grow by following the rule:

13

SOLOWIAN GROWTH AND AK MODELS

323

K t+1 = (1 − d)K t + It The capital stock in the next period is the capital of the current period, discounted for depreciation (d = depreciation rate), plus anything invested. The use of the above production function and the fact that savings are equal to investments lead to the capital accumulation per capita which develops as follows: K t+1 = (1 − d)K t + It = (1 − d)K t + St = (1 − d)K t + sYt = (1 − d)K t + s AK ta Nt1−a K a N 1−a K a N 1−a K t+1 Kt Kt = (1 − d) + sA t t = (1 − d) + s A t t1−a Nt Nt Nt Nt Nta Nt K ta Nt+1 K t+1 Kt = (1 − d) + sA a Nt Nt+1t Nt Nt (1 + n)kt+1 = (1 − d)kt + s Akta Thus,  kt+1 =

 1−d sA a kt + k 1+n 1+n t

Steady State The capital stock per capita is growing but at a declining rate. In the long-run steady state where the per capita output (product) remains constant (hence the growth is now zero), the following will apply: kt+1 = kt = k ∗ We can solve this k ∗ as follows: sA 1−d (1 − d) ∗ (k ∗ )a ⇒ 1 − = s A(k ∗ )a−1 k + 1+n 1+n (1 + n) 1−d s A  ∗ a−1 sA 1 1+n n+d sA − = k = ⇒ ⇒ (k ∗ )1−a = 1+n 1+n 1+n 1+n 1 + n (k ∗ )1−a n+d

k∗ =

324

P. E. PETRAKIS

To this end: Steady State k ∗ =



 s A 1/(1−a) n+d

The steady state of real income, consumption, savings, and investment can be extracted from k ∗ .  s A a/(1−a) n+d   s A a/(1−a) i ∗ = s ∗ = sy ∗ = s A n+d   s A a/(1−a) c∗ = (1 − s)y ∗ = (1 − s)A n+d

 a y∗ = A k∗ = A



In equilibrium, the ratio of capital to output depends on savings, growth, and depreciation rates. This is the gold standard version of the Solow model savings rate. The model predicts that in a world with open market economies and global financial capital movement, investment would flow from rich countries to poor, until the ratio of capital/labour (K/L) and income/labour (Y/L) are equated in all countries. Since the marginal product of physical capital is not higher in poor countries than in rich countries, it implies that productivity is lower in poor countries. Solow’s basic model cannot explain why productivity is lower in these countries.

13.3

Overlapping Generation Models

A special case in neoclassical economics is the Overlapping Generation Models (OLG Models) which approximate growth within a discrete time frame based on the neoclassical total production function. In particular, overlapping generation models are based on interactions between different generations and follow a never-ending process of new generations being introduced into the model. The effects of the actors’ decisions arise at different stages of their lives. The choice between consumption and savings depends on the following:

13

SOLOWIAN GROWTH AND AK MODELS

325

1. The motivation of a person to normalize his or her consumption during their lifetime when faced with different levels of income. Savings allow the individual to save when they are young and use their savings when they are older. Specifically, a person can purchase long-term or invest in assets as well as proceed to debt repayment. 2. The existence of uncertainty that motivates the individual to save. For example, unexpected events, such as unemployment, can lead to fluctuations in income. The new dimension, added to these models, concerns the issue of introducing new generations. As new generations come in, there is an issue of resource selection and management in relation to older generations, so inter-generational interactions emerge, which the neoclassical approach had omitted. In terms of achieving equilibrium, OLG models deny Pareto efficiency—by contrast to neoclassical growth models—as the economy is made up of an infinite number of actors and the value of resources is also infinite. A Pareto improvement can only be achieved through the redistribution of the available resources between generations. The balance in OLGs depends on the interest rates and expectations that are introduced through the money, which acts as a value carrier from the present to the future. The effectiveness of the equilibrium depends on the interest rate as well as on the Cass criterion (the competitive equilibrium is not Pareto optimal). The growth process results from the distribution among generations of savings and investments over consumption. This exchange relationship is determined by both preferences and expectations, which are no more than parameters of human behavior. OLG models critique the case of representative agents, on which Neoclassical thinking relies heavily in order to simplify and homogenize the behavior of individuals in models. The main expression of the criticism, including that of Lucas, is summarized in the fact that the overall reaction of individuals to events is ignored and, consequently, the behavioral changes of individuals, which may alter economic outcome, are also ignored. The problem can only be solved if specific situations for decisionmaking are assumed on behalf of individual actors. In this case, policy makers can adjust their policies based on the response of each actor to each policy. Samuelson’s (1958) seminal work, An Exact Consumption-Loan Model of Interest With or Without Social Contrivance of Money on the Overlapping Generation Model, exerts influence on economic thinking

326

P. E. PETRAKIS

even today. Samuelson (1958) stated that “we live in a world where new generations are always arriving” and attempted to build a model that violates Pareto-type efficiency. According to Samuelson, the market economy is not perfectly structured, as the presence of overlapping generations and market failures move it away from the optimum. In summary, the critical elements of OLG models are: 1. They are an alternative approach to representative models. 2. They are different from Neoclassical growth models. 3. They introduce expectations into their analysis. 4. Interest rates are the mechanism of transition between different generations.

Box 13.2 Diamond (1965)—Overlapping Generation Models Overlapping generations have assumed that households live in distinct periods of time. If a household lives for two periods (e.g., youth and old age), this function can take the following form:   U ct, ct+1 = u(ct ) +

  1 u ct+1 1+ρ

  and households will seek to maximize U ct , ct+1 on the basis of timelimited income constraints: ct+1 = (1 + r )(Wt − ct ) where Wt is the household’s initial wealth and r the interest rate resulting from its savings in the first period (Wt − ct ), through which the household will finance consumption for the 2nd period ct+1 .The ρ > −1 parameter indicates the person’s time preference: If ρ is greater than 0, then the household places more weight on the consumption of the first period, while if ρ is less than 0, then the household places more weight on the consumption of the second period. One of the essential OLG models is that of Diamond (1965) in which, for each period t, production Yt will be Yt = F(K t , L t ) where K t and L t are the available capital and labor, respectively.

13

SOLOWIAN GROWTH AND AK MODELS

327

In addition, a steady rate of increase (n) in the labor force is assumed, that is, L t+1 = L t (1 + n). In other words, for each period t, the number of “new” households (those born in the period t) in the economy will be L t , while the “old” households (those born in the period t − 1) will be L t−1 . Assuming that over the period t, the consumption of each ‘new’ housey hold is ct , while that of each “older” household will be cto , the aggregate consumption of the period t results from the following relation: y

Ct = ct L t + cto L t−1   Therefore, if the capital of the period t + 1 K t+1 is equal to the sum of the capital of the previous period (K t ) and the result of production (Yt ) after deducting the consumption of the period t, is (Ct ), we have: Yt + K t = K t+1 + Ct Equally:   y Yt − K t+1 − K t = Ct = ct L t + cto L t−1 In order to achieve a constant ratio of capital to work (Golden Age Path) capital must be increased at the rate of increase in the labor force (n), that is, K t+1 = (1 + n)K t and equally: y

Yt − n K t = Ct = ct L t + cto L t−1 Expressing each variable of the above relation as proportional to the work (yt = Yt /L t , kt = K t /L t ) we arrive at the relation: y

yt − nkt = ct +

1 o c 1+n t

Finally, assuming that all households have the same lifelong consumption pattern, the Golden Age Path where each household maximizes its utility, is achieved by solving this problem:   Max. U c y , co subject to the constraint:

1 co = y − nk c y + 1+n

328

P. E. PETRAKIS

13.4

Learning by Doing in AK Models

In the neoclassical model, technological progress is perceived as an exogenous variable, while the diminishing returns on capital counteract the accumulation of capital. Therefore, capital accumulation cannot explain the long-term growth of income and the persistent differences in growth rates between countries. Diversifying the hypothesis of diminishing returns can lead to a model of sustained income growth without technological progress being exogenously defined. Attempts to make the technology endogenous to the growth models, initially clashed with how to handle increasing returns in a dynamic general equilibrium context. The solution to this problem was provided by Arrow (1962) who focused his attention on a process that can generate increasing scale returns and thus create opportunities for compensation for those who develop technology. This is a process of learning by doing. So, when people accumulate capital, learning by doing generates technological advancement, creativity, and innovation, which tends to increase the marginal product of capital, thus offsetting the tendency to reduce marginal product when technology remains unchanged. Learning technology prevents marginal product reduction. The growth of technology through “knowledge dissemination” is vital to economic growth. The greater the accumulation of capital, the greater the potential for learning by doing. However, the diminishing returns on capital can also be offset by improving the variety (quantity) of products, which in turn will destroy the previous ones by replacing them. Scale effects can be produced that work in such a way as to offset the diminishing returns on capital. AK models are the simplest version of models that make technology endogenous and assume that endogenous growth is driven by exogenous savings rather than by the diminishing returns on capital. The production function is linear and, therefore, the economy does not approach a steady state, as the Solow model assumes. Increasing the rate of investment has a similar effect on the rate of increase in income. Frankel (1962) first developed AK models in which he included coefficients that can be substituted for external knowledge factors. Frankel’s approach to growth is based on the idea that, in the process of capital accumulation, businesses and individuals contribute to technological knowledge and, therefore, to productivity as a whole. Unlike other factors of production—such as labor—knowledge is automatically increased in combination with capital.

13

SOLOWIAN GROWTH AND AK MODELS

329

It is only reasonable to think that technological change depends on individual or collective decisions and is influenced by the current motivational and institutional framework. If this framework is stable, the following question needs to be answered: “How will people be motivated to develop new technology when they are in an environment with constant returns on capital and labor, so that everyone is rewarded in competitive equilibrium with their marginal product?” Box 13.3 Arrow on AK models (1962) Arrow (1962) assumes that technological progress is an unintended consequence of the production of new capital goods, a phenomenon called “learning by doing.” Learning by doing formed the basis of the first model of endogenous growth theory, known as the AK model. The AK model assumes that when people accumulate capital, learning by doing creates technological progress that tends to increase the marginal product of capital and thus offsets the marginal product’s tendency to decline when technology remains unchanged. The model results in a production function with the following form: Yt = At K t . The production function of Solow’s model is as follows: Yt = At K ta L 1−a , 0 < a < 1, t where A is a positive constant which represents the total factor productivity, K is the capital, L is labor force. Capital represents both physical capital and human capital. Therefore for a = 1 we have: Yt = A t K t By solving the derivative of the above relationship, it turns out that the growth rate of the product produced is determined by: A˙ t K˙ t Y˙t = + Yt At Kt The accumulation of capital is given by: K˙ = sYt − δ K t

330

P. E. PETRAKIS

Where s is the rate of investment and δ is the rate of depreciation, both of which are considered constant. The capital growth rate is: sYt K˙ t = − δ = s At − δ Kt Kt Therefore, the growth rate of the product produced results from: A˙ t Y˙t = + s At − δ Yt At It is worth noting that AK models are so named based on the production function they assume where A is a positive constant and K is the general capital.

References Arrow, K. (1962). Economic welfare and the allocation of resources to invention. Universities- National Bureau Committee for Economic Research and the Committee on Economic Growth of the Social Science Research Councils. The rate and direction of inventive activity: Economic and social factors (pp. 467–492). Princeton, NJ: Princeton University Press. Cass, D. (1965). Optimum growth in an aggregate model of capital accumulation. Review of Economic Studies, 32, 233–240. Diamond, P. A. (1965). National debt in a neoclassical growth model. American Economic Review, 55, 1126–1150. Domar, D. E. (1946). Capital expansion, rate of growth and employment. Econometrica, 14, 137–147. Frankel, M. (1962). The production function in allocation of growth: A synthesis. American Economic Review, 52, 995–1022. Harrod, R. (1939). An essay in dynamic theory. Economic Journal, 49, 14–33. Koopmans, T. C. (1965). On the concept of optimal economic growth. In J. Johansen (Ed.), The econometric approach to development planning. Amsterdam: North-Holland. Ramsey, F. P. (1928). A mathematical theory of saving. The Economic Journal, 38(152), 543–559. Samuelson, P. A. (1958). An exact consumption-loan model of interest with or without the social contrivance of money. Journal of Political Economy, 66, 467–482 (University of Chicago Press).

13

SOLOWIAN GROWTH AND AK MODELS

331

Solow, R. (1956). A contribution to the theory of economic growth. Quarterly Journal of Economics, 70, 65–94. Swan, T. W. (1956). Economic growth and capital accumulation. Economic Record, 32(63), 334–361.

CHAPTER 14

International Trade Relations, Optimum Currency Areas, Externalities, and Public Choice

14.1

Introduction

This chapter tracks the evolution of economic thought, and particularly of developmental thinking from 1940 to 1970. It covers several basic issues, such as international economic relations, optimum currency areas, externalities, and public choice.

14.2

Optimum Currency Areas

The work of Mundell, A Theory of Optimal Currency Areas (OCA) (1961) earned him a Nobel prize and was the theoretical basis for the creation of monetary unions while, later, it proved instrumental in the creation of the European Union. This is the theoretical conception that leads to a series of criteria based on which the application of a single currency is possible in a single geographical area on the basis of the degree of homogeneous economic characteristics. The discussion relates to the opportunities given by exchange rates, whether floating or fixed, to economic policy and in particular to the conditions of growth, employment, etc., as a function of the size of economies and their degree of exposure to international trade (Friedman, 1953). Homogeneous criteria refer to:

© The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_14

333

334

P. E. PETRAKIS

1. labor mobility, cultural constraints, and related institutional dimensions, 2. the open attitude toward capital mobility and price and wage flexibility, 3. the effectiveness of monetary and fiscal policy, including a risksharing system with an automatic fiscal transfer mechanism, and 4. the degree of similarity of economic cycles. The theoretical structure of the optimum currency area may be a theoretical framework for the supporters of the establishment of a monetary union, but it also reveals—as in the case of the European Union (Mongelli, 2008)—the reasons why such a union may not work and be a hindrance to the development of monetary union membereconomies (De Grauwe & Vanhaverbeke, 1991; Krugman, 2012). In essence, the theoretical construction of the optimal currency area is a cost–benefit analysis of adopting a common currency. The benefits come from reducing transaction costs in a union of economies and the costs from losing the flexibility of various policies, especially concerning exchange rate mechanisms. However, when the above four homogeneity criteria for the countries participating in an optimum currency area do not apply or are partially applicable, asymmetric shocks may occur with severe economic consequences (see European crisis of 2008).1

14.3

Leverage, Risk Diversification, and Effective Markets

During the period under review, two basic concepts have emerged in finance that can identify two significant sources of growth, first for businesses and by extension, for the economy. These are: 1. Markowitz’s (1952) Modern Portfolio Theory (MPT) and the importance of risk diversification and 2. Modigliani–Miller Theorem (1958) on the capital structure of enterprises and the importance of leverage. Although both are concepts with microeconomic applications, their conceptual implications relate to the processes of growth, especially in

14

INTERNATIONAL TRADE RELATIONS …

335

terms of the diversification of the productivity prototype and the role of debt. The modern portfolio theory (Markowitz 1952) was developed by the economist of the University of Chicago, Markowitz, who was awarded the Nobel Prize in economics in 1990. Markowitz has presented a model for building effective portfolios, which allows investors to estimate both expected risks and expected returns for their investment portfolios. So, he described how elements are combined in efficiently diversified portfolios. In other words, he explained the optimal way to set up a diversified portfolio and showed that such a portfolio would probably perform well. Markowitz’s theory was used by Sharpe (1964), Lintner (1965), and Mossin (1966) to formulate the Capital Asset Pricing Model where they present the nature of the relationship between expected returns and the systematic risk level of a security. This model argued that only the systematic risk of an asset is an essential determinant of its return, as investors can address non-systematic risks through diversification. The role of diversification is also important for the economy as a whole, as diversification of investment and production is essential for growth. This concept has been extensively analyzed in economic literature.2 An economy is diversified when its income comes from different sources that are not directly related to each other. If a country’s income depends only on the production of one product, fluctuations in the price of that product can also lead to fluctuations in living standards. Imbs and Wacziarg (2003) present the pattern of sectoral diversification in the course of development, pointing out that countries initially diversify, i.e., at first, sectoral diversification increases but after a certain level of per capita income is reached, the sectoral distribution of economic activity starts again to concentrate. Economic growth and structural change depend on the type of products marketed. Therefore, through diversification of exports, an economy can evolve to produce and export advanced products which contribute significantly to sustainable economic growth, the achievement of macroeconomic objectives, satisfactory balance of payments, stable export revenues and the reduction of unemployment and redistribution of income.3 The structure of business capital was first examined by Modigliani and Miller, both Nobel laureates in economics (the first in 1985 and the second in 1990). Modigliani and Miller (1958) have shown in their two proposals on the structuring of capital that the value of an enterprise and

336

P. E. PETRAKIS

the cost of its capital are independent of its capital structure, that is, they are not affected by how much debt it uses to finance its activities. They argue that the value of a business depends on its real assets and not on the securities it issues, i.e., shares and bonds. Thus, in all investment decisions, the origin of the required capital is of no importance. Modigliani and Miller have caused considerable theoretical controversy, due to the overly rigorous assumptions on which they base their proposals. Thus, many academics and market professionals have at times raised serious doubts about the validity of their conclusions (Jensen, 1986; Lang, Ofek, & Stulz, 1996; Myers, 1977; Titman & Wessels, 1988 ). MM4 also concluded that due to reduced taxes, one should use 100% debt for financing, although, certainly, no one does such a thing unless we are referring to companies whose own funds have been used up to cover losses. Modigliani and Miller’s views can be seen as attempting to divert the researcher’s attention to the role of debt, and are the first step in establishing the macroeconomic concept of a Balance Sheet Recession.

14.4

Monetarism and Neutrality of Money

The dominance of the Keynesian perceptions was contested in the late 1960s when large financing of budget deficits, notably in the United States, due to the need to finance operations in the Vietnam War was accompanied by a large increase in the circulation of money linked to significant and persistent increases in inflation. Thus, attention again turned to the quantitative theory outlined by Fisher (1867–1947). Fisher (1930) focused on the interaction between inflation, interest rates, expectations, and the holdings of real cash.5 In particular, he argued that the nominal interest rate is the product of the real interest rate, which in turn is the result of borrowing and lending and the expected inflation rate, that is, the nominal interest rate is the real interest rate plus the expected inflation. Therefore, inflation and expectations affect nominal interest rates. Higher monetary expansion rates may lead to lower nominal interest rates, through an increase in the supply of loan capitals but through inflationary expectations, they will lead to an increase in the nominal interest rate and to higher inflation. What completes the notion of the role of money is the demand for money introduced by Friedman (1956) in the midst of the Keynesian period. Friedman, along with Keynes, influenced the economic thought

14

INTERNATIONAL TRADE RELATIONS …

337

of the twentieth century more than any other, with their key ideological difference being as follows: According to Keynes, an extensive role of the state can be the means to deal with a period of economic recession, as the existence of the state can lead to increased money supply, public investment, reduced unemployment and, in general, improved economic activity. Friedman, on the other hand, advocated the minimization of state intervention (e.g., in regulating interest rates) and the complete liberalization of the market, since “the amount of money available must always reflect the wealth produced.” Mr Friedman is the instigator of monetarism, which states that, when there is government intervention, leading through fiscal or monetary policy to an increase in the quantity of money, the result is a rise in prices and inflation. He argues that any changes in the supply of money have a short-term effect on the actual product produced and a long-term level on the price level. So, for monetarism, money is not neutral, either in the short run or in the long run. By extension, the interpretation of recession and growth in monetarism has a monetary background. Monetarism has enriched classical quantitative theory of money, and the way monetarism interprets the behaviour of the economy is considered to be in line with the Keynesian model in the short term and following the classical model in the long run. In essence, it is a synthesis of Keynesian and Classical economics. The critical determinants of economic output are permanent income, the ratio between human to non-human wealth, the nominal interest rate, the expected rate of changes in prices, the real level of prices and the preference function of money over other goods. Expectations continue to be shaped as an adjustment process. Friedman’s attention to the demand for money and not to the price level and consequently to the role of income (permanent income) is specific to the Keynesian income–expenditure analysis. For Friedman, however, the role of wealth and human capital, which is absent from Keynes approach, is important.6 Since money demand can be forecasted, then it makes sense to be tempted to think that managing money supply (changes in the rate of monetary expansion) will cause inflation (or deflation) changes as well as short-term changes in the produced product and in employment. This will be the case because a monetary expansion will increase the real cash balances of individuals and businesses and reduce the nominal interest rate. Therefore, the demand for commodities, securities, etc., will increase and real prices will start to rise. Expectations will then adjust to price

338

P. E. PETRAKIS

increases, and hence the nominal interest rate will rise until the new inflation rate equals the rate of monetary expansion and the real interest rate goes back to its previous levels. Inflation is therefore a “monetary phenomenon.” Long-term monetary expansion and inflation have little to do with the real conditions of labor supply and demand, and thus with natural employment, since they are influenced by the institutional framework. Therefore, supply-side arguments will arise which occasion the development of the logic of supply economics.

14.5 Public Choice, Regulation, and Rent-Seeking Political action is an endogenous influence on economic development with two major manifestations: 1. Public choice: This is the process of deciding on public revenue and public expenditure. Consequently, the analysis approximates the supply and demand conditions of public goods. 2. Public regulation: This is the process of determining the prices of goods of public interest and, consequently, the decisions concerning industrial organization in areas of public interest and the supply of public goods as a sub-disciplinary field. However, in the process of defining public revenue and expenditure and the public interest in decisions to do with pricing and industrial organization, an extensive area is formed of decisions and regulations regarding development and the process of growth. This is mainly because government—and politics in general—is the source of privileges and opportunities for the creation and transfer of economic wealth in the processes of exchange and production. This happens either because the market fails to perform this function, or because the market is forced to adapt to political decisions and thus restrict its range of activities. Samuelson’s (1954) work A Pure Theory of Government Expenditure on Collective Consumption Goods was a reference point, as public goods featured prominently in many theories. It is now regarded as the foundation text of the modern theory of public goods. The analysis can be expanded to cover economic sites and goods that are not exactly public, in the classical sense, but have many of their

14

INTERNATIONAL TRADE RELATIONS …

339

characteristics. Thus, their consumption cannot quantitatively reduce the consumption of others and, therefore, their marginal cost of supply is zero, so excluding those who do not pay is impossible. Wicksell (1958 [1896]) introduced the concepts of equity and efficiency in public finance decisions and thus linked public revenue decisions with public expenditure decisions. Public activity must consequently link the expected benefits to the expected costs of these decisions. This introduces uncertainty about future preferences. The issue of regulation has clear and immediate implications on where sources of growth are located, how they are organized and how their impact is redistributed. The involvement of politics and policies in shaping the rules of regulation is direct. Initially, the foundation of the introduction of the regulatory process is based on the market’s failure to perform the task of optimal allocation of resources. Admittedly, because people, both politicians and citizens, judge and agree on what constitutes optimal distribution, one realizes that the regulatory process can extend to a multitude of issues, to the point where it completely defines the economic model of a society. One extreme form of regulated economics is the one that applied to the Soviet economies of Eastern Europe. The key tool by which regulators intervene in the processes of producing and redistributing growth products is related to rent -seeking. The concept of rent seeking was developed by Tullock (1967) and used as a term in 1974 by Krueger. When the price exceeds the marginal cost (e.g., indirect taxation) a rent-seeking activity is displayed. A politically effective group may impose a process of “seeking and absorbing rent” (Stigler, 1971). Enforcement usually concerns public goods, but it may also apply to private goods, for example, by allowing a monopoly, granting subsidies or charging fees for the pursuit of specific economic activities. This can be achieved by politically effective coalitions—trade unions, professional associations, political parties. The secret to the ease of enforcing such regulations lies in the fact that their burden is shared by large numbers of citizens, while the benefit is concentrated in specific stakeholder groups.

14.6

Externalities and Institutions

When Samuelson developed the Neoclassical synthesis, in which he described the operation of the economic system to achieve optimal production and price determination, under conditions of complete

340

P. E. PETRAKIS

competition or even monopoly, he triggered Coase (1960) and Galbraith (1958) to recognize the analysis of certain aspects of the institutional framework for the functioning of the economy. This is based on Veblen’s logic and the theoretical framework of the operation of economics, as described by Neoclassical analysis. Starting with the issue of externalities, Coase arrives at the importance of property rights as the place where the market collapses because of the existence of externalities. The reorganization of property rights could restore market functioning if the cost of internalizing the exterior is less than or equal to improving the effectiveness of the business acquiring the property rights. Indeed, if there was a (legal) system that would cost and grant property rights for externalities, the optimal allocation of resources disturbed by the presence of externalities could be restored. This analysis is accurate only to the extent that the negotiation and transaction costs are zero or negligible. If these are significant, several tools, such as taxation and subsidies, could be used. At this point, however, enters the policy which leads the analysis down the different route of “second best theory,” where the final outcome is not necessarily better than the optimal. In essence, Coase relied on the “neoclassical” concept of institutions. At the same time, Galbraith (1958), with his strong criticism of American capitalism and influenced primarily by Veblen, expanded his thinking on how society was organized. His ‘compensating power’ describes the ability of large companies in a concentrated downstream market to obtain price concessions from suppliers. Thus, he recognizes the power of producers over consumers in an non-necessary affluent society, resulting in a social imbalance of the former in relation to the latter. In his analysis, it is only through government intervention that social balance can be restored.

14.7

Industrial Organization and Uncertainty in Perfect and Imperfect Markets

One could argue that the debate on how to organize and operate the markets (monopoly, duopoly, oligopoly) fostered by Pigou (1912), Sraffa (1926), and Robinson (1953) only indirectly touches on the question of sources of growth through the issue of price determination, (hence, also the relative prices of Hayek) and profits, and, as such, it does, therefore, concern the basic source of accumulation and growth. But Pigou’s

14

INTERNATIONAL TRADE RELATIONS …

341

contribution to how monopoly reduces prosperity by lowering production levels, further focuses the discussion onto our point of interest. This is the relationship between the theory of industrial organization and the rate of increase or decrease in production. Robinson’s contribution to price discrimination also touches on issues of relative price and social wellbeing through oligopolistic policy problems and antitrust legislation. The monopoly of the products produced or the monopoly on the raw material markets lead to the formation of particular profits associated with activating entrepreneurship under different levels of uncertainty. The debate on the issues of industrial organization expanded a great deal during the period of the organization of post-war economies.

14.8

Game Theory and Human Interaction

Already in the early 1830s, the formulation of strategic decision-making behavior had emerged with the French economist Augustin Cournot (1838) as its chief advocate, who modelled issues of strategy and competition between businesses operating in an oligopolistic environment, where each producer considers the production level of the other producer as a given and adjusts his output to maximize his profits. Subsequently, the Nash Equilibrium (1949) was the result of a way of resolving noncooperative games involving two or more players. Thus, game theory provides a theoretical approach for determining actors’ decision-making based on the strategies they formulate, the information available and rational choice. Game theory applies to both economics and other sciences, such as political science, psychology and computing. John von Neumann’s and Oscar Morgenstern’s ground-breaking classic book Theory of Games and Economic Behavior (1944) is considered to have created the field of game theory research. An essential component of game theory is human behavior, which determines the actors’ decisions. Therefore, although not a part of behavioral economics, game theory shares certain aspects with the conceptual framework of behavioral economics. Game theory could provide a source of growth based on microeconomic foundations. The equilibrium of a variable (e.g., quantity, prices, etc.) results from the strategies that participants adopt in a game in order to maximize their profit. Assuming that there is rationality and perfect information in a zero sum game, the actors try to make a profit, which is the corresponding loss for the counterparty in the game.

342

P. E. PETRAKIS

Game theory follows a neoclassical approach to microeconomic decision-making. The dominant economic theory approaches the concept of growth based on factors such as technological progress and the accumulation of human and physical capital. However, economists also need to consider human interactions as a critical factor in determining the evolution of the economy. In this way, modern game theory could enlighten us as to the interpretation of the existence of low growth rates in the underdeveloped world or in specific regions. This challenge, as proposed by Wydick (2008) can be understood as a multi-point equilibrium game where parameters such as low productivity, transaction costs, and consumption are entirely predictable, when the rules of the game are set by the institutions (North, 1990) and the actors do not choose the highest equilibrium, as is the case in developed countries. The concept of multiple points of equilibrium was developed by Nash as a product of his proposed system of social equilibrium.

14.9

Nash’s Non-rational Equilibrium

In game theory, the Nash equilibrium is a way of resolving a noncooperative game involving two or more players, in which each player is supposed to know the equilibrium strategies of the other players, and at the equilibrium point no one has anything to gain by changing solely their own strategy. The contribution of Nash (1951) in his Non-Cooperative Games article established a Nash equilibrium of mixed strategy for each game with an infinite set of actions and it proved that such a game should have at least one Nash equilibrium of mixed strategy. Nash’s contribution, beyond game theory, can also be seen from the perspective of a special case of general equilibrium. The general equilibrium model is a landmark for real economy malfunctions, as any deviation from the equilibrium leads to imperfect market conditions. In the general equilibrium models, businesses and households are price takers, as prices are linear, and adopt a Walrasian-type equilibrium. The effect of the created equilibrium—the Walrasian equilibrium—describes the amount of goods and services which businesses, as price makers, are willing to produce in order to maximize their profit at Walrasian prices, and households, as price takers, are willing to consume at the same Walrasian prices. The result of the resulting equilibrium has no “strategic” elements. The Nash equilibrium, on the other hand, results from the strategic decisions of economic actors. In a Nash equilibrium, rather than market

14

INTERNATIONAL TRADE RELATIONS …

343

players being price takers, it is they who set the prices, given the information they have about other players. Strategic decisions are the result of actors’ expectations. In essence, the Nash equilibrium, based on the assumption of rational expectations, tends to make “big” mistakes if the strategy turns out to be wrong. As a result, the resulting equilibrium can be characterized as a non-rational equilibrium.

Notes 1. In Chapter 20 (Sect. 20.6), there is an extensive presentation of empirical observations on optimum and non-optimum currency areas. 2. For example, Nobel laureate Kuznets (1971) argues that a country’s economic growth can be defined as a long-term increase in the ability to provide increasingly diversified economic goods to its population. This argument is further supported by the view of Grossman and Helpman (1992) who argue that the growth of an economy requires the production of an ever-increasing quantity, quality, and variety of goods and services. 3. This is why Romer (1990) recognizes diversification as a factor that contributes and has an effect on improving the efficiency of other factors of production, while Acemoglu and Zilibotti (1997) argue that diversification can increase income by extending the potential for dispersion of investment risks in a wider portfolio. 4. The two economists are well known in financial management as “MM.” 5. Also known as the Fisher effect; see the appendix at the end of the book. 6. Friedman and Schwartz (1963) argue that changes in monetary policy (changes in the rate of money supply growth) have profoundly affected the US economy, in particular the behavior of economic fluctuations.

References Acemoglu, D., & Zilibotti, F. (1997). Setting standards: Information accumulation in development (Economics Working Papers 212). Department of Economics and Business, Universitat Pompeu Fabra. Coase, H. R. (1960). The problem of social cost. Journal of Law and Economics, 3, 1–44. Cournot, A. (1929 [1838]). Researches into the mathematical principles of the theory of wealth. New York: Macmillan. De Grauwe, P., & Vanhaverbeke, W. (1991). Is Europe an optimum currency area? Evidence from regional data, Center for Economic Policy Research. Fisher, I. (1930). The theory of interest. New York: Macmillan.

344

P. E. PETRAKIS

Friedman, M. (1953). The case for flexible exchange rates. In M. Friedman (Ed.), Essays in positive economics (pp. 157–203). Chicago: University of Chicago Press. Friedman, M. (1956). The quantity theory of money-A restatement. In M. Friedman (Ed.), Studies in the quantity theory of money (pp. 3–21). Chicago: University of Chicago Press. Friedman, M., & Schwartz, A. J. (1963). A monetary history of the United States, 1867–1960. Princeton: Princeton University Press. Galbraith, J. K. (1958). The affluent society. Houghton and New York: Mifflin Company. Grossman, G. M., & Helpman, E. (1992). Innovation and growth in the global economy. Cambridge, MA, and London, UK: MIT Press. Imbs, J., & Wacziarg, R. (2003). Stages of diversification. American Economic Review, 93(1), 63–86. Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance and takeovers. The American Economic Review, 76(2), 323–329. Krueger, A. (1974). The political economy of the rent seeking society. American Economic Review, 64, 291–303. Krugman, P. (2012). Revenge of the optimum currency area. New York Times Blog. Retrieved from http://krugman.blogs.nytimes.com/2012/06/24/rev enge-of-the-optimum-currency-area. Kuznets, S. (1971). Modern economic growth: Findings and reflections. American Economic Review, 63, 247–258. Lang, L., Ofek, E., & Stulz, R. (1996). Leverage, investment, and firm growth. The Journal of Financial Economics, 40, 3–30. Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics and Statistics, 73, 13–37. Markowitz, H. (1952). Portfolio selection. The Journal of Finance, 7 (1), 77–91. Modigliani, F., & Miller, M. (1958). The cost of capital, corporation finance, and the theory of investment. American Economic Review, 48(3), 261–297. Mongelli, F. P. (2008). European economic and monetary integration and the optimum currency area theory (European Economy Economic Papers, No. 308). Mossin, J. (1966). Equilibrium in a capital asset market. Econometrica, 34(4), 768–783. Mundell, R. A. (1961). A theory of optimum currency areas. American Economic Review, 53, 657–665. Myers, S. C. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5, 147–175. Nash, J. F. (1949). Equilibrium points in n-person games. Mathematics, 36(1), 48–49. https://doi.org/10.1073/pnas.36.1.48.

14

INTERNATIONAL TRADE RELATIONS …

345

Nash, J. F. (1951). Non-cooperative games. Annals of Mathematics, 54, 286– 295. North, D. C. (1990). Institutions, institutional change, and economic performance. Cambridge: Cambridge University Press. Pigou, A. C. (1912). Wealth and welfare. London: Macmillan. Robinson, J. (1953). The production function and the theory of capital. Review of Economic Studies, 21(2), 81–106. Romer, P. M. (1990). Capital, labor, and productivity. Washington, DC: Brookings Papers Econ. Activity. Samuelson, P. (1954). The pure theory of public expenditure. The Review of Economics and Statistics, 36(4), 387–389. Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19(3), 425–442. Sraffa, P. (1926). The laws of returns under competitive conditions. The Economic Journal, 36(144), 535–550. https://doi.org/10.2307/2959866. Stigler, G. (1971). The theory of economic regulation. Bell Journal of Economics and Management Science, 2, 3–21. Titman, S., & Wessels, R. (1988). The determinants of capital structure choice. The Journal of Finance, XLIII (1), 1–21. Tullock, G. (1967). The welfare costs of tariffs, monopolies, and theft. Western Economic Journal, 5, 224–232. Von Neumann, J., & Morgenstern, O. (1944). Theory of games and economic behavior. Princeton: Princeton University Press. Wicksell, K. (1958 [1896]). FinanztheoretischeUntersuchungen (J. Gustav Fischer, English Trans.: A new principle of just taxation. In R. Musgrave & A. T. Peacock (Eds.), Classics in the theory of public finance (72–118). New York: St. Martin’s Press. Wydick, B. (2008). Games in economic development. Cambridge: Cambridge University Press.

CHAPTER 15

The Era of Low Growth and High Inflation: Contemporary International Trade Theories, New Classics, New Keynesian, Human Capital, Contractization Theories, and Behavioral Economics Under Uncertainty

15.1

Introduction

This chapter traces the evolution of economic thought regarding development and growth during the period of the Keynesian inability to respond to the emergence of the high inflation of the 1970s and the dominance of monetarist conceptions. The era of low growth and high inflation (1970– 1980) prompted economic science to introduce new elements to its view of how the economic system and the process of economic growth work. The failure of the Keynesian economists to explain stagflation and the criticism they received for this (Lucas Critique) led to the emergence of the New Classical Economics based on the neoclassical approach framework and on rational expectations. At the same time, New Keynesian Economics was developed, which serves as an addition to Keynesians economics, with a microeconomic foundation based on market imperfections and nominal wage rigidities. This is how the two currents of modern economic thought on macroeconomics and growth were shaped. At the same time, the period from 1970 to 1980 saw a particular emphasis on the role of human capital and

© The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_15

347

348

P. E. PETRAKIS

the investments in it, in the theory of contractization (cost of representation, adverse selection, moral hazard, and signalling) and institutions. Also, during this period, emphasis was placed on behavioral economics and decision-making under uncertainty.

15.2 The New Classical Economics: Flexible Prices, Market Clearing, and Rational Expectations New Classical Economics emerged in the 1970s in response to the failure of the Keynesian economics to explain stagflation and quickly became the dominant trend of economics. It is a school of thought of macroeconomics based on the Neoclassical approach and rational expectations. Expectations are shaped not as a cumulative experience of the past, but according to the rational expectations of Muth (1961), which are based on the best possible information, discretion and on the policy model of the prevailing government. The assumption of rational expectations is the basic principle of equilibrium. The main differentiation of the New Classicals from the Monetarists lies in the detailed context which they provided. The main characteristic of the New Classical economy is the determination of the analysis of the general equilibrium and, in particular, the determination of prices and clearing of the market based on rational expectations. The hypothesis of rational expectations allowed for compensating for the lack of full information, while creating room for temporary imbalances. As in rational expectations random error tends to zero, fluctuations in the economy and sources of development can be caused by productivity changes, capital accumulation and the marginal product of labour, after taking into account the utility that the individual derives from free time. A central figure to the development of the New Classical approach to macroeconomics is Robert Lucas. His main contribution concerns integrating rational expectations into a dynamic general equilibrium model. Lucas (1972) recognizes that the information available in markets should be consistent. The introduction of rational expectations into the general equilibrium theory requires that market participants adopt common behavior, whether it concerns the purchase or sale of goods, as well as cash balances.

15

THE ERA OF LOW …

349

Lucas’ Critique (1976) led to a review of Keynesian economics, reinforcing the introduction of microeconomic principles into macroeconomic models (Box 15.1). In his work “Econometric Policy Evaluation: A Critique” (1976) Lucas argues for the ineffectiveness of economic policy since the latter changes the structure of the economic system. Lucas’ critique has helped change economists’ view of large-scale macroeconomic models (mainly Keynesian models) in the 1960s and early 1970s. According to Lucas, econometric estimates and analyses, based on experience, cannot be used to predict in advance the impact of economic policy. Lucas (1976) essentially criticizes macroeconomic models that do not take into account changes in the estimated coefficients of the model’s behavioral equations. The problem that arises is that the quantitative change in policy objectives affects the coefficients of the estimated behavioral equations themselves, since the expectations of businesses and households depend on the policy instruments under consideration. Lucas’ solution is to formulate the rational expectations of individuals, based on all available information, in order for them to respond to changes in policy rules. The Policy Ineffectiveness Proposition (PIP) proposed by Sargent and Wallace (1975) moves in the same direction by noting the ineffectiveness of monetary policy in affecting the output and employment levels of the economy. So, governments have little ability to stabilize economies because of the rational expectations which economic actors form. Box 15.1 The Lucas Critique Lucas (1976) adopts a simplified form of economics as follows: Yt+1 = F(Yt , X t , θ, u t )

(15.1)

where, Yt is a vector of economic variables, X t is a vector of policy instruments, θ is a vector of parameters, and u t represents random shock. A policy rule for regulating the policy instrument is given by the relation: X t = G(Yt , λ, ηt )

(15.2)

350

P. E. PETRAKIS

where λ is a parameter vector and ηt is a random shock. Lucas (1976) argued that “scientific, quantitative evaluation of policy” required the comparison of alternative policy rules (changes to λ) and took into account actors’ expectations of future policy actions. He noted that, “a policy change (for example in λ) affects the behavior of the system in two ways: first by changing the behavior of the time series [X t ], secondly by modifying the behavioral parameters θt that govern the rest of the system.” The first result is the obvious immediate effect of the change in the rule of policy to do with the system’s dynamics. The second result reflects the fact that changes in policy rules change actors’ expectations of the future and, as a result, change the dynamics of the simplified form of economy. This sensitivity of the simplified form to the expected results of structural policy changes, constitutes the contribution of Lucas’s critique.

15.3

New Keynesian Economics: Market Imperfections

New Keynesian economics1 is the school of thought of macroeconomics endeavoring to complement Keynesian economics with elements of microeconomic analysis, market imperfections, and nominal wage rigidity. The emergence of New Keynesian economics came in the 1980s, as a result of the strong criticism by New Classical economists of many aspects of the Keynesian revolution. The fundamental principles of New Keynesian economics derive from Keynes’ General Theory, and they also draw from the hypothesis of rational expectations. Beyond rational expectations, the second key hypothesis of the New Keynesians is market failures. In particular, New Keynesians have embraced the existence of imperfect competition in an attempt to explain wage and price stability, arguing that in the short run, prices are stable because their adjustment is costly. Moreover, recessions are nothing more than a coordination of failures. The incomplete hypothesis of competition was accompanied by the assumption that actors are not price takers but price makers. However, this can only happen when demand is equal to supply. The New Keynesian approach also argues that the perfect competitive balance must be abandoned.

15

THE ERA OF LOW …

351

Market failures mean that the economy is unable to achieve full employment. As a result, New Keynesians allow space for fiscal and monetary policy to achieve better macroeconomic results than the free market. By contrast to New Classical theory, they use involuntary unemployment in their analysis. Friction in labour markets, the cost of mobility, the existence of trade unions and other institutions, affect wages and they in turn affect employment levels. The Search Friction (Pissarides, 2011) analysis—for which a Nobel in economics was awarded to Diamond, Mortensen, and Pissarides in 2010—attempts to interpret how unemployment, job vacancies and wages are affected by market regulation and policy choices. Due to the costs and uncertainty involved in the job search process, on the part of the workforce, labor market imperfections are created. Thus, there may be people who are unemployed and job vacancies at the same time. The equilibrium resulting from the free market is therefore not always optimal, which demonstrates the need for conditional state intervention. Fischer was one of the first New Keynesian theorists to focus on nominal rigidities due to the presence of contracts in the labor market. Fischer (1977) examines the role of monetary policy, which may influence the behavior of the real product Fischer (1977) and Taylor (1980) argue that labor market contracts are a factor of wage rigidity. At the same time, as money supply fluctuates more frequently than these contracts, monetary policy can affect the product in the short term. On the contrary, there is no effectiveness in the long run. In his model, Fischer uses the assumption of rational expectations to describe how monetary policy can affect performance. As he puts it, “the only way monetary policy can affect performance … is by making a difference between the real price level and the expected price level.” However, if the monetary policy pursued is known to the economic actors and is based on full information, then, the expected effect of the increase on prices, for example, through money supply, is incorporated into the expectations at the end of the last period and “monetary policy may affect performance only by doing the unexpected” (Fischer, 1977). Expectations are formed during the previous time period. But, if one assumes that the period is one year, the fact that the employment contracts are longer than one year means that expectations for prices in periodt (formed during periodt −1) are likely to have a bearing on the behavior of production. In the long run, the situation is different, with long-term contracts offering inelasticity in nominal wages, thus favoring the effectiveness of monetary policy.

352

P. E. PETRAKIS

Monetary policy, however, can lose its force in the long run “only if longterm contracts are adjusted in an elaborate way that reproduces the effects of one-year contracts (a given time period?)” (Fischer, 1977). … money is neutral, and economic actors know every period what the money offer will be for the next period. The purpose of determining their wages is only to obtain a specific real wage and the nominal wage is adjusted accordingly to reflect the expected level of prices. (Fischer, 1977)

15.4

Human Capital as Intangible Capital

The idea that education can offer benefits, including economic ones, is certainly nothing new. However, the use of human capital to reflect the economic impact of education and training began to develop mainly from the late 1950s onwards. Most economists, prior to World War II, believed that the benefits of education were primarily political and moral rather than economic, and tended to disregard the role of education in their views. After World War II, there were signs of increasing familiarity with human capital as an intangible capital and the economic value of education. Fisher (1946) emphasized the economic dimension of educational policy and the need to view education as an economic policy tool. He believed that education should be a privilege because it not only improves human factor performance but also improves equality in income distribution. Harrod (1943) used human capital in relation to unemployment and living and emphasized that unemployment could lead to the depreciation of human capital. Knight (1941) linked economic freedom with the accumulation of human capital. Friedman (1943, 1953) exploited the concept of human capital in relation to fiscal policy, as well as in relation to choice, opportunity, and personal income distribution. Spengler (1950, 1955) also made several references to human capital about population qualitative analysis. Since the 1960s, human capital has begun to gain increasing attention. Becker2 (1964, 1975) defined human capital as “activities that affect future monetary and psychological income by increasing resources for people” mainly in the form of on-the-job learning and training, although he excluded medical care and immigration from his view. He focused on developing a general theory of investing in human capital rather than just evaluating the profitability of these investments. This included an

15

THE ERA OF LOW …

353

explanatory framework for concentrating investment in human capital at an early age, and the distribution of personal income, based on the process of accumulating human capital in continuation of the work of Mincer (1957, 1962). Becker (1975) also dealt with the evaluation of the rate of return on investment in human capital, which was analyzed in several previous studies of human capital research and has become the cornerstone of education economics. He focused on the case of general training—provided that the case of special training could be construed in a similar way—by analyzing how the returns and costs of human capital could be introduced into an equation representing the present value of the net profits of a person’s entire life.

15.5 Theories of Cotractization, Agency Cost, Adverse Selection, Moral Hazard, and Signaling An important dimension of the introduction of microeconomics into macroeconomic thinking concerns how the economic and legal frameworks co-operate. More specifically, it concerns the behavior of the leading actors in shaping the boundaries of the rules of the game covered by the contracts of the relations between the economic agents. Three situations have been analyzed in particular: • The Adverse Selection (Akerlof, 1970) • The Moral Hazard • Signaling. All three of these situations are shaped by the existence of asymmetric information and affect the principal-agent relationship resulting in incomplete contracts. The reason why this field is considered to be relevant to institutions (North, 1971) is related to transaction costs (Williamson, 1975, 1985, 1996) and monitoring cost, which would be necessary to eliminate the asymmetry of information. The three dimensions of microeconomics that shaped the field of Contract Theory do not seem at first sight to have theoretical bearing on the theoretical infrastructure of accumulation and growth. It is, nevertheless, argued, that asymmetry information is one of the main reasons for the continued production of economic crises with very serious effects

354

P. E. PETRAKIS

on growth. It can readily be assumed that the lower the cost of transactions to improve market efficiency, the lower the loss of prosperity in the economy and the higher the resources available for capital accumulation and hence growth. The same applies to the signaling processes, which can refer to extremely sensitive areas, such as the investment area, providing indications of returns, risks and uncertainty. There are typical cases of brand equity as a signaling phenomenon regarding the role of dividends as signaling means (Erdem & Swait, 1998). Moral hazard (Arrow, 1963) is encountered in situations where risks are taken because someone else bears the potential costs associated with that risk. Moral hazard has two areas of application: • the area of microeconomics, that is, the relationship between the principal-agent with particular reference to the functioning of the financial sector (lender–borrower relationship), and • the area of macroeconomics, with particular reference to the bailin procedures of banks and the member states of monetary unions. Indeed, after the 2008 crisis, these problems have been greatly compounded.

Box 15.2 Akerlof—Information Asymmetry G. Akerlof (1970) considers a situation in which the demand D for used cars depends on the price of the car p and the quality μ = μ( p), while the supply depends only on the price p. The economic equilibrium is given by S( p) = D( p, μ) and there are two groups of traders, given by: U1 = M +

n 

xi

(15.3)

i=1

U2 = M +

n  3 xi 2

(15.4)

i=1

where M is the consumption of goods other than cars, x is the quality of cars and n is the number of cars. Suppose that Yi , Di and Si is the

15

THE ERA OF LOW …

355

income, the demand and the supply for group i. Assuming that the utilities are linear, traders are utility maximizers, according to Von Neumann— Morgenstern, and that the price of other M goods is uniform: Demand D1 for cars is Yp1 if μ ρ > 1, otherwise it is zero. Demand D2 is Yp2 , if 3μ 2 > p, else it is zero. Market demand is given by:

D( p, μ) =

⎧ (Y +Y ) 2 1 ⎪ ⎨ p ⎪ ⎩

Y2 p

0

p 3μ 2

(15.5)

The group 1 has N cars to sell with quality between 0 and 2 with S1 = pN 2 and group 2 has no cars to sell and, therefore, S2 = 0. For a given price p, p average quality is 2 , and therefore D = 0. The used car market collapses when there is asymmetric information.

15.6 Trading Theories Based on Business and New Trade Theory: Product Life Cycle, Porter’s Advantage, Barriers to Entry The economic thinking of international economics and international trade has provided interpretations of the global framework for capital movements, economic relations, and trade. In the 1980s, elements were added from the field of strategic advantage development at the level of enterprise and business strategy with international horizons. There are two approaches that have played a major role in the development of the above: 1. Vernon’sProduct Life Cycle, 1970. 2. Porter’sAdvantage, 1980. Pre-existing theoretical constructs that were based on the potential of comparative advantage for international equilibrium, were unable to interpret the patterns of international trade development and movements of capital observed internationally. By contrast, shifting attention to

356

P. E. PETRAKIS

the timetable for development (the accumulation of knowledge) and release of new products, along with the role of economies of scale and uncertainty, can better interpret international standards. Porter’s Theory of National Competitive Advantage (1980) is a much more sophisticated view of the interpretation of international trading patterns by comparison to the classical and neoclassical concepts of comparative advantage. Porter identified four determinants that influence the development of competitive advantage at the business level and then at the economy level: 1. domestic resources and capabilities (factor conditions), 2. the conditions of the local market, 3. domestic suppliers and complementary industries (effective support from related industries), and 4. characteristics of domestic business, including business strategy, industry structure, etc. In addition, the government can play an active role in increasing the competitiveness of local industries. The New Trade Theory, developed mainly by Krugman (1979), focused its attention on multinational companies and their efforts to develop a competitive advantage over other similar global companies. In order for a global competitive advantage to develop, barriers to entry must be removed. To this end, multinational companies can optimize research and development, copyright ownership, economies of scale, exclusivity in modes of production and knowledge and, finally, assume a central role in the necessary raw materials and production resources.

15.7

Behavioral Economics and Decision-Making Under Conditions of Uncertainty

During the classical period, economics was closely linked to psychology, with particularly important contributions by Adam Smith (1759), who described the psychological principles of individual behavior, and Bentham (1987 [1824]) who has extensively referred to the psychological ramifications of utility. Economists began to move away from psychology during the development of Neoclassical economics, as they sought to reshape the basic principles of natural science by giving explanations of

15

THE ERA OF LOW …

357

economic behavior that derived from assumptions about the nature of economic actors. Thus, developed the concept of homo economicus, who exhibited a fully rational behaviour. Nevertheless, psychological explanations continued to be involved in the analysis of many important forms of neoclassical economics, as they appeared in Edgeworth (1961), Pareto (1935), Fisher (1919), and Keynes (1936). Various factors have contributed to the revival of the use of psychology in the development of behavioral economics. A key factor was that expected utility theory and discount utility models had gained widespread acceptance, leading to controlled assumptions about decision-making under uncertainty, while a number of observed and repeated anomalies contradicted these hypotheses. In addition, during the 1960s, psychology began to describe the brain as an information processing device. Other researchers (Edwards, 1968; Tversky & Kahneman, 1971, 1974, 1992) began to evaluate cognitive decision-making models, under conditions of risk and uncertainty, in contrast to the rational behavior models that had been developed up until then, thus launching the appearance of behavioral economics. Behavioral economics, rather than interpreting economics through an entrenched and strictly defined view of human rationality, try to expand their perspective, seeking the lights of other social sciences, i.e., psychology, sociology, anthropology, etc. Behavioral models incorporate ideas from psychology in conjunction with the Neoclassical economic theory. Behavioral economics consider that people do not behave in a perfectly rational way, and use evidence to that effect from various experiments. Traditional Neoclassical theories explain the various market behaviours in terms of investor rationality. For psychological or sociological reasons, investors do not behave in a completely rational way, which leads to the appearance of various “anomalies.” A better study of these phenomena and the further development of behavioral economics could, in the future, lead to markets eliminating or limiting the presence of these “anomalies,” thus improving their effectiveness. Perhaps the most important articles in behavioral economics and finance in the period 1970–1980 are those written by Tversky and Kahneman. They argued that individuals “rely on a limited number of heuristic principles which reduce complex cumbersome intellectual tasks for assessing probabilities and predicting prices to simpler crisis operations” (Tversky & Kahneman, 1974). Cognitive psychology techniques were used (Kahneman & Tversky, 1979) to explain various documented

358

P. E. PETRAKIS

anomalies in the rational decision-making process. Indeed, in 2002, the Nobel Prize was awarded to Daniel Kahneman for integrating ideas from psychological research into economic science, especially in the context of human judgment and uncertainty. The model of Tversky and Kahneman (1974) is based on the logic that people underestimate uncertain results, as opposed to certain results. This phenomenon is called the “certainty effect” and, in terms of the model of expected utility, indicates that people avoid risk if they expect certain benefits and seek risk if they expect certain losses, because they weigh their potential losses more than the gains, and they want a specific situation for their future decisions. Moreover, based on this theory, there is a “framing effect,” in which individuals who want to make a strategic decision, ignore specific factors that are common to all of their alternative decisions. If, when making a decision, people took into account all the common parameters, they might have made a different assessment of all the alternatives and therefore changed their original decision. A third aspect of Prospect Theory is the existence of a psychological reference point whereby the effects of decisions estimated to be below this psychological point of reference, are perceived as damages. The psychological reference point is not common for all decision makers, as each recipient has a different psychological reference point depending on their expectations. Depending on the level of the psychological reference point, the outcomes of decisions vary. In this light, the uncertainty decisions made by the individual entrepreneur in an environment of uncertain situations are influenced by the psychological reference point of each person and, as such, can only be identical by coincidence. According to Prospect Theory, there are six main stages that a strategic decision maker has to analyze under uncertainty until his final decision is made (Petrakis & Konstantakopoulou, 2015). 1. Problem definition 2. Generating prospects for the problem 3. Prospects editing using appropriate techniques and scenarios 4. Prospects Evaluation 5. Choosing the alternative that is considered the most advantageous 6. Implementation of the selected alternative.

15

THE ERA OF LOW …

359

The most important contribution of Prospect Theory is that—unlike the theory of rationality which considers that certain solutions are produced in the second stage—it produces alternatives that are being worked out until the best possible alternative is selected. This innovative element of the theory relates to the processing stage, which is broken down into six sub-stages (operations): • In the first sub-stage, there is the psychological reference point, where potential benefits and losses are calculated (coding). • The second sub-stage lists the alternatives that are expected to yield identical results and is limited to one decision (combination). • The third sub-stage is that of segregation, where certain factors that are expected to generate gains are separated from those that include risk and thus create the expectation of losses. • The fourth sub-stage is that of cancellation, whereby the factors common to all alternative decisions are removed. • The fifth sub-stage is simplification, where alternative decisions are simplified to make it easier to assess the value of the end result. • The sixth sub-stage is detection dominance, where the dominant alternatives are isolated for further research and treatment. After the processing phase is completed, the evaluation of the dominant alternatives begins, from which that with the highest value is selected and defined as the optimal combination of asset position and magnitude of change. Uncertainty is introduced as an exogenous variable and relates to the decision-making of only one individual, in which case we are in the territory of decision theory. If we are referring to an interactive decision problem, that is, one person’s decision-making is influenced by the decision-making of another/others, then, obviously, uncertainty is inherent in the model as an endogenous variable and so we must move to the territory of game theory. Behavioral theories, and in particular the behavioral theories of growth under uncertainty, are now particularly relevant, as more and more modern models of growth and macroeconomic management incorporate behavioral elements.

360

P. E. PETRAKIS

Box 15.3 Prospect theory by Kahneman and Tversky (1979) The Prospect Theory by Kahneman and Tversky (1979) is a behavioral economic theory that describes how people choose between possible, risk-inclusive alternatives with a known probability of results. In the theory of expected utility, the utility of possibilities is weighted by their likelihood of occurrence. The utility function shows asymmetry between the utilities which individuals embody in gains and losses. In fact, the probability of loss is twice as high against the probability of gain with the same proportion (Fig. 15.1). 30

20

Value of gains

10

0 -30

-20

-10

0

10

20

30

-10

Value of losses

-20

-30

Fig. 15.1 Loss a version by Kahneman and Tversky (Source Author’s own creation) The formula assumed by Kahneman and Tversky for the evaluation phase (in its simplest form) is given by: V =

n 

π ( pi v(xi ))

(15.6)

i=1

where: V is the overall or expected utility of the outcomes of the decision maker,x1 , x2 , . . . , xn are the potential outcomes, and p1 , p2 , . . . , pn their respective probabilities, and v is a function that assigns a value to an outcome.

15

THE ERA OF LOW …

361

The value function passing by the reference point is s-shaped and is asymmetric. Losses “hurt” more than the positive impact of profits (loss aversion). This differs from the theory of expected utility, in which a rational economic actor is indifferent to the reference point. In the theory of expected utility, one only cares about absolute wealth, and not about the outcome of losses and gains. The function π is a probability weighted function which captures the idea that people tend to overreact to events with small probability of occurring but underreact minimally to events with   large probability of occurring. Suppose that x, p; y, q denotes a prospect for a outcome x with a probability p and an outcome y with a probability q and nothing with probability 1 − p − q. If is a regular prospect (i.e., either p + q < 1, or x ≥ 0 ≥ y, or x ≤ 0 ≤ y), then: V (x, p; y, q) = π ( p)v(x) + π (q)v(y)

(15.7)

However, if p + q = 1 and either x > y > 0 or x < y < 0, then: V (x, p; yq) = v(y) + π ( p)(v(x) − v(y))

(15.8)

We can deduce from the first equation that v(y) + v(−y) > v(x) + v(−x) and v(−y) + v(−x) > v(x) + v(−x). The value function is therefore determined by deviations from the reference point, and is generally concave for gains and commonly convex for losses and steeper for losses than for gains. If (x, p) it is equivalent to (y, pq) then (x, pr ) is not preferred to (y, pqr ), but by the first equation it follows that π ( p)v(x)+π ( pq)v(y) = π ( pq)v(y), which leads us to π ( pr )v(x) ≤ π ( pqr )v(y), therefore: π ( pqr ) π ( pq) ≤ π ( p) π ( pr )

(15.9)

This means that, for a fixed ratio, decision weights are closer to unity when the probabilities are low than when they are high. In prospect theory, π is never linear. If x > y > 0, p > p  and, p + q = p  + q  < 1,   prospect x, p ; y, q dominates   x, p ; y, q , that means  over prospect that π ( p)v(x) + π (q)v(y) > π p  v(x) + π q  v(y), hence:   π ( p) − π p  v(y)   ≤ v(x) π q  − π (q)

(15.10)

362

P. E. PETRAKIS

    As also y → x, π ( p) − π p  → π q  − π (q), but if p − p  = q  − q, this would mean that π should be linear; however, dominant alternatives enter the evaluation phase as they are eliminated in the editing phase. Although direct violations of dominance never occur in prospect theory, it is likely that prospect A dominates B, B dominates C, and C also dominates A.

Notes 1. The term New Keynesian was first used by Parkin (1984). Gordon (1990) defines New Keynesianism as a field within Keynesian tradition that seeks to build the microeconomic foundations of wage and price inequality, and considers that real GDP is not determined by business and households, because of the hypothesis of constant prices. The work of Fischer (1977) and Phelps and Taylor (1977) in the late 1970s, falls in this area. 2. Becker’s research was fundamental to the argument for the use of the concept of human capital and led to the publication of his book Human Capital in 1956, which was an important step in establishing Becker’s reputation and provided a comprehensive picture of what had already become known as the theory of human capital. When his research was first presented it was considered highly controversial as some considered it to be disparaging. However, it has been able to convince many that individuals make choices by investing in human capital based on the rational benefits and costs involved in return on investment as well as the cultural dimension.

References Arrow, K. J. (1963). Uncertainty and the welfare economics of medical care. The American Economic Review, 53(5), 941–973. Akerlof, G. A. (1970). The market for “lemons”: Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84(3), 488–500. Becker, G. (1964). Human capital. New York: Columbia University Press. Becker, G. (1975). Human capital: A theoretical and empirical analysis, with special reference to education. New York: Columbia University Press for NBER. Bentham, J. (1987 [1824]). An introduction to the principles of morals and legislation. In J. S. Mill & J. Bentham. Utilitarianism and other essays. Harmandsworth: Penguin.

15

THE ERA OF LOW …

363

Edgeworth, F. ([1881] 1961). Mathematical journal of economic perspectives psychics: An essay on the application of mathematics to the moral sciences. New York: Augustus M. Kelly. Edwards, W. (1968). Conservatism in human information processing in formal representation of human judgment. New York: Wiley. Erdem, T., & Swait, J. (1998). Brand equity as a signaling phenomenon. Journal of Consumer Psychology, 7 (2), 131–157. Fisher, I. (1919). Economists in public service: Annual address of the president. The American Economic Review, 9(1), 5–21. Fisher, A. G. B. (1946). Education and economic change. South Australia: W. E. A. Press. Fischer, S. (1977). Long-term contracts, rational expectations, and the optimal money supply rule. Journal of Political Economy, 85(1), 191–205. Friedman, M. (1943). The spendings Tax as a wartime fiscal measure. The American Economic Review, 33(1), 50–62. Friedman, M (1953). Choice, chance, and the personal distribution of income. Journal of Political Economy, LXI (4), 277–290. Gordon, J. R. (1990). What is New-Keynesian economics? Journal of Economic Literature, 28(3), 1115–1171. Harrod, R. (1943). Full employment and security of livelihood. The Economic Journal, 53(212), 321–342. Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47 (2), 263–292. Keynes, J. M. (1936). The general theory of employment, interest and money. London: Macmillan. Knight, F. H. (1941). The role of the individual in the economic world of the future. Journal of Political Economy, 49(6), 817–832. Krugman, P. R. (1979). Increasing returns, monopolistic competition and international trade. Journal of International Economics, 9, 469–479. Lucas, E. R., Jr. (1972). Expectations and the neutrality of money. Journal of Economic Theory, 4, 103–124. Lucas, E. R. Jr. (1976). Econometric policy evaluation: A critique. In Carnegie Rochester Conference Series on Public Policy, 1, 19–46. Mincer, J. (1957). A study on personal income distribution (PhD Dissertation). New York: Columbia University Mincer, J. (1958). Investment in human capital and personal income distribution. Journal of Political Economy, 66(4), 281–302. Mincer, J. (1962). On the job training: Costs, returns, and some implications. Journal of Political Economy, 70(5), 550–579. Muth, F. J. (1961). Rational expectations and the theory of price movements. Econometrica, 29, 315–335.

364

P. E. PETRAKIS

North, D. C. (1971). Institutional change and economic growth. The Journal of Economic History, 31(1), 118–125. Pareto, V. (1935). The mind and society. New York: Harcourt Brace. Parkin, M. (1984). Macroeconomics. Scarborough, ON: Prentice-Hall. Petrakis, P. E., & Konstantakopoulou, D. (2015). Uncertainty in the entrepreneurial decision making: The competitive advantage of strategic creativity. New York: Palgrave Macmillan. Phelps, E. S., & Taylor, J. B. (1977). Stabilizing powers of monetary policy under rational expectations. Journal of Political Economy, 85, 163–190. Porter, M. E. (1980). Competitive strategy. New York: Free Press. Pissarides, C. (2011). Equilibrium in the labor market with search frictions. American Economic Review, 101, 1092–1105. Sargent, T., & Wallace, N. (1975). Rational expectations, the optimal monetary instrument, and the optimal money supply rule. Journal of Political Economy, 83, 241–254. Smith, A. (1759). The theory of moral sentiments. London: A. Millar, in the Strand. Smith, A. (1981 [1776]). An inquiry into the nature and causes of the wealth of nations. In R. H. Campbell & A. S. Skinner (Eds.), The Glasgow edition of the works of Adam Smith (Vol. 2). Indianapolis: Liberty Fund. Spengler, J. J. (1950). Some economic aspects of the subsidization by the state of the formation of ‘human capital. Kyklos, 4(2), 316–341. Spengler, J. J. (1955). Socioeconomic theory and population policy. American Journal of Sociology, 61(2), 19–133. Taylor, J. B. (1980). Aggregate dynamics and staggered contracts. Journal of Political Economy, 88, 1–23. Tversky, A., & Kahneman, D. (1971). Belief in the law of small numbers. Psychological Bulletin, 76(2), 105–110. Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science, 185, 1124–1131. Tversky, A., & Kahneman, D. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty, 5, 297–323. Vernon, R. (1966). International investment and international trade in the product cycle. The International Executive, 8(4), 16. Vernon, R. (1970). Creativity: selected readings. United Kingdom: Penguin Books. Williamson, O. E. (1975). Markets and hierarchies: Analysis and antitrust implications. New York: Free Press. Williamson, O. E. (1985). The economic institutions of capitalism: Firms, markets, relational contracting. New York: Free Press. Williamson, O. E. (1996). The mechanisms of governance. New York: Oxford University Press.

CHAPTER 16

The Great Moderation, Real Business Cycles, and Dynamic General Equilibrium Models

16.1

Introduction

During the Great Moderation, the global economy has experienced high stability. Low and steady inflation, steady growth in advanced economies and rapid growth in emerging economies make up the landscape of the Great Moderation. In the 1970s and early 1980s, the strong fluctuations that prevailed were normalized and in the years that followed, we saw the moderation reflected in the reduction of high-frequency fluctuations. During the Great Moderation, economic science flourished as the previous schools of economics became active, creating new approaches to critical issues. However, the economic boom and the absence of uncertainty gave way to the Great Recession of 2008. Many have argued that already during the Great Moderation, the signs leading to the outbreak of the 2008 crisis were visible. It is noteworthy that, before the 2008 crisis, businesses experienced increased leverage and higher financial risk-taking.

16.2 The Evolution of the New Keynesians: Microfoundation of Growth Economics The key difference between Keynesian macroeconomics and the New Classical macroeconomics is the presence or absence of microfoundation. Microfoundation was completely absent from the Keynesian approach but was central to New Classical economics. This gap was filled by the © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_16

365

366

P. E. PETRAKIS

New Keynesian economics, which emerged as a school of macroeconomics that seeks to provide microfoundation to Keynesian economics. This school developed partly in response to the criticism of Keynesian macroeconomics by supporters of the New Classical macroeconomics. Thus, someone could argue that New Keynesianism is an answer to Robert Lucas and the New Classical School. From the 1970s onwards, the use of microfoundation has assumed the function of a methodological principle for macroeconomics. The New Classical Macroeconomics seeks to use Neoclassical microfoundation for macroeconomic analysis. The basic assumption for the existence of microfoundation concerns how the choices of economic actors are made, since they are supposed to be driven by the optimization of their decisions. This presupposes the existence of a function that must be maximized or minimized under specific constraints. Consequently, the existence of such a condition for maximization or minimization was sufficient for it to be clear which models entail microfundation and which do not.1 The New Keynesian School uses microfoundations in its analysis to produce macroeconomic models similar to older Keynesian models. New Keynesian macroeconomics, as well as New Classical economics, assume that households and businesses shape rational expectations. However, there are certain main assumptions which characterize the New Keynesian approach to macroeconomics. Specifically, several imperfections-failures are observed in the market: • Imperfect competition on the determination of prices and wages, which means that they cannot duly adjust to fluctuations in the economic conditions. This price and wage rigidity is the key microeconomic foundation for New Keynesian macroeconomics. • Credit market imperfections • Coordination failures • Unemployment caused either by moral hazard problems or by matching frictions. In an attempt to provide the microeconomic foundations for the Keynesian approach, Ball, Mankiw, and Romer (1988) have examined the tradeoff between the product and inflation. Market imperfections (monopoly, rigid prices) make the microeconomy consistent with Keynesian macroeconomics. In their analysis, they demonstrate the importance of nominal

16

THE GREAT MODERATION …

367

rigidities to explain the fluctuations in aggregate demand. Thus, without nominal rigidities, it is quite difficult to interpret this relationship. The actual effects of the nominal disturbances (e.g., changes in the money supply) depend on the occurrence of nominal imperfections. The operative event of nominal rigidities is “imperfect information on the overall price level” (Stiglitz, 2003). The importance of nominal rigidities is demonstrated by the fact that they can explain the effects of real shocks on aggregate demand caused by changes in expectations. Nominal rigidities result from the optimization of behavior. Moreover, macroeconomic impacts can come from microeconomic considerations. Specifically, average inflation can strongly influence the competitive relationships between products obtained and inflation, through its effects on the frequency of price changes. The role of expectations in their model is introduced as an exogenous variable. The relationship between product and the inflation rate, influences average inflation rate. According to their analysis, countries with low price levels have a relatively stable short-term Phillips curve, namely, fluctuations in nominal aggregate demand have a significant impact on the production. Conversely, in countries with a strong downward Phillips curve, fluctuations in nominal aggregate demand are directly reflected in price levels and do not affect production. The New Keynesians had an explanation to offer concerning the inability to clear the labor market (Blanchard & Summers, 1986). The Natural Rate of Unemployment (NAIRU), that is, the level of unemployment below where unemployment rises, is a useful tool for predicting inflation rate changes (Stiglitz, 1997). Equilibrium is defined as the case where inflation is stable at a level equal to its expectations. If inflation rises, then the imbalance will be resolved. The increase in inflation to the levels indicated by NAIRU equals the behavior of those who set wages and prices. Essentially, the case of the Natural Rate of Unemployment perceives inflation as a labor market phenomenon and unemployment rate as a measure of excessive labor supply.

16.3 Real Business Cycles and Growth: Supply Shocks The Real Business2 Cycle Theory (RBC) is an extension of the Neoclassical theory of the 1950 s and of the New Classics that came later. In a sense, the RBC models are descendants of the models of Lucas (1975)

368

P. E. PETRAKIS

and Barro (1976). At their core lies the background of microfoundations and the decisions of the protagonists which shape the upward and downward course of the economy. The expansion of the role of the New Classics created the conditions for the development of RBC theory. RBC models are mainly based on the Neoclassical dynamic model of capital accumulation, so they attempt to explain the business cycles in terms of the reactions of an economic actor. The innovative element introduced by RBC theory was the terms of the microfoundations in the economic environment, so as to eliminate the shortcomings of Keynesian theory. Business cycles in an economy exist in line with the perfectly competitive environment in which economic actors make decisions in order to maximize their utility. Maximizing a person’s expected utility and the resulting product is the main foundation of RBC models. In other words, the economy works most efficiently without market failures. The RBC theory leaves out of its analysis coordination failures, rigid prices, monetary policy, and government policy in general, as well as the existence of optimistic or pessimistic perceptions. Kydland and Prescott (1977, 1982) provide a methodology for business cycle theory to answer what causes economic fluctuations and how they can be eliminated. The dominant source of fluctuations is changes in productivity (Solow, 1956, 1957; Stadler, 1994). These changes are also the main point of difference between Keynesian theory and RBC theory, where changes in investment, public spending, and consumption affect the short-term output. Productivity and technological change are key factors for both growth and RBC models. However, the RBC models focus on the issue of fluctuations and not on growth. Factors that create disparities in the economy from a steady-state do not necessarily lead to growth. RBC models are the result of real changes—supply shocks—and not of nominal changes, as mentioned above, while the existence of cycles in the economy is an integral part of the functioning of the economic system and not the result of its imperfections. Their approach is based on rational expectations and we can see the business cycles as a product of the rational behavior of economic actors in response to real shocks in the economy. The implications of the RBC models for policy development are quite clear, leaving no room for state intervention.3 According to the model, in times of recession associated with a negative output shock, people who opt not to work respond effectively as their low productivity creates the incentive to stay on standby and to work when it will have increased.

16

THE GREAT MODERATION …

369

This way, though, they produce productivity gains due to the decline in the denominator and thus lead to deterioration of the negative effects of the initial decrease in productivity and a return to equilibrium. Improving competition conditions, reducing transaction costs and stimulating innovative activity are some of the policy actions which might be a form of government intervention to boost recession productivity. Despite their contribution to the interpretation of the phenomenon of business cycles, the RBC models have received strong criticism on the grounds that: • They do not include the possibility of a technological shock causing a real economic recession. • As a rule, these models are not subjected to tests against competing alternative theories (Summers, 1986). • While the RBC models imply that the increase in supply is associated with a decrease in inflation and vice versa, inflation is, nevertheless, reported to be procyclical4 (Kydland & Prescott, 1990; Stadler, 1994). • The assumption of price and wage flexibility due to distortions in the product market, but mainly in the labor market, weakens this hypothesis. • They reject how fiscal and monetary policy affect business cycles. This criticism has significantly differentiated the “freshwater” school5 (or Chicago School, influenced by neoclassical tradition) which is in favor of the RBCs against the New Keynesian “saltwater” school6 (Krugman, 2015). RBC models began to show signs of weakness as the business cycles went on for too long. It was then that economic science began to reconsider its view of money neutrality and the assumption of rational expectations. Box 16.1 The Real Business Cycles (RBC) Models (Kydland & Prescott, 1977, 1982) – The basic assumptions underpinning the RBC models, are: – There are representative firms and households trying to maximize their objective utility functions.

370

P. E. PETRAKIS

– – – –

Pareto Efficiency decision-making. Existence of competitive markets, flexible prices, and wages. Households and firms face technological and budgetary constraints. Exogenous shocks in technology and productivity shift the function of production. – Economic actors have rational expectations. – There are exogenous shocks to the economy. Labor Market

w/p

Is (NLI)

25 20 15

c

10

d

5

Id (A,K)

0 0

5

10

30 Y

15

L*

20

Capital Market Y

L

30 25

S (W, Y)

20

ProducƟvity a

25Y*

25

F (A, K, L)

g

15

10Y*

20

f

5

e

15

b

0 0

10

5

10

15

S, I

20

I (A',25L') S,

5 0 0

10

20L*

30

40L

Fig. 16.1 Negative productivity shock and interest rates (Source Author’s own creation) The models of Cass (1965), Koopmans (1965), and Solow (1956) can also be used as models for understanding the fluctuations of economy and growth. From these models, we understand that the economy is made up of representative economic actors who seek to maximize their utility. The utility is a function of consumption and rest time, and any economic active individual is subject to technological and resource constraints. Decisionmaking is about dividing the actor’s time between labor and rest and between current consumption and future investment. A positive productivity shock makes the economy more efficient and shifts the curve of long-term aggregate demand to the right, thereby increasing output and lowering inflation. A negative productivity shock leads to the opposite results (Fig. 16.1).

16

THE GREAT MODERATION …

371

In particular, a negative productivity shock is expected to reduce the output produced for a given level of employment and capital (moving from point a to point b in the figure). Initially, this shock will affect the labor market. The demand for labor will shift to the left. This creates an excess of labor supply and so real wages fall and employment declines— falling below L*—(moving from point c to point d on the figure). This creates a further reduction in the output (moving from point b to point e in the figure). The above developments also affect the capital market. The decrease in income relative to wealth—which is not affected by these developments—creates a reduction in savings and thus the savings curve shifts to the left. The interest rate increases and the level of savings-investment decreases (move from f to g in the figure). Overall, real wages, employment, product, consumption, and investment are reduced after a negative shock to productivity, while real interest rates and price levels rise. If the productivity shock becomes permanent, it will increase the supply of labor—as non-labor Income (NLI) decreases and individuals will have to work to earn an income—and this will lead to a greater reduction in real wages. The result is that we are not sure what the employment outcome will be as, after this evolution, it may be smaller, greater, or equal to L*. Indeed, when the productivity shock is constant, this can lead to an even greater reduction in out-of-work incomes and thus a further increase in labor supply. This, in turn, will lead to a real decline in real wages and the employment level will again be in doubt. This permanent change in productivity may have no further impact on the level of savings, but it will reduce the level of investment (shifting the investment curve to the left) and thus lower interest rates. The decrease in investment will lead, in turn, to a reduction in the stock of capital, which exacerbates the recession and demand for further labor decrease, lowering the level of real wages. However, as the capital stock decrease, so does the marginal product of capital increase. From one point onwards, the increase in the marginal product of capital increases the investment, and hence interest rates and the level of employment. More generally, the exogenous positive shock to the economy leads to a dynamic change in the behavior of economic actors. The person trying to exploit high productivity, will prefer to direct the resources available to investment, which in the future will provide him with higher outflows in later periods. However, the impact on the labor effort is questionable (Plosser, 1989), as current productivity is particularly high. Thus, the economic actor could consider replacing current work with future work

372

P. E. PETRAKIS

and current consumption with rest (non-work). Consequently, a productivity shock has effects on the future product of the economy, consumption and rest (non-work). However, if the economic actor’s expectations for productivity have a longer and more stable orientation, then the individual’s reaction may be different. Here, the increase in productivity tends to enlarge wealth through future increases in output. At the same time, there is an incentive to increase current consumption by reducing investment propensity. The RBC models are driven by supply shocks (Plosser, 1989). However, a change in preferences or technology is not easy to identify solely as a shock to supply or demand. For example, the introduction of new technology can affect both the side of supply and of demand.

16.4

Dynamic Stochastic General Equilibrium Models (DSGE): Technological Shocks

As mentioned, in spite of Lucas’ criticism, economists in the 1980s and 1990s began to develop macroeconomic models in order to have a sufficient microeconomic foundation. This process has also led to Dynamic Stochastic General Equilibrium (DSGE) models, the design of which begins by identifying the economic actors in an economy, their preferences, their capacity, and their potential institutional constraints. It is assumed that each economic actor makes his choices optimally, but with sufficient information on the prices and corresponding choices of the other actors in the economy for the present and the future. Therefore, when all these behaviors are concentrated, it is possible to reach equilibrium in which there are specific prices that equate supply with demand in each market. The term dynamic refers to the fact that DSGE models describe the evolution of the economy over time as opposed to the static equilibrium models of the Walrasian economy. The term “stochastic” refers to their ability to include accidental shocks that affect the economy such as technological change. The fact that these models are based on microeconomic foundations, enables them to incorporate the preferences of economic actors in their analysis. Both preferences as well as technological change and exogenous effects, are key sources for the evolution of economic variables over time. The DGSE models assume that the market is cleared

16

THE GREAT MODERATION …

373

through supply and demand adjustments. Their main advantage is that they can predict the course of the economy, at least on a theoretical level, as they “know” their preferences, technology, and institutional background. However, forecasts of the evolution of the economy in traditional models are likely to be unreliable, given that these models are based on past values of macroeconomic variables. DSGEs are widely used in macroeconomics to explain economic behaviors in a wide area of interest, such as fiscal and monetary policy, business cycles and economic growth. The usefulness of DSGEs is that they can assess the evolution of critical economic variables by acting as tools for economic policymaking. DSGE models apply to two competing schools of thought: New Keynesian Economics and the theory of the Real Business Cycle (RBC) (Kydland & Prescott, 1982). New Keynesian DSGE models (Rotemberg & Woodford, 1997) follow the structure of RBC models, but assume non-competitive markets, with prices adjusted at no cost.

16.5 Great Moderation and Central Banks Coordination Great Moderation marks the period from the mid-1980s to the start of the Great Recession of 2008. Economists argue that the causes of the Great Moderation can be summarized in: structural changes in the economy (Groshen & Potter, 2003) good fortune (Justiniano & Primiceri, 2006; Stock & Watson, 2002)—by contrast to previous periods of great wars, such as in Vietnam and the Middle East, impacting oil prices— and good policy, particularly the implementation of monetary policy by the Central Banks (Bernanke, 2004). The characteristics of the Great Moderation period could be summarized as follows: • Both developed and developing countries exhibit a satisfactory growth. • Developed countries are dominated by low and steady inflation and a steady growth rate. • Rapid growth is taking place in developing countries.

374

P. E. PETRAKIS

• Regarding economic policy issues, stabilization policies are in place, the Central Banks are released from fiscal constraints and there is space for monetary policy. Before the 1980s, the Central Banks were, in a way, inconsistent in implementing a specific policy, as their goals changed in the short run. For example, the initial target of controlling inflation might gave way to unemployment reduction or controlling the exchange rate. That is, the objectives of the Central Banks were not only changing at regular intervals, but they were also contradictory, confusing the real economy. The synchronization of the Central Banks with the pursuit of a common monetary policy, leads to inflationary stability and a reduction in the fluctuations in the output. During the Great Moderation, the models used to conduct monetary policy followed Taylor’s rule based on the socalled Central Bank’s style model. According to Taylor’s rule, the interest rates are adjusted for inflation and product changes. The low volatility in product and inflation was primarily due to the use of interest rate rules (Taylor, 2013). In a globalized environment, the across-the-border effects of policy spillovers are greater than those observed up until the 1980s, with the policy effects diffusing more widely when periods of recession and uncertainty prevail. The big issue that arises is that the policies most frequently implemented lack effectiveness in their ultimate goal, which should be economic growth.7 Theoretically, the joint implementation of macroeconomic policies should lead to global policy outcomes and better results than policies which are restricted to each national economy separately. However, the benefits of policy coordination may be small, as quantitative studies note (Obstfeld & Rogoff, 2002). The coordination of macroeconomic policies is not an easy task, as several factors need to be taken into account, since on an institutional basis, each economy is made up of separate organizational and administrative structures, such as, for example, the Central Banks. At the same time, the existence of uncertainty and external shocks to the economy are conditions that cannot be foreseen, making attempts to devise a common economic policy quite difficult.

16

THE GREAT MODERATION …

375

16.6 Post-Keynesian Economic Theory and the Financial Instability Hypothesis Post-Keynesian economic theory is a school of thought that can be seen as an attempt to reconstruct Keynes’ main inspirations. As a heterodox economic theory, it disagrees with Classical, Neoclassical economic theory and New Keynesians. It focuses primarily on financial markets while ignoring their impact on the real economy. It also focuses on the behavior and functioning of the real economy, on controlling monetary and financial impacts, as well as on uncertainty, monetary and financial impacts. Indeed, this is the element for which post-Keynesian economists are best known. • The post-Keynesian theoretical background is based on the principle of active demand. Unlike the Neoclassics, post-Keynesians do not accept that the failure of market for full employment is due to rigid prices and wages, while they do not accept the IS/LM model. On the contrary, in addition to the theory of total employment, they ascribe a central role to money supply and how it responds to the demand for bank credit. The Central Banks had at their disposal the required amount of money and interest rates for intervening. • They support the neutrality of money, as it affects the real variables in the short- and long-term. Money as a means of payment represents a link between the present and the uncertain future. Pessimistic expectations for the future tend to increase liquidity preferences and demand for money. • Post-Keynesian economists argue that no change in relative prices alone is capable of bringing the economy back to full employment. The market clearance is not the result of an autonomous process and the behavior of households and businesses is determined by many factors other than relative prices. Davidson (2011) argues that the world operates in a non-ergodic context. The economy is a stochastic system, and the Keynesian notion of uncertainty is based on the assumption of non-ergodicity. As (1984) points out, “Keynes rejected the notion that past information from events implemented in economic time forecasts can provide reliable, useful data that allows for stochastic forecasts of the economic future.” The unknown future means that households and companies have to make decisions

376

P. E. PETRAKIS

under uncertainty with limited knowledge. Therefore, the concept of Keynes’ uncertainty, according to Davidson, is summarized in the fact that, while we may be fully aware of past events, there is no possibility to have a correct view of the future. Yet another prominent post-Keynesian economist, Minsky (1985), focused on financial crises and proposed market volatility as a basic interpretative concept for the creation of financial crises. He is known thanks to the phrase “Minsky moment,” during which long periods of speculation lead to a deep crisis. The Financial Instability Hypothesis (FIH)8 was intended to interpret volatility in financial markets as a result of the normal functioning of a capitalist economy. In Minsky’s theoretical context, investment is driven by expectations. The Financial Instability Hypothesis is based on an understanding of human behavior and how it changes over time. Minsky classified financial units in order to show how stability leads to volatility. More specifically, in a healthy economy, most loans are offered to borrowers who can repay them, even with interest added. However, because borrowers feel safe, they are becoming less and less conservative—taking on more risks which they finance with new loans. This classification includes hedge units, speculative units, and Ponzi units.9 The classification is based on the current liquidity of the agents and the expected solvency. Each unit’s view of expected liquidity (inflows and outflows) influences financial market fluctuations. In the hedge units, which are more conservative than the rest, debtors of all kinds—governments, businesses, households—earn enough money from their work to pay both interest and loan rates. In speculatively units, debtors’ incomes are sufficient only for interest payments, but not for debt payments. Then, the borrower has to constantly look for ways in which he can pay off his debt payments, so he essentially gets new loans to pay off the old ones (debt recycling). In Ponzi units,10 the debtor’s income is not enough to even pay interest, so his only survival opportunity is to increase artificially the value of the assets in his balance sheet, so that he can borrow mortgages (as happened with US mortgage loans). Expectations about future returns contribute to the creation of periods of economic expansion. As the riskiest behavior is rewarded with higher returns, we are led to financial instability. Financial actors are taking more risks than they should be, creating a bubble in the market. This approach is in stark contrast to the classical approach, in which the invisible hand moves the economy toward equilibrium. Further, Minsky argues that orthodox economics is unable to stabilize the economy because there are

16

THE GREAT MODERATION …

377

not enough effective institutions. As he says, the only way for market stability is to establish effective institutions. The price mechanism plays a crucial role in market stability. The expectations of the player are reflected in the prices. Minsky’s two-price system (current production and capital assets) is based on expectations. By interpreting its key aspects, it is easy to understand why the economic models have failed to predict financial crises. The concept of uncertainty is prevalent in Minsky’s theoretical framework, which is markedly influenced by Keynes’ General Theory. Investing involves a negotiation process between the financier (bank or financial institution) and the investor (entrepreneur). Both parties to the deal are aware that their decision to create and fund assets whose value has not been determined at the time of trading, depends on their longterm expected returns. Such a decision has an element of uncertainty. Minsky (1996), in addition to the term “uncertainty,” uses the term “uninsurance” to which he gives an identical meaning. Based on the Minsky moment, we can explain the great financial crisis of 2007–2008, approaching the economic process as an open system, which is constantly in a state of volatility. According to Minsky’s approach, the economy as an open system was constantly evolving and interacting with every change. As a result, there is no tendency for equilibrium. The uncertainty and volatility of markets are not inevitable, as it can be reduced through institutions. The institutions are created to provide a framework for reducing uncertainty in decision-making. In turn, expectations are formed based on trust and knowledge. According to Minsky, as the economy is an unstable system, state intervention is needed to stabilize it.

Notes 1. Lucas and Sargent ([1979] 1994) note that the models should assume that individuals act in their personal interest, that their behavior is optimal, and that markets are cleared (in the sense that behavior is compatible between individuals). 2. The term real in the RBC refers to the fact that the business cycle is associated with a real shock to the economy, as opposed to a monetary intervention that has nominal effects. Economic actors form rational expectations while reacting to exogenous changes in the real economic environment (Plosser, 1989).

378

P. E. PETRAKIS

3. However, some researchers believe that taxation and public spending are a source of disturbance to the economy (Arrow, 1962; Hall, 1971; Romer, 1983) as they affect the demand side. This, of course, insofar as it reduces wealth and budget constraints, breaches the Pareto efficiency assumption. Barro (1981) and Hall (1980) argue that there are two channels of economic policy influence: • Through a negative effect that reduces consumption and increases the work effort and output. • Through the temporal substitution of this labor effort with the future, when growth is temporary.

4. 5.

6.

7.

8.

Therefore, these channels lead to lower consumption, investment, higher labor effort, and output in the current period. A procyclical variable is one that flows along with the state of the business cycles. It increases in blooms and decreases in recessions. The “fresh water” School of Economics emphasizes the functioning of the free market, rational expectations, real business cycles and monetarism, while criticizing the degree of state intervention in the economy. In the early 1970s, “freshwater economies” challenged the prevailing consensus in macroeconomic research. The centers of this new macroeconomics approach were the schools of Carnegie Mellon University, the University of Chicago, the University of Minnesota and the University of Rochester. They were called thus because the universities are located around the Great Lakes of the United States. The “saltwater” School of Economists tends to be more cautious about the free market by supporting government intervention and discreet fiscal policy. Economists at universities near the United States’ east and west coast (salty waters) mainly supported this view. These included the University of California, Berkeley, Brown University, Harvard, the University of Pennsylvania, Princeton, Columbia, MIT and Yale. For example, the implementation of demand-side reduction policies or the deleveraging of the public and private sectors, can act to stabilize the economy without providing prospects for growth. The Financial Instability Hypothesis (FIH) states that, during periods of economic expansion, the dynamic structures of a capitalist economy end up evolving into a fragile situation where short periods of prosperity lead to speculatively increased asset values based on borrowed funds. However, the ensuing lack of cash to service the accumulated debt, leads to asset sales leading to a sharp decline in values. This decline in values, coupled with the lack of liquidity, leads to Fisher-type deflation. As Minsky himself points out, the case of financial instability “is offered as an interpretation of Keynes’ general theory” (Minsky, 1991).

16

THE GREAT MODERATION …

379

9. The term Ponzi Scheme refers to any financial fraud based on a “pyramid” of investors. The investor pyramid is an illegal investment scheme that involves paying investors a return on money paid by downstream investors, instead of the net profits accruing from actual sales of financial instruments. 10. The Ponzi units were so named after an Italian, Charles Ponzi, who in the 1920s through such a system, embezzled $15 million. C. Ponzi arrived from Italy in the United States in 1903 at the age of 21 with $2.5 in his pockets, and by 1920, he was one of the wealthiest investors of that time, with his daily income reaching $250,000 in July 1920. His practice collapsed in August 1920, following a relevant newspaper article.

References Arrow, K. J. (1962). Economic welfare and the allocation of resources for inventions. In R. R. Nelson (Ed.), The rate and direction of inventive activity: Economic and social factors. Princeton University Press: Princeton. Ball, L., Mankiw, N. G., & Romer, D. (1988). The New Keynesian economics and the output-inflation trade-off. Brookings Papers on Economic Activity, 1, 1–82. Barro, R. J. (1981). Unanticipated money growth and economic activity in the United States. In Money, expectations, and business cycles, essays in macroeconomics. New York: Academic Press Barro, R. J. (1976). Rational expectations and the role of monetary policy. Journal of Monetary Economics, 2, 1–32. Bernanke, B. S. (2004). The Great Moderation. Remarks at the meetings of the Eastern Economic Association, Washington, DC. Blanchard, O., & Summers, L. (1986). Hysteresis and the European unemployment problem. NBER Macro Annual, 1, 15–90. Cass, D. (1965). Optimum growth in an aggregate model of capital accumulation. Review of Economic Studies, 32, 233–240. Davidson, P. (2005). Responses to Lavoie, King and Dow on what post Keynesianism is and who is a post Keynesian. Journal of Post Keynesian Economics, 27, 393–408. Davidson, P. (2011). A response to John Kay. Institute for New Economic Thinking Davis, S. J., & Kahn, J. A. (2008). Interpreting the great moderation: Changes in the volatility of economic activity at the macro and micro levels. Journal of Economic Perspectives, American Economic Association, 22(4), 155–180. Groshen, E., & Potter, S. (2003). Has structural change contributed to a jobless recovery? Current Issues in Economics and Finance 9. Federal Reserve Bank of New York.

380

P. E. PETRAKIS

Hall, R. E. (1971). The dynamic effect of fiscal policy in an economy with foresight. Review of Economic Studies, 38, 229–244. Hall, R. E. (1980). The rational expectations approach to the consumption function: A multi-country study by Bilson. European Economic Review, Elsevier, 13(3), 301–303. Justiniano, A., & Primiceri, G. (2006). The time-varying volatility of macroeconomic fluctuations (NBER Working Paper No. 12022). Koopmans, T. C. (1965). On the concept of optimal economic growth. In Scientific Papers of Tjalling C. Koopmans. New York: Springer. Krugman, P. R. (2015). Sarcasm and science, the conscience of a liberal. New York Times. Kydland, F. E., & Prescott, E. C. (1977). Rules rather than discretion: the inconsistency of optimal plans. Journal of Political Economy, 85, 473–491. Kydland, F. E., & Prescott, E. C. (1982). Time to build and aggregate fluctuations. Econometrica, 50(6), 1345–1370. JSTOR 1913386. Kydland, F. E., & Prescott, E. C. (1990). Business cycles: Real facts and a monetary myth. Federal Reserve Bank of Minneapolis, 14(2), 3–18. Lucas, R. E., Jr. (1975). An equilibrium model of the business cycle. Journal of Political Economy, 83(6), 1113–1144. https://doi.org/10.1086/260386. Lucas, R. E. Jr., & Sargent, T. ([1979] 1994). After Keynesian macroeconomics: The in Preston. In R. Miller (Ed.), The rational expectations revolution, readings from the front line (pp. 5–30). Cambridge: MIT Press Minsky, H. P. (1985). The financial instability hypothesis: A restatement. In P. Arestis & T. Skouras (Eds.), Post Keynesian Economic Theory: A challenge to neoclassical economics. Brighton: Wheatsheaf. Minsky H.P. ([1987] 2008). Securitization. New York, NY: Levy Economics Institute of Bard College. Minsky, H. P. (1991). The financial instability hypothesis: A clarification. In M. Feldstein (Ed.), The risk of economic crisis. Chicago: University of Chicago Press. Minsky, H. P. (1996). Uncertainty and the institutional structure of capitalist economies (Working Paper 155). Annandale-on-Hudson, NY: Levy Economics Institute of Bard College. Obstfeld, M., & Rogoff, K. (2002). Global implications of self-oriented national monetary rules. The Quarterly Journal of Economics, 117 (2), 503–535. Plosser, C. (1989). Understanding real business cycles. The Journal of Economic Perspectives, 3(3), 51–77. Romer, P. M. (1983). Dynamic competitive equilibria with externalities, increasing returns and unbounded growth (Ph.D. dissertation). University of Chicago.

16

THE GREAT MODERATION …

381

Rotemberg, J. J., & Woodford, M. (1997). An optimization-based econometric framework for the evaluation of monetary policy. NBER Macroeconomics Annual, 12, 297–346. JSTOR 3585236. Solow, R. (1956). A contribution to the theory of economic growth. Quarterly Journal of Economics, 70(1), 65–69. Solow, R. (1957). Technical change and the aggregate production function. The Review of Economics and Statistics, 39(3), 312–320. Stadler, G. (1994). Real business cycles. Journal of Economics Literature, XXXII , 1750–1783. Stiglitz, J. E. (2003). The roaring nineties: A new history of the world’s most prosperous decade. New York: W. W. Norton. Stiglitz, J. E. (1997). Reflections on the natural rate hypothesis. The Journal of Economic Perspectives, 11(1), 3–10. Stock, J. H., & Watson, M. (2002). Has the business cycle changed and why? In Mark Gertler & Kenneth Rogoff (Eds.), Macroeconomics (pp. 159–218). Cambridge: MIT Press. Summers, L. H. (1986). Some skeptical observations on real business cycle theory. Federal Reserve Bank of Minneapolis Quarterly Review, 10(4), 23–27. Taylor, J. B. (2013). International monetary coordination and the great deviation. Paper prepared for the Session on International Policy Coordination, American Economic Association Annual Meetings, San Diego, CA.

CHAPTER 17

Endogenous Growth, Convergence, and Evolutionism

17.1

Introduction

This chapter covers the theoretical aspects that correspond to the period of the Great Moderation (mid-1980s to the beginning of the Great Recession of 2008). It is essentially a continuation of Chapter 16 and focuses on the issues of growth and, in particular, the key models of endogenous growth, the process of convergence, and evolutionary growth theory.

17.2

Endogenous Growth: Summary

From the early 1970s until the mid-1980s, the focus of development and growth research was on short-term fluctuations by incorporating rational expectations into the theory of the real business cycle. Exogenous variables of growth—technological progress—were replaced in the mid-1980s by models in which the key determinants of growth were explicitly within the models. Thus, endogenous growth models are based on the basic assumption that investing in human capital, innovation, and knowledge, contributes decisively to growth and addresses declining returns. Technological change, and in particular the need to interpret and rationalize it, have been the cornerstone of further development in the theory of growth. The entire focus of growth analysis has been on how to offset the diminishing returns on capital. The theory of endogenous growth © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_17

383

384

P. E. PETRAKIS

(Acemoglu, 2009; Aghion & Howitt, 1988, 1992, 2009; Barro & Salai-Martin, 2003; Mankiw, Romer, & Weil, 1992) was created along with two main approaches: The AK models which are the first wave of endogenous growth, where declining returns disappear because they integrate physical and human capital. As technological change depends on individual or collective decisions and is influenced by the current motivation and institutional framework, the question arises: “If the institutional framework is stable, how are people motivated to develop new technology when they are in an environment with stable returns on capital and labor, so that everyone is paid in a competitive equilibrium with their marginal product?” Growth models based on innovation constitute the second wave of endogenous growth theory, with two subcategories evolving in parallel: Romer’s Product Variety Model (1986, 1990) with multiple products leading to the elimination of diminishing returns and Lucas’ Model (1988) of human capital accumulation through knowledge to achieve the same result. Schumpeterian quality improvement through innovation, which relies on creative destruction and eliminates diminishing returns. It is worth noting here the contribution of Acz, Braunerhjelm, Audretsch, and Carlsson (2009), which expanded the microeconomic foundation of endogenous growth models (Lucas, 1988; Romer 1990) through the knowledge diffusion theory of entrepreneurship, which creates new knowledge and ultimately new technological opportunities (Block, Thurik, & Zhou, 2013). 17.2.1

P. Romer’s Product Variety Model

Romer’s Product Variety Model (1986, 1990) states that innovation generates productivity growth by creating new, but not necessarily improved, products and thereby increases the productivity of the economy, as a given stock of capital is distributed for more uses, in each case with decreasing returns. Thus, the existence of multiple products becomes the parameter of the increase in the productivity of the economy, and its rate of growth is the long-term rate of growth of the per capita product of the economy, that is to say, growth variety (quantity) of products produced, or by improving the quality of products that will eventually destroy old products by replacing them. The economies of scale produced are geared toward offsetting the diminishing returns on capital.

17

ENDOGENOUS GROWTH …

385

In 1986, Romer introduces in his model the effects of R&D technology as a source of growth along with the secondary effects of the available knowledge stocks. The entry and exit from the market of the business and the turnover, ensure the continuous improvement of all innovations and an increase in the output of the economy. This is done by introducing the role of the entrepreneur who generates innovation through the exploitation of the results of his research. The more productive the research, the higher the product growth. As a result, the more an economy spends on research and increases its productivity, the higher the growth rate. Essentially, this is what Arrow (1962) suggested as learning by doing. Box 17.1 Romer’s Product Variety Model Romer’s model (1986, 1990) is a growth model based on innovation. The model starts with the production function of Dixit-Stiglitz (1977), which is: Yt =

 Nt 0

K ita di

(17.1)

in which there are Nt different varieties of intermediates products, with each one being produced using K it Capital units. For symmetry, the total capital stock K t is distributed across all Nt product varieties equally, which means that the production function can be expressed as: Yt = Nt1−α K tα

(17.2)

According to this production function, the degree of product variety Nt is a parameter of the total productivity of the economy, and its growth rate is the long-term growth rate of the production per capita output. The existence of multiple products increases the productivity of an economy because it allows a given stock of capital to be used for a greater number of uses, each one having reduced returns. The fact that there is only one type of innovation, which always leads to the same kind of new product, means that the product variety models are limited in their ability to generate growth. In addition, the model notes that businesses’ exit from the market can have no other effect than to reduce the GDP of the economy by reducing the Nt variable expressing the product variety, which determines total productivity. Furthermore, it

386

P. E. PETRAKIS

plays no role in the “creative destruction” which is the driving force in Schumpeter’s model.

17.2.2

Luca’s Model Based on the Deepening of Knowledge

In his 1988 article “On the Mechanics of Economic Development,” Robert Lucas developed a model of endogenous growth focusing on the accumulation of human capital through knowledge. In particular, he emphasized the positive impact of human capital on increasing the productivity of the economy and ultimately on the output produced. In Lucas’ model, human capital contributes to economic growth in two ways: first through the labor in business, by creating an internal impact and second, through its external influence on all businesses. While not introducing a theory of technological change, he finds that the process of economic growth does not necessarily lead to diminishing returns. The absence of diminishing returns is due merely to the diffusion of knowledge and the accumulation of human capital. The accumulation of human capital for Lucas is a process that, while requiring resources that are extracted from production, nevertheless entails many skills, and abilities acquired on the job (in the production process) and not exclusively through education. Lucas, therefore, believes that capital accumulation can occur either through education or through learning by doing. Both Lucas and Romer focused on the externalities resulting from the diffusion of knowledge. However, Romer argued that knowledge is acquired through the increase of physical capital, by contrast to Lucas who conceived the accumulation of knowledge as the result of investing in human capital. Box 17.2 Lucas’ Growth Model (1988) Lucas (1988) develops a model of growth where the product derives from the following form of the production function, which is similar to that of Solow’s model with the concept of human capital added: Y = Aa K a (lh L)1−α , 0 < α < 1

(17.3)

17

ENDOGENOUS GROWTH …

387

where Y , A, L represent the product, technology, and labor, respectively. l is the proportion of total labor spent working and his “human capital.” The production function of prices per capita is as follows: Y = Ak a (lh)1−α

(17.4)

Which is a constant returns to scale production function in k and lh. The accumulation of capital results from the differential equation, k˙ = y − c − (ξ + δ)k

(17.5)

Where h accumulates according to: h˙ = ϕh(1 − l)

(17.6)

h˙ = ϕ(1 − l) h

(17.7)

where 1 − l is the proportion of times spent learning. Increasing learning time increases the rate of growth of human capital. A policy that leads to a permanent increase in learning time leads to a permanent increase in productivity per employee.

17.2.3

The Schumpeterian Model

The Schumpeterian theory of growth evolved in the early 1990s, influenced by the emerging divergence of national growth rates, the challenge of Japan’s technological hegemony over the United States, and the failure of the neoclassical theory of growth to account for the long-term causes of technological progress. In the Schumpeterian models, endogenous growth is the result of the endogenization of the innovation process, while they also incorporate Schumpeter’s creative destruction. Such models were developed by Aghion and Howitt (1992) and Grossman and Helpman (1991), whereas Segerstrom, Anant, and Dinopoulos (1990) and Corriveau (1991) developed their earlier versions. The term “endogenous models” refers to innovations resulting from investment in research and development.

388

P. E. PETRAKIS

The Schumpeterian paradigm emerges through the modern theory of industrial organization and places businesses and entrepreneurs at the heart of the growth process. There are three basic ideas of the Schumpeterian paradigm: 1. Long-term growth depends on innovation. These innovations may relate to: • innovations in the processes of increasing the productivity of the production factors, • product innovations, with new products entering the market, • organizational innovations, in the sense of the most effective combinations of factors of production. 2. Innovations can come from investments, such as investment in R&D, business investment in skills, or by searching for new markets that are motivated by the prospect of monopoly profits. An important aspect in considering the role of public intervention in the growth process, is that innovations create positive effects on knowledge dissemination (on future R&D activity), which private businesses cannot fully integrate. Private businesses in a free economy tend to invest less in R&D and workforce training. This tendency is also reinforced by the flaws of the financial markets, which limit borrowing in times of recession. Thus, the role of the state as a co-investor in knowledge becomes crucial. 3. The creative destruction. New innovations tend to override previous innovations, technologies, and skills. Therefore, growth creates a “conflict” between the old and the new: innovation of the past resists today’s innovations that make old activities obsolete. This point highlights an additional role for the state in ensuring the turnover of businesses and employees so that they can move from one profession to another. Governments need to strike the right balance between maintaining the profits which innovation brings while, at the same time, not preventing future ventures and research into new innovation.

17

ENDOGENOUS GROWTH …

389

Box 17.3 Schumpeterian Model of Endogenous Growth The version of innovation-based growth theory developed by Aghion and Howitt (1992, 1998) and Grossman and Helpman (1992) is based on Schumpeter’s ideas. In particular, in Schumpeterian theory (Aghion, Akcigit, & Howitt, 2015) the final product is produced at any time using an intermediate input, according to the formula: Υ = Ay a

(17.8)

where A represents the current input quality, which is multiplied by a factor γ > 1 each time an innovation made. Innovations occur randomly at λz (which results from the Poisson distribution) where z is the size of labor which results from research and development (R&D). The intermediate product uses labor in an analogy of one-to-one, and thus y represents the size of the labor involved in the manufacturing (processing) of the intermediate good. The model has two main equations: The first concerns market clearing: y+z = L

(17.9)

which represents the total labor supply. The second is a research arbitrage equation which states that in equilibrium, a person is indifferent to working in R&D or, for example, in manufacturing: wk = λVk+1

(17.10)

where wk is the wage paid by the intermediate sector after the K th innovation, and Vk+1 is the value of the next innovation (K + 1). The two equations above allow the R&D equilibrium to be set. The resulting R&D equilibrium value, z, depends on the parameters of the economy. In particular, the increase in productivity of R&D technology, as measured by λ or a larger size of innovation—γ —or a larger population size L, has a positive impact on overall R&D. On the other hand, a higher price of α (corresponding to the intermediate producer facing a more elastic inverse demand curve and who therefore has a lower monopoly income) or a higher discount rate tends to discourage R&D.

390

P. E. PETRAKIS

Finally, the expected growth rate is: E(gt ) = λzlny

(17.11)

A distinct prediction of the model is that business profits are positively correlated with the rate of productivity change. The Schumpeterian Model for growth with a gradual increase of innovation leads to three different interesting—predictions: 1. The relationship between competition and innovation follows an inverted U curve. When competition is low, the intensity of innovation is low in related sectors, and thus these sectors perform well. 2. Stronger competition raises innovation levels for business leaders but reduces it for other businesses. More specifically, a business leader can escape competition through innovation, while a simple business has only to strive to converge with leading businesses. 3. There is a complementarity between patent protection and product market competition that improves innovation levels. Competition reduces the flow of profits for businesses that do not innovate, while protecting patents is likely to enhance the profits of an innovative business. The Schumpeterian theory of growth can bridge the gap between development economics and growth economics: first, through the diversity of policies that promote growth based on the level of technological development in a country, and second, through the analysis of how institutional growth affects business dynamics. Competition and free entry into a market should be factors that promote greater growth of business leaders, which means that they should promote growth in developed economies to a greater extent as these economies have a larger number of leading businesses. Acemoglu (2009) added: “The average growth rate should be decelerating more rapidly as a country approaches the optimal world technology frontier, when the degree of openness is low.” Also, “high entry barriers become more detrimental to growth the closer a country gets to the optimal global technological horizon.” Finally, “the correlation between democracy and innovation/growth is more positive and statistically significant for economies close to the optimal global technological horizon.”

17

ENDOGENOUS GROWTH …

391

It should be noted that the dynamics of businesses vary widely between countries. Thus, the probability of hiring an external manager and hence the number of external managers: – increases based on the size of the business, – is reduced depending on the owner’s free time – grows under conditions of the rule of law. Finally, the average size of business: – increases depending on the owner’s free time, – grows under conditions of the rule of law and – the positive relationship between business size and the owner’s time becomes weaker as the rule of law improves. – business growth decreases with the size of a business, all the more so when the rule of law is weaker. Creative destruction and redistribution among businesses will be much higher in economies where the rule of law is stronger.

17.3

The Convergence of Economies

The idea of Convergence of Economies is the hypothesis that the per capita income of the poorest economies tends to increase at a faster rate than that of the wealthier economies (Barro & Sala-i-Martin, 2003). The lower the level of real GDP per capita, the higher the expected growth rate. When some economies have similar preferences and technology, they converge to the same steady state equilibrium and, if these conditions do not apply, they converge at different levels of equilibrium. The result of such a process is that all economies will eventually converge in terms of per capita income. It is, after all, a fact that developing countries have the potential to grow faster than developed countries, as diminishing returns are not as strong as in developed countries, while at the same time being able to reproduce developed countries’ production methods and technologies in order to converge with them (Barro, 1998). In this discussion, Lucas (1990) observed that, contrary to what is suggested by neoclassical theory, global resources do not flow from rich to poor countries, but are invested mainly in wealthier countries. This inconsistency between theory and practice is known as Lucas’ paradox.

392

P. E. PETRAKIS

The Lucas paradox tries to explain why capital flows are not directed from developed countries to developing countries, even though developing countries have lower levels of capital per employee. The result of Lucas’ paradox is that developing economies cannot easily converge with developed economies. Recently, while discussing the future of convergence, Rodrik (2011) sought to explore whether the difference in growth between developed and developing world can continue, and in particular, whether developing economies can continue the rapid growth they have experienced during the last decades of the twentieth century. He points out that growth in the developing world should not depend so much on the growth of the developed economies themselves, but on the difference in productivity levels between the two groups of countries. This is the “convergence gap” which remains quite large. Box 17.4 The Lucas Paradox (Lucas, 1990): Convergence The theoretical explanations for the “Lucas paradox” can be grouped into two categories. The first group includes differences in factors affecting the productive structure of the economy, such as technological differences, the absence/lack of factors of production, government policies, and institutional structure. Imagine a small open economy, where the product is produced using capital K and labor L through the Cobb–Douglas production function: Yt = At F(K t , L t ) = At K tα L 1−α t FK (·) > 0, FL (·) > 0; FK K (·) < 0, FL L (·) < 0, F(0) = 0

(17.12) (17.13)

Which Y denotes production and A the total factor productivity (TFP). Actors can borrow and lend funds internationally. If all countries share a common technology, perfect capital mobility implies instant capital returns convergence. Therefore, for countries i and j, At f  (kit ) = rt = At f  (kit )

(17.14)

where f (·) is the capital production function in terms of per capita and k denotes capital per employee.

17

ENDOGENOUS GROWTH …

393

One of the explanations for the lack of capital flows from rich to poor countries is the existence of other factors, such as human capital and land that positively affect returns on capital, but are generally ignored by the conventional neoclassical approach. For example, if human capital has a positive effect on return on capital, less capital tends to flow to countries with lower human capital stocks. So if the production function is given by β 1−α−β

Yt = At (K t , Z t , L t ) = At K tα Z t L t

(17.15)

where Zτ indicates another factor representative of other factors affecting the production process, then, for countries i and j, true return:   At f  (kit , z it ) = rt = At f  k jt , z jt

(17.16)

The second group concerns government policies that can hinder flow and convergence of returns. For example, differences between countries in government tax policies can lead to significant differences in capitallabor ratios. Inflation can act as a tax and reduce the return on capital. In addition, the government can explicitly restrict capital flows by imposing capital controls. We can model the impact of these distorted government policies by assuming government taxation, which varies from country to country. Therefore, for countries i and j, the true return is:    At f  (kit )(1 − τit ) = rt = At f  k jt 1 − τ jt

17.4

(17.17)

Evolutionism: Neo-Darwinism

Neo-Darwinism, encompasses the basic principles of natural selection. Of particular interest is the theory of evolution in economic science and in particular the role of entrepreneurship in the theory of growth. Evolutionary theory seeks to provide answers to the way businesses grow in an ever-changing economic environment. Key to this has been the theoretical contributions of Alchian (1950) who developed an evolutionary approach to describe the behavior of companies, incorporating the principles of biological evolution and natural selection. Starting with Alchian (1950), Nelson and Winter (1982) use the concept of physical choice to describe business behavior in the light of the evolutionary theory, emphasizing that the theory is based on learning and adaptation

394

P. E. PETRAKIS

and, on account of this, is perhaps superior to other theories of business. In particular, evolutionary theory integrates in economic natural selection, which refers to the role and influence of the external environment on the ability of businesses to obtain and develop competitive advantages in a competitive environment, organizational genetics which refers to how organizational characteristics are transferred, transformed and integrated into decision-making under uncertainty. Evolutionary theory makes a detailed distinction between: • the effects of routines according to which business knowledge is embedded in its routines, which determine its behavior • the effects of research as through research, businesses adjust their routines to new conditions, while the role of innovation in introducing novelty is also important at this stage, something which is amply acknowledged in evolutionary theory. • the effects of selection whereby effective businesses tend to displace ineffective ones in the long run. Evolutionary theory is built on certain basic principles, particularly important in understanding it, but also useful for business executives to act more efficiently in their decision-making regarding the evolution of their business plans. Initially, it is desirable to use an indicator that links R&D spending with the number of business sales, thereby showing the intensity of R&D spending and their effective use. According to evolutionary theory, business decisions on R&D spending are shaped by previous decisions and the results of those decisions. Finally, it is noted that there are significant and persistent cross-sectoral differences in the intensity of R&D spending and that existing pressures from the economic and technological environment play an important role in highlighting these differences. It is clear that focusing on research and development spending has been the basis for restructuring economic theory through a more pragmatic approach, which contributes to decision-making by business executives in conditions of uncertainty. The terms technology, organization, and change feature prominently in management1 and theory of evolution and offer business executives a different, more interesting and useful way of thinking. A model of evolutionary theory in the context of strategic management should include the processes for entering a particular sector

17

ENDOGENOUS GROWTH …

395

and the market, the learning processes which can upgrade skills, the competition framework for the sector and the market in which the business operates, the development of an organizational structure appropriate to the development of a path-based approach, development standards, and competitive advantages. Consequently, models should be developed to take into account both internal and external factors that can either inhibit growth or have a regulatory role in the development process. Box 17.5 Evolutionism (Nelson & Winter, 1982) Nelson and Winter (1982) were among the first to realize that people with different abilities and skills need to be organized and to interact in order to perform their day-to-day responsibilities better. In their model, heterogeneity is defined on the business side. Businesses use production techniques characterized by constant labor and capital coefficients (aL and aK, respectively). Production is homogeneous. Businesses produce using a Leontief-type production function, which does not allow for the substitution between labor and capital. Over time, the technical change can be biased (that is, the changes of aL and aK are not proportional), so that a phenomenon occurs that looks like a substitution between labor and capital. Innovation comes as a result of business search activities. Also, search activities are determined by satisfaction behavior. A search process can take two different forms: local research, where new techniques are sought, or imitation, in which a business searches for techniques used by other businesses but not yet used in its production process. Since business deals with research, it can only engage in one type of research at random. Also, if the research process is successful, the company adopts this new technique only if its expected rate of return is higher than the current rate of return. An additional source of innovation in the economy is the entry of new businesses into production. The Nelson and Winter model will have to be simulated using computer systems in order to get a picture of its impact. The model, using elements of the Total Factor Productivity of Solow (1957), observing the US economy for the first half of the century, gives a good picture of the evolution of the variables of capital, labor, product output, and wages. Nelson and Winter conclude that the neoclassical explanation of Solow’s economic growth and their own model come to the same conclusion. Localness of search leads to higher technological change, higher

396

P. E. PETRAKIS

capital-to-labor ratios, and lower market concentration rates. Also, the high search for innovation through imitation leads to a higher capital-to-labor ratio and a lower market concentration. In addition, higher capital costs lead to lower levels of technological change and lower capital-to-labor ratios. Finally, technological change, associated with labor-saving technical change, leads to a higher capital-labor ratio. These effects (ascertained by regressions on the simulation results) are readily explicable by the evolutionary theory provided by Nelson and Winter.

Note 1. From the perspective of management theory, evolutionary theory focuses on businesses and the problems they face when operating in a competitive environment. It does not simply accept, but urges extensive in-house research on the company’s processes and operations, on how to organize it, the type and the quantity of products it can produce and the services it can provide, the way costs are allocated and evaluated, promotion costs and the direction in which research and development spending will be efficiently driven to create a development model. It also leads to the identification of gateways in terms of which the direction to follow, especially if there is a concern about the company’s being able to operate and successfully cope in an open economy. Finally, it considers that entrepreneurs (and executives) with great skills and experience and open to challenges, can prove very useful in making decisions under uncertainty.

References Acemoglu, D. (2009). Introduction to modern economic growth. Princeton: Princeton University Press. Acz, Z., Braunerhjelm, P., Audretsch, D., & Carlsson, B. (2009). The knowledge spill-over theory of entrepreneurship. Small Business Economics, 32, 15–30. Aghion, P., & Howitt, P. (1988). Growth and cycles through creative destruction (Unpublished). University of Western, London,ON. Aghion, P., & Howitt, P. (1992). A model of growth through creative destruction. Econometrica, 60, 323–351. Aghion, P., & Howitt, P. (1998). A Schumpeterian perspective on growth and competition. In F. Coricelli, M. Matteo, & F. Hahn (Eds.), New theories in growth and development. London: Palgrave Macmillan. https://doi.org/10. 1007/978-1-349-26270-0_2.

17

ENDOGENOUS GROWTH …

397

Aghion, P., & Howitt, P. (2009). The economics of growth. Cambridge: MIT Press. Aghion, P., Akcigit, U., & Howitt, P. (2015). Lessons from Schumpeterian growth theory. American Economic Review, 105(5), 94–99. Alchian, A. (1950). Uncertainty, evolution, and economic theory. Journal of Political Economy, 58(3), 211–221. Retrieved from http://www.jstor.org/sta ble/1827159. Arrow, K. J. (1962). Economic welfare and the allocation of resources for inventions. In R. R. Nelson (Ed.), The rate and direction of inventive activity: Economic and social factors. Princeton: Princeton University Press. Barro, R. J. (1998). Determinants of economic growth: A cross-country empirical study. Cambridge: MIT Press. Barro, R. J., & Sala-i-Martin, X. (2003). Economic growth. Cambridge: MIT Press. Block, J. H., Thurik, R., & Zhou, H. (2013). What turns knowledge into innovative products? The role of entrepreneurship and knowledge spillovers. Journal of Evolutionary Economics, 23, 693–718. Corriveau, L. (1991). Entrepreneurs, growth, and cycles. PhD dissertation, University of Western Ontario. Grossman, G. M., & Helpman, E. (1991). Trade, knowledge spillovers, and growth. European Economic Review, 35(2–3), 517–526. Grossman, G. M., & Helpman, E. (1992). Innovation and growth in the global economy. Cambridge: MIT Press. Lucas, R. E. (1988). On the mechanisms of economic development. Journal of Monetary Economics, 22, 3–42. Lucas, R. E. (1990). Why doesn’t capital flow from rich to poor countries? American Economic Review, 80(2), 92–96. Mankiw, N. G., Romer, D., & Weil, D. (1992). A contribution to the empirics of economic growth. Quarterly Journal of Economics, 107, 407–437. Nelson, R. R., & Winter, S. G. (1982). An evolutionary theory of economic change. Cambridge: Harvard University Press. Rodrik, D. (2011). The future of economic convergence (NBER Working Paper Series, Working Paper 17400). Romer, P. (1986). Increasing returns and long run growth. Journal of Political Economy, 94, 1002–1037. Romer, P. (1990). Endogenous technological change. Journal of Political Economy, 98(5), S71. Segerstrom, P., Anant, T., & Dinopoulos, E. (1990). A Schumpeterian Model of the product life cycle. The American Economic Review, 80(5), 1077–1091. Retrieved October 2, 2020, from http://www.jstor.org/stable/2006762. Solow, R. (1957). Technical change and the aggregate production function. The Review of Economics and Statistics, 39(3), 312–320. https://doi.org/ 10.2307/1926047.

CHAPTER 18

The Macroeconomic and Development Debate After the Great Recession: The European Crisis, Deleveraging, and Secular Stagnation

18.1

Introduction

This chapter focuses on the evolution of economic and development thinking in the wake of the Great Recession of 2008 and on the themes that emerged during its course and in the years that followed. A priority for economists and policymakers has been to analyze the conditions for eliminating the productivity gap resulting from the Great Recession, as opposed to issues around boosting potential growth. Hence the observed explosion of macroeconomic literature, accompanied by heated debates. The particular issues that people have been called on to address during this period, have influenced the profile of economic literature. The first, and most important of these, concerns the ability of economic thinking to foresee the next great economic crisis. The other urgent issue concerned the need to restore and normalize economic life. Consequently, there has been a growing concern about sources of growth whose operation has been disrupted.

© The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_18

399

400

P. E. PETRAKIS

18.2

The Nature of the Great Recession

The global crisis began with subprimes in the United States1 and, so, at first, it was called the Subprime Crisis. Following that, it was signaled by the collapse of the Lehman Brothers bank.2 Eight hundred years of economic crisis experience, as analyzed by Reinhart and Rogoff, categorize economic crises into two groups: financial and non-financial. The Great Recession of 2008 belongs in the first group. Financial crises can be divided into four subcategories (Claessens & Kose, 2016): currency crises, sudden interruptions (of capital inflows), debt crises and banking crises. 18.2.1

The 2008 Crisis in the United States, and Globally

In recent decades, apart from the recent global debt crisis, major financial crises in the global economy—have been identified during 1975–1977 period and in 1992. The most serious among them (Reinhart & Rogoff, 2008) appear to have been: Spain in 1977, Norway in 1987, Finland and Sweden in 1989 and, finally, Japan in 1992. During the period 1970– 2007, there were 42 systemic banking crises in 37 countries. In addition, Reinhart and Rogoff (2008) have shown that from 1800 to 2010, there were five incidents globally of financial crisis: The first, during the Napoleonic wars. The second concerns the period from the 1820s to the late 1840s when nearly half of the world’s countries were unable to pay their debts (including all Latin American countries). The third incident, which lasted two decades, began in the 1870s. The fourth began from the great recession of the 1930s until the early 1950s when almost half the countries globally were again unable to repay their debts. The fifth and most recent incident was the debt crisis of the emerging economies of the 1980s and 1990s. To these five cases, the incident of the 2008–2010 crisis should be added, where many countries, including countries in the developed world, exhibited symptoms of over-indebtedness (Iceland, Greece, Ireland, and Portugal). The sequence of economic impacts is almost identical in all financial crises. When it occurs, demand for products declines, incentives for capital investment decrease, uncertainty and risk increase, while the financial system reduces private sector financing. The weakening of the labor market increases unemployment and further aggravates demand conditions. Usually, the economic recession leads to permanent production

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

401

losses, which Furceri and Mourougane (2009) estimate between 1.5 and 2.5% of GDP for ordinary crises, while for deeper crises—such as the recent global crisis of 2008—at 4%. The work carried out by Reinhart and Rogoff (2009, 2010) but also by the Public Finance division of the IMF offers a similar, long-term perspective on the evolution of the financial crises. Reinhart and Rogoff treat financial crises either as national bankruptcy crises or situations of near insolvency of a country’s external debt, which include the bankruptcy of a government, either because of its debts or private sector debts. The economic reasons for the creation of these international crises must be sought in a number of theoretical constructions, e.g., the Minsky moment. According to Bulow and Rogoff (1990), Mauro, Nathan, and Yishay (2006), and Reinhart and Rogoff (2008), causes could also be sought in global economic factors, such as product prices, and the price of capital (interest rates) in key global economies. Reinhart and Rogoff (2008) found that “periods of high mobility of international capital have repeatedly led to international financial banking crises.” In fact, their research (Reinhart & Rogoff, 2010) on the long-term perspective of financial crises has identified the repeated occurrence of a sequence of crisis-related events: • private and public debt rises as an early indication of impending crisis • banking crises—domestic and international—appear or they accompany fiscal crises • public debt is inflated excessively, usually revealing “hidden public debt”. An even more important finding was that the financial crisis periods are usually accompanied by about 6–8 years of low growth or economic stagnation. Their assessment is more or less confirmed. Moreover, this is the reason that in the case of the United States, where the crisis broke out in 2007 and in the Eurozone, where the crisis broke out in 2009, recovery is still under way with a lag of about two years. Figure 18.1 shows the swift response by the economies of Japan (where the crisis broke out in 1992), of the United States and the Eurozone, since the outbreak of the financial crisis and during subsequent years. The financial crisis cases of these three major economies are the three most recent global crises.

100= the unemployment rate in the year bofore the crisis broke out

402

P. E. PETRAKIS

260 240 220 200 180 160 140 120 100 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Years since the outbreak of the crisis Japan (1992)

USA (2007)

Eurozone (2009)

Fig. 18.1 Change in the unemployment rate from the year before the crisis broke out and for the next 25 years (indicator: 100 = unemployment rate in the year before the crisis broke out) (Source IMF data processing World Economic Outlook—October 2016 and author’s own calculation)

In the case of the Japanese crisis, the unemployment rate has not been able to return to pre-crisis levels even 25 years after the event. In the case of the United States, the reaction was quite immediate, as, in the fourth year since the breaking out of the crisis, the unemployment rate began to decline, and 11 years later, it is expected to almost reach the level before the eruption of the financial crisis. In the case of the Eurozone, the response is slower than in the United States, as unemployment rate began to decline 5 years after the outbreak of the crisis, and 15 years later, it is still not expected to reach the levels before the crisis. In general, it is argued that the global impact of the Great Recession was comparatively lighter than that of the Great Depression of 1929. The comparison of recent crises in the United States and the Eurozone with that of Japan in the 1990s is also of interest to researchers. Hoshi and Kashyap (2013) point out that are many similarities between the developments before 2008 in the United States and Europe and those before 1992 in Japan. The result is that, although the problems that emerged in the Japanese crisis were well known, countries such as France, Italy, and

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

403

Spain failed to realize, at least in time, the problem in their banking sector and the need to recapitalize their banks. At the same time, the United States, by contrast to the economies of Europe and Japan, has responded better to the crisis of 2008, as it has been able to recapitalize its banks relatively quickly and has not faced structural problems. However, despite the expansionary US macroeconomic policy, recovery is relatively slow, which means that the US economy is also experiencing problems, though these are different to those of Europe and Japan. Finally, Rogoff (2017) points out that a rise in populism accompanies the periods of widespread financial crises. 18.2.2

The European Crisis

The origin and unfolding of the European crisis had two main areas of reference: the public sector and the banking system. The crisis has affected each of the two sectors separately, creating a feedback loop. The inefficient and costly public sector has been the deficit generating mechanism in many Eurozone countries, such as Greece and Portugal. On the other hand, the banking system—contaminated with unsafe public and private securities—saw its survival threatened. State intervention to rescue the banking sector was considered a mandatory requirement. Thus, private debt became public debt, triggering the national debt crisis in Europe. In parallel with the debt crisis in Europe, there has been observed a lack of competitiveness of the member countries in the region, which fueled deficits and increased national debt. The management of the banking crisis has created a number of areas of theoretical and empirical debate, such as issues of budgetary and bank liquidity, bank capital adequacy, state intervention but also the degree of state intervention, etc. All of this is ultimately linked to the national debt crisis as it is both triggered and caused by it. Conversely, the fiscal crisis has increased the cost of borrowing, leading investors to abstain from the public debt market and, ultimately, to the creation of bailouts. Thus, appears the problem of the banks’ viability. The transfer of impacts from the banking system to the public sector, and vice versa, played an important role. Mody and Sandri (2011) consider that government debt spreads reflect the domestic weaknesses of the domestic national banking system and that this interaction has a greater impact on countries with high debt-to-GDP ratios. On the other hand (Acharya, Drechsler, & Schnabl, 2011), the bailout of the financial sector translates into a deterioration

404

P. E. PETRAKIS

in the fiscal balance and, at the same time, a decline in the creditworthiness of the state. In fact, the confidence crisis that has arisen over the credibility of the fiscal budget, lost all the advantage of the convergence of the cost of public borrowing (Sapir, 2011) by the different Eurozone economies, gained after 2000. While the Eurozone crisis has evolved into a debt crisis, its roots lie in the sudden cessation of cross-border lending. The confidence deficit created by the collapse of the Lehman Brothers, increased borrowing costs and has shown imbalances between the core countries of the Eurozone (e.g., Germany, France, the Netherlands) and countries in the periphery (e.g., Greece, Ireland, Portugal). From the adoption of a common currency and up until the start of the 2008 crisis, there were large flows of capital from the central countries to the periphery. With the onset of the crisis, investors began to be reluctant to borrow in countries and businesses with low credit ratings, thereby raising risk premiums.3 The sudden stop of capital flows raised concerns about the viability of both the banking sector and public debt. In 2009, capital inflows were discontinued, the capital transfer balance changed sign and a crisis occurred. This opposite movement of capital is designated as a sudden stop (Merler & Pisani-Ferry, 2012) and occurred to a greater or lesser extent in all the Eurozone countries under surveillance (Greece, Ireland, Italy, Portugal, and Spain). None of these countries could use the exchange rate as a means of adjustment. Calvo (1998) reports that a sudden stop in international credit flows can bring about a financial and fiscal balance crisis, and also shows that these crises can occur even when the current account deficit is fully financed by direct investment. The above statements also seem to gain support by the widening imbalances between the Central Banks in the Eurozone through the Target2 system.4 After 2010, the presence of sudden interruptions in capital movements exacerbated the external balance of payments situation. The operation of the European Monetary Union has adversely affected the adaptation process of the Eurozone countries under surveillance (Gros & Alcidi, 2013). This seems to have happened: 1. because the financing channel available through the Eurosystem has protected the Eurozone banking systems from the immediate effects of a sudden downturn, which has led to a slowdown in the correction of imbalances and

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

405

2. the effects of the banking crisis bequeathed to some of the Eurozone countries under surveillance, would burden their incomplete adjustment process for quite some time to come. The feedback loop of the crisis created the need for a series of actions and policies that focus on ensuring the financial stability of the Eurozone, which has been substantially threatened. As a result, the stability of the euro has also been threatened. Looking at the European crisis from a different perspective, it reveals all the typical features of a deep recession characterized by the implementation of austerity policies and processes of deleveraging and deflation (Fig. 18.2). Thus, initially, the normal levels of savings and investment in the economy lead to an increased level of investment and excess demand. This, in turn, results in excessive debt, over-investment, and over capacity. At this point, the operation of the price mechanism is weakened. The outlet, under conditions of austerity, may come from the stimulation of exports by depreciation, whether external or internal. A process of synchronized devaluation, however, weakens the effectiveness

Fig. 18.2 The cycle of austerity, deleveraging and deflation (Source Comstock Partners Inc. [2012] and edited by the author)

406

P. E. PETRAKIS

of this policy. At the same time, a wave of bankruptcies is triggered in the private sector. At this point, depending on the prevailing circumstance, state bankruptcies can also occur—whereby economies are deprived of the ability to issue money. At the same time, the prices of all assets (shares, real estate) are falling. When the deleveraging process is completed in the private sector and the debt-to-income ratio is reduced to a healthy level, that is, when private portfolios are consolidated, consumers return to the markets, increasing their consumption. Finally, through this painstaking process, the price mechanism is restored and economic activity recovers. An additional problem present in the real developments is that the above cycle of events is asynchronously triggered in the various economies, depending, of course, on the policy being implemented. So if we try to reformulate the problem of the European crisis, we end up with reduced demand at the heart of slowing growth rates. Decreasing demand does not have a static nature. It is not just about the production model, as was the case in the European economy before the crisis erupted. It is dynamic, presenting circular and structural elements. Weak demand comes from domestic and international sources. Domestic factors have three types of causes: long-term, medium-term, and those that are the result of policies. The international factors are related to sudden interruptions in capital inflows. The evolution of the Great Recession of 2008 brought to light the weaknesses of the European economy, a fact which have helped shape the policies for dealing with it. A typical example, as we will see later in this chapter, was the implementation of the European Central Bank’s non-conventional monetary policies, especially with the implementation of the Quantitative Easing (QE) program. Box 18.1 The European crisis The long-term causes of low growth and weak demand in the European economy can be identified as follows (Fig. 18.3): • Non-optimal monetary area: the optimum currency area (OCA) is a geographic area where the use of a single common currency as a whole would maximize economic returns. • The tendency to shift production and demand to the East, mainly to China.

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

407

Fig. 18.3 The European crisis: domestic and international factors (Source Petrakis, Kostis, and Valsamis [2013]) • The European economy is lagging in terms of productivity and innovation relative to the US economy. The low productivity of EU countries stems from a lack of investment in knowledge and a rigid regulatory framework. • The asymmetric development of European institutions and cultural background. • The barriers on the side of supply. • The problem of the aging of the population. Some of these causes have a level or flow character, as well as a structural and/or cyclical one. The medium-term causes can be specified as follows: • Excess savings in northern and central Europe, which were exported to the periphery in the form of capital inflows and investments, in the early 2010s, followed by a sudden stop of capital movements in those countries. • Weak intra-state net investment position, including imbalances in the external balance. • A negative picture in two critical areas, debt pricing (public and banking), and entrepreneurial signals, which lead to misallocation of resources. • Financial deleverage (borrower compliance and, therefore, demand reduction).

408

P. E. PETRAKIS

• Debt accumulation (debt borrowers fail to engage in consumer expenditures) (Blanchard, Furceri, & Pescatori, 2014; Rajan 2013). • Banking system malfunction: this includes the phenomenon of transmission and the broken banking system, financial fragmentation and the effects of the liquidity trap. • Increasing inequality as a barrier to growth, and depreciation of human capital due to long-term unemployment. • Lack of political leadership. • The disproportionate privilege of lower borrowing costs, which, even though in the case of the European crisis, combined with a strong/stable currency, has enormous costs for Germany. The policies responsible for weak growth and demand can be classified as follows: • Excessive rebalancing of net investment position against fiscal stimulus. • Weak quantitative easing, at the start of the Great Recession of 2008, versus stronger quantitative easing in the course of the crisis. • One-size-fits-all monetary policy versus a balanced monetary policy. • Synchronized supply-side and fiscal consolidation policies against country-specific policies. • Fiscal and monetary policies moving in the opposite direction. In earlier periods of recovery, both monetary and fiscal policies have been added.

18.3

The Macroeconomic Debate

The post-crisis macroeconomic debate has strongly disputed prevailing theoretical perspectives, highlighting weaknesses in understanding the operation of the economy. Much of the work has focused on revising economic theories and on restarting economies through different approaches and a lack of consensus. Issues related to stimulating growth, boosting productivity, reducing spillovers effects and the spread of secondary consequences are only some of the challenges.

18

18.3.1

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

409

Deleveraging, Balance Sheets Recession and Weak Demand

Deleveraging refers to the process of an organization or a person reducing its total financial leverage. The most immediate way of deleveraging is the instant repayment of the debt in the balance sheet of a business or a person. The deleveraging of the banking sector (e.g., improving banks’ capital ratios) can take various forms, including dividend cuts, equity issuance, reduction in operating costs (e.g., redundancies) and sale of assets. After the Great Recession of 2008, private sector deleveraging was combined with the need for simultaneous deleveraging in the public sector of the heavily indebted countries of the European periphery. The issue of deleveraging has two sides, one negative (the negative effects in the present) and one positive, whereby organizations are re-purposed and can engage again in development. Therefore, economic policy must facilitate the process of deleveraging, while at the same time there is awareness of the social implications of this process. Businesses go under, people lose their jobs, lives are destroyed—but because of this creative destruction, social and economic regeneration becomes again possible (Schumpeter, 1942). All the evidence shows that, after the 2008 crisis, the deleveraging process was unfolding on a global scale. The deleveraging process did not affect all countries or all sectors of the economy. The McKinsey Global Institute 2010 has published a study out of which two types of information emerged: first, where the phenomenon of deleveraging occurred, and second, what the general model was of deleveraging, as this emerges from the overall global post-war experience. The originating source of the forces of deleveraging is found to be the United States, Great Britain, and Spain (Table 18.1). The sector that was most heavily burdened was private households and this puts considerable pressure on the level of economic activity. The same study came to form a more general pattern of behavior of the relationship between the real rate of GDP change and the process of deleveraging based on the observation of deleveraging episodes in the developed world after the Great Depression of 1930. It should be noted that 32 of them concern the financial crises of either the private or public sector. All of these 32 episodes of financial crises went through four separate phases:

410

P. E. PETRAKIS

Table 18.1 Map of deleveraging in the second quarter of 2009 Business Households

Non-Commercial Real Commercial Real Estate Estate

Country

Financial Sector

Spain Italy Germany France United Kingdoms Japan USA

Note Black indicates a high degree of deleveraging, gray a medium degree of deleveraging, and white a low degree of deleveraging. In some areas, there are different degrees of deleveraging in the units that make them up, and for this reason, some cells have two colors Source McKinsey Global Institute (2010) and author’s own creation

• Austerity, where credit growth is lagging behind GDP and the economy is still in the process of leverage while shrinking (1– 2 years). • The onset of deleveraging, with recession continuing (2–3 years). This is the period when a major inability to pay occurs. • Economic recovery, while deleveraging continues (4–5 years). • Debt management with a sharp increase in real GDP. By all indications, the deleveraging process in Europe, and in particular in the Eurozone, has had a long-term character, especially in comparison to the United States (Fig. 18.4). Thus, if we organize the deleveraging model for the Eurozone and the United States on a time axis, we will find that the post-deleveraging period is set after 2015–2017, while the corresponding years for the United States are 2013–2014. We note that deleveraging in the United States occurs earlier than in the Eurozone. These forecasts have been substantially confirmed. All of this has made the recovery process extremely slow or, at the very least, much slower than in bank-supported recovery cases. This has a particularly negative

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

411

Fig. 18.4 Depression, deleveraging and growth in Europe and US (Source McKinsey [2010] and author’s estimates)

impact on the deeper rejuvenation process, which concerns the so-called creative destruction of the productive sector. The peak of deleveraging occurs either when the levels of debt and debt servicing are high relative to income, or when monetary policy does not cause credit expansion. Debt and its servicing levels have no fixed framework, as debt can be easily serviced through low-interest rates—as in Japan’s example—, although an increase in interest rates leads from credit expansion to credit shrinkage. In the case of an economy transitioning from credit expansion to credit contraction, debt as a percentage of net wealth increases because net wealth decreases. In this case, the deleveraging process begins by increasing the total debt. This is followed by an increase in savings (at the same time, an increase in savings simultaneously reduces everyone’s income), which causes a contraction in the economy, leading to higher levels of unemployment. Lower interest rates boost lending, while interest rates close to 0% do not allow the central bank to use policy tools. Moreover, in the context of the liquidity trap, the central bank is not able to increase economic activity, and even at zero interest rates, it is not able to achieve credit expansion. In the event of a recession of a normal economic cycle, the central bank would act through lower interest rates to generate credits. However, in the 2008 debt crisis, such a policy was not feasible and that is why the central banks went into quantitative easing.

412

P. E. PETRAKIS

Public debt has mainly attracted attention, but it is necessary to look at total debt, as leverage is equally, if not more, dependent on households, businesses and financial institutions. That is why the report of the McKinsey International Institute (2012) was so alarming as regards Europe. The direction of debt movement also depends on how it is divided into the key sectors of the economy—public, financial, nonfinancial, and households. As with all major economic policy issues, the process described above takes time. The average time required to complete the deleveraging process is at least ten years (e.g., United States in the 1930s, Japan in the 1990s and 2000s), but the rate of deleveraging is not the same for all economies. The experience of the Japanese economy which, unlike other successful exit examples (Sweden, Finland), has been involved in a deleveraging process for three decades, shows that a successful deleveraging effort is characterized by a combination of factors. These factors vary, but three of them relate to: a. The state of the banking system, that is, to what extent and at what rate the banking system is deleveraged and, therefore, consolidated b. The credibility of the long-term course of macroeconomic management, c. The activation of the export sector. The great concern of European countries was whether they would be led to a lost decade like that of Japan. Japan’s public sector, with the outbreak of this crisis, turned from a lender of funds into a debtor who had to repay debt. However, Japan has managed to avoid the recession without affecting private sector income, thereby allowing businesses and households to pay off debt. It is estimated that the losses from this fiscal drive were considerably less than those that would have been caused by a recession, and the fact also made a difference that deleveraging in the private sector did not allow high levels of inflation to occur. A fiscal stimulus is needed to prevent both GDP and money supply from shrinking during a balance sheet recession. Monetary policy may not be effective in the deleveraging phase because people with negative equity are not interested in raising their lending, no matter what the interest rate is. In addition, creditors cannot be found for economies that have overloaded balance sheets, when creditors themselves

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

413

may have debt problems. As Koo (2011) characteristically points out, the money supply, mostly from bank deposits, shrinks when the private sector withdraws its bank deposits en masse to repay debt. Although the central bank can boost the banking system’s liquidity, it may be under strong pressure to reverse the contraction of bank deposits when there are no lenders and the money multiplier is zero or marginally negative. Finally, a policy of inflation reduction or inflation targeting will not necessarily be effective, as “people are paying off their debts by responding to falling property prices rather than consumer prices. And with the money multiplier marginally negative, the Central Bank does not have the means to increase the money supply necessary for rising inflation” (Koo, 2011). In conditions of private sector deleveraging, despite zero interest rates, economies are entering a deflationary phase. As households stop borrowing and spending, economies continue either to lose on demand a rate which is equal to the sum of savings and net debt repayment, with this process continuing until the private sector balance sheets are corrected or the private sector becomes too poor to be rescued. Eggertsson and Krugman (2010), in their attempt to provide a formulation for a deleveraging crisis, point out that treatment of debt brings back a long tradition of economic analysis. Initially, according to Fisher (1933), the cause of the Great Recession was the fall in prices, which increased the real burden of debt, which in turn led to additional deflation. Excessive “leverage” increases the risk of bankruptcy and removes future prosperity. Fisher (1933) called this situation of excessive leverage within a financial system “debt-deflationary” and, later, Minsky (1986) called it “Ponzi finance.” Finally, the analysis of Eggertsson and Krugman’s (2010) focuses on the concept of “balance sheet recession,” referring to Japan’s lost decade and comparing it with the Great Recession. Both cases were essentially caused by problematic balance sheets, with large parts of the economy unable to spend due to over-indebtedness. After a deleveraging shock, the policy debate may be more confusing than usual as the deleveraging shock leads to a situation where no savings are made, productivity gains may reduce yields and flexible wages may increase unemployment. Still, expanded fiscal policy may be partially effective as the macroeconomic effects of a leverage shock are temporary and, therefore, the fiscal response must also be temporary. To the above points, two more should be added, which characterize the process of deleveraging in the Eurozone during the Great Recession of 2008: this is the global nature of the crisis, and therefore the spread of

414

P. E. PETRAKIS

adverse effects worldwide, and also the massive transfer of debt from the private to the public sector, which essentially creates conditions of “counterfeiting” of leverage rather than the actual devaluation that could come from repayment, bankruptcies or inflation. Both phenomena are common to the whole world, but they have a greater impact on the process of deleveraging in Europe. 18.3.2

Managing the European Crisis During the Great Recession

By the beginning of 2013, the European crisis had moved on to a next stage. Whereas initially, the elements of public debt, bank debt, and external imbalances had lent their own characteristics to the definition of the great European recession, it is now gradually recognized that the post-2008 government debt blowout was triggered by a balance sheet recession, triggered by the private sector’s desire to reduce its excessive debt, forcing governments to take on private debt in order to avoid the dynamics of debt deflation. This dynamic was observed both inside and outside the Eurozone. Subsequently, the crisis took on a more permanent character, whose main feature was the low growth rates stemming from weak demand. The individual components of the crisis co-operate and interact, setting in place a vicious circle of a Low Growth trap (Fig. 18.5). All four key components play a role in shaping the low growth trap (UN, 2013): fiscal austerity and public debt risk, the vulnerability of the financial sector, high unemployment rates and deleveraging by businesses and households. A recession which is rooted in the financial sector is deeper and the recovery is slower than a normal recession (Akerlof, 2013), with extremely slow recovery of employment. We wonder. Therefore, if, in the search for deeper causes, we need to delve even deeper into the fundamental assumptions of economic theory: the quantitative theory of money (which attributes the collapse to the volatility of money supply, such as the mortgage crisis which led to a boom in consumption) as opposed to the Keynesian theory of aggregate spending (which attributes the crisis to volatility of the investments that followed the collapse of dot.com (Skidelsky, 2010). In the first case:

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

415

High Unemployment Levels

Fiscal Austerity and Public Debt

Low Growth Trap

Deleveraging Procedure

Vulnerable Financial Sector

Fig. 18.5 The low growth trap (Source UN [2013] and author’s own creation)

• The cause lies in the financial systems and diffuses into the real economy. • Central Bank administrations have failed to focus on the money supply. • The solution is to increase the money supply. In the second case: • The cause lies in the insufficient demand which is affecting the real economy and is spreading through the financial system. • The public authorities fail to compensate for private investment deficits through a sufficient expansion of public investment. • The solution is to increase the overall expenditure.

416

P. E. PETRAKIS

18.3.3

The Hypothesis of the Secular Stagnation

Ever since the 1950s, widespread monetary policy has led to a large increase in money worldwide. The increased circulation of money is evolving along with lower interest rates, which in turn leads to a climate of reduced investment incentives. It has been argued that low-interest rates, and hence low returns, as well as increased levels of uncertainty, also fuel the conditions of permanent secular stagnation—that is to say, economic stagnation—which emerged after the outbreak of the Great Recession. A simple definition of the secular stagnation is the following: it is the situation where in order to equalize savings and investment with full employment negative real interest rates are required. The key concern is that secular stagnation5 greatly hampers full employment when the prevailing conditions are low inflation and zero lower bound in interest rate policy (Teulings & Baldwin, 2014). If the existence of conditions of secular stagnation is confirmed, with the real interest rates remaining low or negative for a long time, the tools of classic monetary policy are not enough. The extraordinary monetary and fiscal measures currently in place may not be available next time. According to Summers (2014) “In the coming years, we will probably need to consider how we manage an economy in which zero rates are a long-term and systemic inhibitor of economic activity, lowering our economy to below its potential.” During such a period, the conditions of permanent secular stagnation are enhanced: • the existence of zero interest rates (zero lower bound) has greater impacts than we thought, • there seems to be a downward trend in real interest rates, and • leverage and demographic trends are expected to weaken future demand. Secular stagnation was transmitted to different countries through two complementary channels (Eggertsson, Mehrotra, & Summers, 2016): • the reduced demand from abroad and the zero lower bound leading to a revaluation of the domestic exchange rate, pushing central banks to cut their rates.

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

417

• the capital flows that are directed through current accounts in countries not facing a secular stagnation. This development, however, is pushing down real interest rates for the recipients of capital inflows. It is noted that economic policy, mainly through monetary policy, tends to run out of its “ammunition” (Fig. 18.6). Low real interest rates play a central role in the debate on secular stagnation conditions as: First, if real interest rates are low under normal conditions, adverse macroeconomic disturbances are more likely to require negative real interest rates to restore a balance between full employment and investment savings. In fact, in a low inflation environment, such as that of today, this situation tends to undermine the effectiveness of monetary policy. Second, the low nominal and real interest rates undermine financial stability. 20 18 16 14 12 10 8 6 4 2 0 Jan-80 Jan-81 Jan-82 Jan-83 Jan-84 Jan-85 Jan-86 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19 Jan-20

-2

Germany - Long Term Interest Rates USA - Long Term Interest Rates Germany - Short Term Interest Rates USA - Short Term Interest Rates

Fig. 18.6 Economic policy and interest rates (Source OECD [2020] and author’s own creation)

418

P. E. PETRAKIS

Summers (2014) identifies three ways in which low interest rates can encourage economic stagnation and create volatility: • They encourage “sustainable” risk-taking as investors can look for additional returns. • They promote “irresponsible” loans because the loan obligations become very small and easy to fulfill. • These make Ponzi financial structures more attractive, as interest rates show lower than expected growth rates. Teulings and Baldwin (2014) also add the following factors as causes of lowered interest rates: • Increasing the supply of borrowed funds: An increase in the supply of borrowed funds could help to explain the existence of real low interest rates. Such an increase is closely linked to demographic developments, assuming that people save to ensure their future consumption. • The falling demand for borrowed funds: Blanchard et al. (2014) put a slight emphasis on the demand side, while Glaeser (2014) makes interesting observations on the rising role of the IT sector in increase of investment demand. • The demand for safe assets and their limited supply: Most real interest rate calculations are based solely on nominal returns on investment securities, such as the US Treasury Bills. The prices of these bonds depend on their availability and investors’ preference for risk. In conclusion, in times of global recession, deflation, and negative interest rates create disincentives for new investments, as returns are very low. As long-term investment (infrastructure, education, etc.) is limited, the maintenance of stable future economic growth is jeopardized. The lack of investment leads to a reduction in income, further absence of new investment and, ultimately, an outflow of savings creating long-term stagnation.

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

419

Box 18.2 The Function of the Secular Stagnation Under constant economic stagnation, low demand is observed and, consequently, low levels of product output, while interest rates are very low. If monetary policy intervenes by increasing, e.g., the money supply, then the LM curve will move to the right and, hence, the product will rise, but the interest rate will decrease further, which is not possible because it is already low (constant economic stagnation). That is to say, we are in a liquidity trap since the nominal interest rate is very close to zero so that it is not possible to stimulate economic activity by monetary authorities’ further reducing interest rates (Fig. 18.7).

Fig. 18.7 Monetary policy and liquidity trap creation)

(Source Author’s own

420

P. E. PETRAKIS

Fig. 18.8 Fiscal policy and liquidity trap (Source Author’s own creation) Therefore, what can stimulate the economy and boost demand is the fiscal policy. Then, the IS curve will shift to the right and the product and interest rate will increase (Fig. 18.8).

Fig. 18.9 Fiscal policy and floating exchange rates (Source Author’s own creation)

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

421

But then, in a floating exchange rate regime, the solution cannot be fiscal policy. Under floating exchange rates, an exogenous increase in aggregate demand would move the IS curve right (IS’) and then, at point B, capital will flow into the economy as the interest rate rises and exceeds the rate of return on foreign assets. Then the exchange rate is appreciated, the primary current account balance is affected, and competitiveness disappears. The aggregate demand decreases and the IS curve turns to point A (Fig. 18.9).

Fig. 18.10 Policy mix and floating exchange rates (Source Author’s own creation) Theoretically, the solution consists of a mixture of fiscal and monetary policy, as monetary policy, properly combined with fiscal expansion, prevents the exchange rate appreciation, and at the same time, the interest rate is not reduced further. Suppose, however, that the IS curve goes to the right IS ‘due to fiscal expansion, while the monetary policy support shifts the LM curve to LM’ (perhaps from securities purchased by the central bank) so that eventually the two curves intersect BP line (balance of payments line) at the same point. This prevents appreciation and, at the same time, does not raise interest rates while the product rises. The extra costs incurred by the fiscal expansion are implemented domestically and do not leak abroad (Fig. 18.10).

422

P. E. PETRAKIS

18.4

The Hysteresis Issue

One of the major and most permanent effects of the Great Recession of 2008 was the change in the trend of the GDP relative to the precrisis trend in all developed economies. This resulted in a debate on the issue of hysteresis6 in GDP. The hysteresis in GDP, i.e., the change in GDP trends, can be due to several factors such as productivity changes and demographic changes. It is, nevertheless, interesting that its appearance coincides with the Great Recession (Fatás & Summers, 2016). The persistence of the Great Recession becomes apparent in Fig. 18.9, which presents the change in GDP and the estimation of potential output based on the IMF report (World Economic Outlook—April 2016) (Fig. 18.11). The existence of hysteresis is both a cause and a consequence of the reduced effectiveness of monetary and fiscal policy. The traditional analysis of their implementation suggested that, in the absence of hysteresis in unemployment, central banks seeking to reduce inflation, can pursue 12000 11500 11000 10500 10000 9500 9000 8500 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

8000

Real GDP

PotenƟal GDP

Fig. 18.11 Eurozone GDP and potential GDP (Note It is noteworthy that the IMF estimations of 2016 for the year 2021 indicate that the Eurozone will be at 15% below potential GDP, relative to the trend before the 2008 crisis. This fact is common to all advanced economies [Ball, 2014; Fatás & Summers, 2016]. Source Oxford Economics-Global Economic Model [May 2020] and author’s own creation)

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

423

a tight monetary policy. If a tight monetary policy is not entirely expected, it will temporarily increase unemployment. But if this policy continues, the increase in unemployment will eventually disappear and unemployment rates will return to their normal level. Policy makers have been puzzled in the wake of the 2008 Great Recession by indications that cyclical phenomena may have a permanent effect on the GDP. The adoption of more permanent policies to stabilize the economy, rather than fiscal consolidation policies, has galvanized reflection on the impact of shocks on the real economy. The literature, based on the impact of fiscal consolidation on GDP, confirms that changes in fiscal policy lead to changes in GDP, not only in the short term but also in the long term (Blanchard & Leigh, 2013; Fatás & Summers, 2016). The emergence of hysteresis in GDP has contributed to the creation of a political (economic) response that focused on two key components: • The implementation of monetary policy expressed in low-interest rates, quantitative easing, forward guidance, and helicopter money. • Applying the policies from the supply side, to meet the problems at the level of debt.

18.5 Monetary Policy: Zero Lower Bound, Quantitative Easing, Forward Guidance, and “Helicopter Money” Various thoughts have been expressed on the issue of the prevailing of low-interest rates. Here are some of them: • It may be due to the decline in the rate of change in the outputs— although many are skeptical of a direct relationship between the natural rate of interest and the output (Laubach & Williams, 2016). • Factors have emerged that may have altered people’s propensity for savings and investment. Such factors are demographic changes (increase in life expectancy, lower population growth rates) (Carvalho, Ferrero, & Nechio, 2016; Gagnon, Johannsen, & LopezSalido, 2016), the unequal distribution of income, which has worsened in recent decades (Del Negro, Giannone, Giannoni, & Tambalotti, 2017), the increased level of uncertainty in economies

424

P. E. PETRAKIS

(Bloom, 2009) and the reduction in the prices of capital linked to rapid technological change (Eichengreen, 2015). • There are conditions of secular stagnation. • Strong leverage conditions push and keep interest rates at a constant zero lower bound. • Del Negro et al. (2017) emphasize the role of spreads between government and corporate bonds, pointing out that interest rates in the United States are very low as risk and liquidity premiums increased significantly after the 1990s. At the same time, these conclusions are very close to the literature on the causes and consequences of the lack of safe assets. The global financial crisis of 2008 has shown to a large degree that shocks to reduce inflation, even leading to deflation, and slow economic activity, while Central Banks may be locked in a situation with nearzero interest rates (almost Zero-Lower Bound—ZLB). Examining the economic crisis of 2008 and the ECB’s reaction to interest rates, Gerlach and Lewis (2011) concluded that the zero lower bound (ZLB) did indeed restrict monetary policy, as the estimated target was particularly negative until December 2010. To address this situation and in fear of the liquidity trap, the central banks, like the ECB, have resorted to unconventional monetary policies (BIS, 2016) and specifically the policy of quantitative easing (QE). With quantitative easing (QE), central banks are buying public securities or other market securities in order to increase the money supply in the real economy. A range of low-interest rates, as these are mainly determined by the central bank’s interest rate, which is close to 0–1%, i.e., the level at which excessive risk-taking behavior is developed, is defined as a liquidity trap.7 The appearance of the liquidity trap results in an increase of the likelihood of a crisis, which in turn will require low interest rates to be dealt with. In the manner, a vicious cycle is established of low-interest rates and loss of dynamic recovery. Under low interest rates, liquidity transfers from surplus to deficit portfolios are suspended. At the same time, monetary policy loses one of its most important tools of implementation, interest rate management. As a result, the only options that remain are quantitative interventions—open market interventions—or other non-standard measures. Similar situations arise when there is a fear that short-term funds will not be available at any time, because other participants in the interest

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

425

system have the same goals, that is, they expect the funds to be available whenever they want. For this reason, there is a growing demand for zerorisk placements, which only the central banks can offer. Deflationary conditions lead to lower central bank interest rates (for example, when the targets set to apply the Taylor rule), thus increasing the likelihood of a liquidity trap.8 The crisis of 2008 has given rise to strong concerns about the effectiveness of monetary policy under zero lower bound. At the same time, the accumulation of deficits and overindebtedness has made it impossible to pursue fiscal policy because of a lack of resources. Because of these developments, both monetary and fiscal policy have lost much of their power. On the one hand, the absence of fiscal space weakens the effectiveness of the fiscal policy, resulting in the low demand for consumption and investment forms a framework of lowinterest rates and the subsequent inability of monetary policy to break the vicious cycle of secular stagnation and zero lower bound. The role of expectations, with the emergence of forwarding guidance, in the effectiveness of the economic policy, became particularly evident after the Great Recression. The forward guidance has played an important role in monetary policy in the United States, as well as other developed countries since the great crisis of 2008. According to the theory, forward guidance can influence the future interest rate developments, while empirical studies have shown its significant impact on monetary policy. The effectiveness of forward guidance depends on people’s belief that the central bank will follow through on its commitments. After all, the management of human expectations by the central banks, has been widely accepted for several decades as one of their most basic functions, at least in theory (Kydland & Prescott, 1977; Barro & Gordon, 1983). This issue is of even greater interest to economic policymakers at a time of near-zero interest rates. New Keynesians argue that because of nominal rigidities, the increase in interest rates by the central bank translates into a change in real interest rates and, therefore, encourages economic agents to increase or defer their future consumption and investment decisions. If the central bank can effectively manage the expectations of the private sector, then a credible statement about lower short-term interest rates should lead to lower long-term interest rates today. Lowering long-term interest rates subsequently incentivizes households to reduce savings and increase consumption. For their part, businesses, seeing the opportunity cost decrease, are lead to an increase in their investment costs in the present.

426

P. E. PETRAKIS

In the wake of the Great Recession of 2008, there is a need to adopt even more radical policies due to the limited effectiveness of monetary policy. Thus, Milton Friedman’s (1969) theory of helicopter money began to gain more and more supporters over time. The term “helicopter money” refers to the immediate transfer of money from the central banks to everyone in order to increase inflation. The concept is based on the fact that citizens would see it as a one-off increase in the amount of money they move, and thus start spending more freely, stimulating economic activity and increasing inflation, in line with the central bank’s goal. The re-emergence of the idea of helicopter money as a possible option for economic recovery has found supporters, who have recommended it as a key tool for the US Federal Reserve (Caballero, 2010). At the European level, the limited effectiveness of fiscal and monetary policy has raised concerns, with many supporters citing helicopter money as a precise monetary financing tool to tackle these problems (Bossone, Cattaneo, & Zibordi, 2014). This rationale was expressed in the view recommending temporary tax relief measures to be financed by the non-sterile acquisition of long-term government debt by the ECB (Perotti, 2013).

Notes 1. The subprime crisis broke out in the United States in August 2007— and led to the Great Recession of 2008—due to the inability to control subprime mortgages. These loans were given to low income insolvent borrowers who were unable to repay them. This crisis was triggered by a sharp drop in the residence prices following the collapse of the housing bubble, leading to delays in mortgage payments, foreclosures, and depreciation of mortgage-related securities. The crisis has had a serious and lasting impact on the United States and European economies. 2. The Lehman Brothers was one of the four largest US financial services investment banks. On 15 September 2008, the company filed for bankruptcy protection following the massive exodus of most of its customers, a drastic reduction in its stocks, and the depreciation of assets by credit rating agencies that were largely caused by its involvement in the high-risk mortgage crisis and subsequent allegations of negligence and mismanagement. 3. Credit Default Swap (CDS) is an exchange contract, which provides that the seller will indemnify the buyer (usually the loan creditor) in the event of default (by the borrower) or in case of another credit event. This means that the CDS buyer insures the seller against defaulting on the loan. The buyer makes a series of payments (CDS price or margin -spread) to the

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

427

counterparty and, in return, receives a lump sum payment if the loan obligations have defaulted. The initiator of the risk premium was JP Morgan’s Blythe Masters in 1994. 4. The TARGET2 interbank payment system aims to smooth out the imbalances (deficits and surpluses) in current account balances for Eurozone member states and it lays claims against the national central banks of countries with a surplus, for the benefit of national central banks whose economies are in deficit. In this way, the surplus capital accumulated in a Eurozone country by exports of goods or other capital inflows (flight of capital to higher-quality securities) is recycled through the TARGET2 system to the deficient economies of the euro area, and it thus becomes “sterile.” Of key interest in TARGET’s balance is the fact that there is no provision for the liquidation of claims (liabilities) of countries in surplus (or those in deficit). The United States applies a system of regional federal banks (regional Feds) that provides for the liquidation of surpluses and deficits of the local federal bank through the transfer of securities (usually by appealing to federal gold reserves). In the Eurozone, however, no such mechanism is envisaged. So, there is a situation of unsecured credit, whereby countries in deficit and whose national Central Banks receive credit, are not required to offer any guarantees to the national Central Banks of the surplus countries of the Eurozone (Petrakis et al., 2013). 5. The term was first used by A. H. Hansen (1938) in a speech that could be described as crucial and insightful, but at the same time wide off the mark and erroneous (Teulings & Baldwin, 2014; Summers, 2014). The reason for this is that he applied the term to a situation in the United States where low birth rates and the end of agricultural development were about to push the country into low investments, low demand, and low development. Eventually, it was thoroughly disconfirmed, as, in the following years, the United States became the largest economic power in the world achieving investment rebound, aggregate demand, and rapid growth. Larry Summers reintroduced the term “secular stagnation“ at the end of 2013. In his article “The Age of Secular Stagnation,” Summers defines the concept and describes its function: “The economies of the industrialized world suffer from an imbalance arising from the increasing momentum toward savings and the declining momentum for investment. The result is that excessive economies act as a deterrent to demand, reducing growth, and inflation, while the imbalance between economies and investments determines real interest rates. In the meantime, when significant growth is achieved, as happened in the United States between 2003 and 2007, it comes from risky lending levels, which translates excess savings into unsustainable levels of investment—a procedure which, in this case, took the form of a housing bubble.”

428

P. E. PETRAKIS

6. The term hysteresis was first discussed in the context of the labor market, where Blanchard and Summers (1986) argued that cyclical unemployment can be permanent, as the unemployed lose some of their skills over time, resulting in a persistent cyclical shock, while long periods of high unemployment tend to tip unemployment over the point of NAIRU (non-accelerating inflation rate of unemployment). When a negative shock reduces employment levels, there are fewer employees in the business. Since workers usually have the power to influence wages, once the economy rebounds, the decline in numbers encourages them to negotiate for even higher wages instead of letting wages remain at reached equilibrium, where there would be a correlation between supply and demand for the workers. This causes hysteresis whereby, for example, unemployment is on a steady rise after negative shocks (Blanchard & Summers, 1986). 7. A liquidity trap is defined as a situation in which the short-term nominal interest rate is very close to zero, implying that cash and bonds are perceived as perfect substitutes (Eggertsson, 2010). In the liquidity trap, low or zero interest rates fail to mobilize consumer demand, thus making monetary policy ineffective. In essence, consumers’ preference for liquid assets (cash) is greater than the rate of increase in the amount of money which implies that any effort of the policymakers to push individuals to hold non-liquid assets in the form of consumption, increasing the money supply, is bound to fail. In the liquidity trap, Say’s law, according to which supply creates its own demand, ceases to apply. When interest rates are close to zero, the tools available to the monetary authorities are limited. Consequently, when interest rates are near zero, a quantitative easing through the interest rate is no longer possible, since, in theory at least, it cannot be negative. 8. This is especially the case if the central bank’s only objective is price stability, as, for instance, with the European Central Bank, rather than the activity of the economy, as is the case with the US Federal Reserve. When the latter occurs, the central bank is much more likely to engage in quantitative interventions in the capital markets by increasing liquidity in quantity and duration, so that the formulation of risk depends on the provision of quantitative liquidity and not only on its price of the capital. At the same time, a possible intervention through open market operations may not have the desired results if the central banks do not change their expectations about future policy.

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

429

References Acharya, V. V., Drechsler, I., & Schnabl, P. (2011). A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk (NBER Working Papers No. 17136). National Bureau of Economic Research, Inc. Akerlof, G. A. (2013). The cat in the tree and further observations: Rethinking macroeconomic policy II . IMF Conference on “Rethinking Macro Policy II: First Steps and Early Lessons”. Ball, L. (2014). Long-term damage from the Great Recession in OECD countries (NBER Working Paper, No. 20185). Barro, R. J., & Gordon, D. B. (1983). Rules, discretion and reputation in a model of monetary policy. Journal of Monetary Economics, 12(1), 101–121. BIS. (2016). Unconventional monetary policies: A re-appraisal (BIS Working Papers No. 570). Blanchard, O., Furceri, D., & Pescatori, A. (2014). A prolonged period of low real interest rates? In C. Teulings & R. Baldwin, Secular stagnation: Facts, causes, and cures (pp. 101–110). London: A VoxEU.org Book, CEPR Press. Blanchard, O., & Leigh, D. (2013). Growth forecast errors and fiscal multipliers. American Economic Review: Papers and Proceedings, 103(3), 117–120. Blanchard, O., & Summers, L. (1986). Hysteresis and the European unemployment problem (NBER Macroeconomics, 1). MIT Press. Bloom, N. (2009). The impact of uncertainty shocks. Econometrica, 77 (3), 623– 685. Bossone, B., Cattaneo, M., & Zibordi, G. (2014). Which options for Mr. Renzi to Revive Italy and save the Euro? Economonitor. Bulow, J., & Rogoff, K. (1990). Cleaning up third—World debt without getting taken to the cleaners. Journal of Economic Perspectives, 4, 31–42. Caballero, R. J. (2010). Macroeconomics after the crisis: Time to deal with the pretense-of-knowledge syndrome (NBER Working Paper No 16429). Calvo, G. A. (1998). Balance of payments crises in emerging markets: Large capital inflows and Sovereign governments. Paper presented at the NBER Conference on Currency Crises. Carvalho, C., Ferrero, A., & Nechio, F. (2016). Demographics and real interest rates: Inspecting the mechanism. European Economic Review, 88, 208–226. Claessens, S., & Kose, A. M. (2016). Financial crises: Explanations, types, and implications (IMF Working Paper No. 13/28). Comstock Partners Inc. (2012). Special Deflation Report. Del Negro, M., Giannone, D., Giannoni, M. P., & Tambalotti, A. (2017). Safety, liquidity, and the natural rate of interest. Brookings Papers on Economic Activity, Conference Drafts.

430

P. E. PETRAKIS

Eggertsson, G. B. (2010). Liquidity trap. In S. N. Durlauf & L. E. Blume (Eds.), Monetary economics. The new Palgrave economics collection. London: Palgrave Macmillan. https://doi.org/10.1057/9780230280854_18. Eggertsson, G. B., & Krugman, P. (2010). Debt, deleveraging, and the liquidity trap: A Fisher-Minsky-Koo approach. Princeton University. Eggertsson, G. B., Mehrotra, N. R., & Summers, L. H. (2016). Secular stagnation in the open economy. American Economic Review, 106(5), 503–507. Eichengreen, B. (2015). Secular stagnation: The long view. American Economic Review, 105(5), 66–70. Fatás, A., & Summers, L. H. (2016). The Permanent effects of fiscal consolidations (NBER Working Paper No. 22734). Fisher, I. (1933). The debt-deflation theory of great depressions. Econometrica, 1(4), 337–57. Friedman, M. (1969). The optimum quantity of money. London: Macmillan. Furceri, D., & Mourougane, A. (2009). The effect of financial crises on potential output: New empirical evidence from OECD countries (OECD Economics Department Working Papers No. 699). Gagnon, E., Johannsen, B. K., & Lopez-Salido, J. D. (2016). Understanding the new normal: The role of demographics. Finance and Economics Discussion Series 2016-080, Board of Governors of the Federal Reserve System (U.S.). Gerlach, S., & Lewis, J. (2011). ECB reaction functions and the crisis of 2008 (CEPR Discussion Paper No. 8472). Glaeser, E. L. (2014). A world of cities: The causes and consequences of urbanization in poorer countries. Journal of the European Economic Association, 12(5), 1154–1199. Gros, D., & Alcidi, C. (2013). Country adjustment to a ‘sudden stop’: Does the euro make a difference? (European Economy, Economic Papers 492). Hansen, A. H. (1938). Economic progress and declining population growth. American Economic Review, 29, 1–15. Hoshi, T., & Kashyap, A. K. (2013). Will the U.S and Europe avoid a lost decade? Lessons from Japan’s post crisis experience. Paper presented at the 14th Jacques Polak Annual Research Conference, International Monetary Fund, Washington, DC. Koo, R. C. (2011). The world in balance sheet recession: Causes, cure, and politics. Real-world Economics Review, 58, 19–37. Kydland, F. E., & Prescott, E. C. (1977). Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy, 85(3), 473–491. Laubach, T., & Williams, J. W. (2016). Measuring the Natural Rate of Interest redux. Business Economics, 51(2), 257–267. Mauro, P., Nathan, S., & Yishay, Y. (2006). Emerging markets and financial globalization: Sovereign bond spreads in 1870–1913 and today. London: Oxford University Press.

18

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

431

McKinsey Global Institute. (2010). Debt and Deleveraging: The Global Credit Bubble and its Economic Consequences. McKinsey Global Institute. (2012). Debt and deleveraging: Uneven progress on the path to growth. Merlerm, S., & Pisani-Ferry, J. (2012). Sudden stops in the Euro area. Bruegel: Policy Contribution. Minsky, H. P. (1986). Stabilizing an unstable economy. New Haven: Yale University Press. Mody, A., & Sandri, D. (2011). The Eurozone crisis: How banks and Sovereigns came to be joined at the hip. Washington, DC: International Monetary Fund. OECD. (2020). Short and Long Term interest rates. https://doi.org/10.1787/ 2cc37d77-en. Perotti, R. (2013). The ‘austerity myth’: Gain without pain? In A. Alesina & F. Giavazzi (Eds.), Fiscal policy after the financial crisis (pp. 307–354). Chicago: Chicago University Press. Petrakis, P. E., Kostis, P. C., & Valsamis, D. G. (2013). European Economics and politics in the midst of the crisis, from the outbreak of the crisis to the fragmented European federation. New York and Heidelberg: Springer. Rajan, R. G. (2013). Why stimulus has failed. EuropeanVoice.com. Reinhart, C., & Rogoff, K. (2008). Is the 2007 US sub-prime financial crisis so different? An international historical comparison. American Economic Review, 98(2), 339–44. Reinhart, C., & Rogoff, K. (2009). This time is different: Eight centuries of financial folly. Princeton: Princeton University Press. Reinhart, C. M. & Rogoff, K. S. (2010). From financial crash to debt crisis (NBER Working Paper No. 15795). Rogoff, K. (2017). Growing Out of Populism? Project Syndicate. Sapir, A. (2011). European integration at the crossroads: A review essay on the 50th anniversary of Bela Balassa’s theory of economic integration. Journal of Economic Literature, 49(4), 1200–1229. Schumpeter, J. (1942). Capitalism, socialism, and democracy. New York: Harper & Bros. Skidelsky, R. (2010). Unipolar disorder. Survival, 52(1), 187–190. Summers, L. H. (2014). Reflections on the ‘new secular stagnation hypothesis’. In C. Teulings & R. Baldwin, Secular stagnation: Facts, causes, and cures (pp. 27–38). A VoxEU.org Book, CEPR Press. Teulings, C., & Baldwin, R. (2014). Secular stagnation: Facts, causes, and cures. A VoxEU.org Book, CEPR Press. UN. (2013). World economic situation and prospects. New York: United Nations.

CHAPTER 19

The Macroeconomic and Development Debate After the Great Recession: Fiscal Space, Multipliers and GDP, Debt Supercycle and Supply-Side Economics

19.1

Introduction

This chapter, following Chapter 18, presents the discussion on macroeconomic and development that has taken place since the Great Recession of 2008, in terms of issues such as the existence of a fiscal gap in economies, the management of the course of public debt and policies for the increase of supply.

19.2

Fiscal Space and Fiscal Multipliers

Fiscal space is “capacity in a government´s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy” (Heller, 2005). In essence, it expresses the flexibility of a government to increase government spending and, more generally, to promote the economics of prosperity. However, there are different views on how to measure it, as there is difficulty in identifying a country’s current, future and potential liabilities. An approach to measuring fiscal space can be:

© The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_19

433

434

P. E. PETRAKIS

• As a measurement of the loss of access to capital markets, since fiscal space can be considered as the difference between the current level of debt and the limit of debt at which the government would lose access to markets. • As a benefit from achieving long-term sustainability. These two approaches are interlinked. Figure 19.1 summarizes the approaches to measuring the fiscal space. Fiscal space is important because the larger it is, the smaller the need is for central banks to intervene through unconventional policies. After the crisis, the ECB’s quantitative easing (QE) program has helped reduce government bond yields and debt servicing costs. But it is the actual use of fiscal space that can increase demand and lead to sustainable growth. A fiscal multiplier is the link between public expenditure and the GDP produced. A multiplier equal to one unit means that an increase in government spending of 1% increases GDP by about 1%. The size of fiscal multipliers is particularly critical, as the effects on the Gross Domestic Product, caused by an exogenous change in the budget deficit, depend on these multipliers. Therefore, the smaller the multipliers, the lower the

Fiscal Space Market Access in order to roll over debt

Actual Debt

Debt Limit

Interest Rates

PotenƟal Output Growth

Fiscal Track and Debt ReacƟon

Sustainability in order to service debt Spending vs Maximum Revenues Macro Shocks

Actual Debt

Spendings ProjecƟons

Structural Reforms

Fig. 19.1 Estimation of the fiscal space (Source Botev, Fournier, and Mourougane [2016] and author’s own creation)

19

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

435

cost caused by the budgetary restraint in relation to the product. This results in a great debate about whether the negative short-term effects of fiscal consolidation are more severe than expected, because the fiscal multipliers are underestimated, as happened after the Great Recession of 2008 (Alesina & Ardagna, 2010). The results of the study by the IMF (2010) show that a fiscal consolidation of 1% of GDP, when it is attempted on the expenditure side, causes a contraction of the real economy (ceteris paribus), after two years, by 0.3%, while when it is attempted through the increase of taxes, the recession caused approaches −1.3%. Furthermore, in order to predict the results of adjustment programs in different countries, multipliers of around 0.5 were used (IMF, 2010). However, the fact that the contraction of economic activity in some countries was more pronounced than expected, raises questions about whether the size of fiscal multipliers was underestimated. A plethora of studies (Auerbach & Gorodnichenko, 2012a; Batini, Callegari, & Melina, 2012; IMF, 2012) argued that in an environment of economic contraction, in which the zero lower bound rates constrain monetary policy, fiscal multipliers are likely to exceed one unit. This view is also supported by Blanchard and Leigh (2012) in the IMF’S World Economic Outlook for October 2012. Based on data from 28 countries, they found that multipliers were significantly underestimated,1 given that, from the beginning of the recession, they received values from 0.4 to 1.2 percentage points, depending on the source of the forecast and the estimate’s approach. Their new estimates for multipliers range between 0.9 and 1.7, suggesting that the austerity policies followed are the direct causes of the deep recession in many European countries. This finding is consistent with research showing that, in the context of the economic slowdown after 2008, with monetary policy constrained by the zero lower bound and a simultaneous fiscal adjustment, the multipliers can exceed the unit. A wave of econometric surveys estimated the size of fiscal multipliers as higher. More specifically, Baum, Poplawski-Ribeiro, and Weber (2012) allow the multiplier estimation to be changed when a output gap limit is exceeded, while Batini et al. (2012) allow for a regime change in depressions against booming periods. Most of the above surveys calculate the expected: that is, fiscal multipliers larger than one unit, under conditions of excess capacity and low interest rates. The model QUEST used by the European Commission (2012) shows that in normal situations, the short-term multiplier for the EU as a whole

436

P. E. PETRAKIS

is around 0.4 and can increase to 0.5–0.7 in times of crisis. The ECB (2012) adds, however, that when markets initially distrust the government’s commitment to fully implement the announced fiscal adjustment measures, then the biggest recession is observed. Yet, this is the exception whereby negative fiscal multipliers are observed higher than the unit. Finally, the ECB adds that short-term fiscal multipliers are smaller when a decreased risk premium on government bonds lowers the debt-to-GDP ratio. The effects are reducing government debt servicing costs, lowering the cost of financing the private sector and boosting private investment. Table 19.1 summarizes the results of studies on fiscal multipliers in both the rise and the downturn of the business cycle. As we can see, recession has a stronger impact on multipliers than recovery. In other words, multipliers tend to increase more in times of recession than they decrease in recovery. The debate on fiscal multipliers and their size should center on the observation that different kinds of expenditure have different multipliers (Stiglitz, 2014). What matters is not how multipliers were formed in the past, but the effect of a well-planned expansionist policy today. If fiscal relaxation is the only option, it is important to understand through the multipliers which countries can benefit from such a perspective. It is the countries with the highest multipliers that will benefit from a fiscal expansion. Finally, the observation is critical that the coordinated implementation of an expansionary fiscal policy becomes more effective, when many countries expand at the same time. On the contrary, when only one economy attempts fiscal expansion, this is very likely to benefit only its trading partners and not itself.

19.3 Multiple Equilibrium Points in Public Debt Costs and Confidence Until the onset of the financial crisis of 2008, financial markets valued euro area bonds at almost the same risk premium, despite large differences in debt-to-GDP ratios. But then, the markets’ ascribed huge differences in performance (spread) to the peripheral countries of the Eurozone. De Grauwe and Ji (2012) argue that the markets, both in the pre-crisis period and after the crisis, priced the government bonds of peripheral countries incorrectly, i.e., overestimating the risks, and conclude that the increased spread is not associated with a similar increase in the ratio of debt to GDP or the growth of other macroeconomic aggregates. In essence, the

19

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

437

Table 19.1 Fiscal multipliers and business cycle Expenditure

Auerbach and Gorodnichenko (2012a), USA, 6 quarters Auerbach and Gorodnichenko (2012b), OECD, first year Auerbach and Gorodnichenko (2014), Japan, 4 quarters Batini et al. (2012), 4 quarters Baum et al. (2012), 4 quarters Canzoneri, Collard, Dellas, and Diba (2012), DSGE, USA, multiplier effect Hernandez de Cos and Moral-Benito (2013), Spain, 4 quarters Owyang, Ramey, and Zubairy (2013), USA, multipliers of 2 years Owyang et al. (2013), Canada, multipliers of 2 years

Revenues

Expansion

Linear Recession

Expansion

Linear

Recession

0

0.4

1.7

N/a

N/a

N/a

−0.2

0.2

0.5

N/a

N/a

N/a

1

1.2

2.4

N/a

N/a

N/a

0.82

0.93

2.08

−0.08

−0.17

0.08

0.72

0.79

1.22

−0.04

0.29

0.35

0.89

1.3

2.25

N/a

N/a

N/a

0.6

0.65

1.3

N/a

N/a

N/a

0.7

n/a

0.8

N/a

N/a

N/a

0.4

n/a

1.6

N/a

N/a

N/a

Source Batini, Eyraud, and Weber (2014) and author’s own creation

Eurozone crisis is the story of a systematic mispricing of public debt, leading to macroeconomic instability and conditions of multiple equilibrium. Thus, markets show their preference for low interest rate sovereign bonds reflecting the belief that the default rate is low, while showing their aversion by increasing pricing on other sovereign bonds. In this case, however, they are more likely to incite the breaching of obligations, pushing these countries in a self-fulfilling way to bad equilibriums.2

438

P. E. PETRAKIS

In order to address the multiple equilibriums problem in the euro area, the ECB maintained the marginal monetary policy conditions by providing monetary liquidity (Blanchard, 2011). Its main concern was to keep public debt financing lines open by keeping its financing costs within a reasonable fluctuation band. To do this, however, investors need to be persuaded that they can liquidate their bonds, or to know that the ECB will intervene in the bond market at any given time. Otherwise, a demand for higher interest rates on the part of investors is inevitable in order to finance a country’s debt thereby increasing the likelihood of a country going default. This process amounts to a self-fulfilling prophecy in terms of the unfolding of the crisis in the euro area. This trend among investors can lead the system to a dead end (Blanchard, 2011). In order to convince bond buyers to move to the correct point of equilibrium, there has to be either a general intervention price, or abundant internal liquidity in the system. However, if the extra liquidity is provided and there is not enough production capacity, the risk of inflation emerges. This risk is higher in Europe than it would be if something similar were to happen in the USA, as Europe is characterized by segregated markets, especially that of labor. Thus, the conditions of output gap in Southern Europe (high unemployment, low demand) can coexist with conditions of reduced output gap in the European North. At the end of 2011, the ECB increased funding for the financial system by offering three-year credits (e200 billion at the beginning of 2012) in sterilized form. Specifically, in December 2011, the ECB announced the three-year Long Term Refinancing Operation (LTRO) for the support of the Eurosystem. Thus, many European banks resorted to drawing large-scale capital from the ECB. In September 2012, the ECB announced a new plan to tackle the debt crisis in the Eurozone, The plan, known as Outright Monetary Transactions (OMT), enables the Central Banks to intervene in the secondary bond market of troubled countries to promote the transmission of an appropriate monetary policy. The OMT differs from quantitative easing (QE). The liquidity generated by OMT is fully sterilized. The OMT decision ceased the Security Market Program (SMP) (Fig. 19.2). It is noteworthy that, following the LTRO announcement, the pressure on the European money markets has fallen sharply. According to the ECB (2012), LTRO managed to squeeze the spread between LIBOR and the overnight interest rate, while reducing volatility on the financial markets, with the standard deviation falling to around 54%.

19

439

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

1400 1200 1000 800 600 400 200 Jul-17

Jan-18

Jul-16

Jan-17

Jan-16

Jul-15

Jan-15

Jul-14

Jul-13

Jan-14

Jul-12

MRO

Jan-13

Jul-11

Jan-12

Jul-10

Jan-11

Jan-10

Jul-09

Jan-09

Jul-08

Jan-08

0

LTRO

Fig. 19.2 ECB’s operations (in billion e) (Source Bruegel—European liquidity database and author’s own creation)

The ECB’s estimates suggest that decongestion was achieved primarily through compression of the liquidity element of spread LIBOR/OIS. With this monetary policy, although the European bond markets have been rescued, the financing of economies has not increased, despite an equal increase in deposits. The excess funding has ensured the prevalence of logical points of equilibrium in terms of the cost of the public debt of major economies, but without the additional funds being channeled to the economies of the countries. This establishes the critical importance of the confidence of investors and their perception of risk regarding the probability of a country’s bankruptcy and the effectiveness of the exercise of fiscal and monetary policy, especially in periods where these have a restrictive character. The importance of the issue stems from two features of risk perception. Firstly, it is an additional factor influencing the effectiveness of fiscal policy, especially when it is restrictive and socially burdensome. Secondly, because it may be an endemic feature of a society which is evolving in unexpected ways. It may therefore be affected by factors that are not of an endogenous economic nature.

440

P. E. PETRAKIS

Factors contributing to a country’s risk of bankruptcy include factors related to external risk, macroeconomic factors as well as liquidity risk. The role of a country’s fiscal institutions is also important, as credible fiscal institutions enhance the credibility of government policies, leading to a lower risk premium. At the same time, the markets reward high financial transparency and punish countries that do not submit accurate official fiscal data, by demanding a higher risk premium. However, the contagion effect can also be important, which can cause imbalances in some countries, not because of real economic links with countries experiencing a crisis, but because of changes in investors’ expectations and beliefs. Particular attention should be paid to the possibility of purely exogenous predetermination of risk perception. Mohl and Sondermann (2013) identified that the spread of the periphery countries between 2010 and 2011 was significantly affected by press statements on the issue of restructuring and rescuing countries. The more the political leadership of the European governments referred to these issues, the more the spread of these countries increased. Regarding the role of perception of risk in the effectiveness of fiscal policies, one would intuitively expect that in the face of increased doubts about reliability, the application of a restrictive economic program would contribute to the restoration of confidence, decreasing borrowing costs, hence making the program less costly for society. Empirical studies (Giavazzi & Pagano, 1990; IMF, 2010) confirm this intuitive logic. The IMF in particular, splitting 15 developed countries into two categories, high and low risk, concludes that the politics of deficit reduction for the case of countries where the levels of risk were high, had in fact less pronounced shrinking effects than for the low risk category. Despite this, experience from the Great Recession in 2008 has shown that the measures taken by many countries have failed to appease the markets’ concern about the sustainability of their debts, resulting in the skyrocketing of interest rates for many of them. The importance of risk from government bonds for macroeconomic stability (Corsetti, 2012) is related to the fact that it can adversely affect borrowing conditions in the wider economy. This implies that heavily indebted economies are particularly vulnerable to a negative spiral of self-fulfilling expectations. So, expectations for a deterioration of the fiscal balance can trigger the concern of the markets and, therefore, the rise in risk premiums, affecting the cost of borrowing for the domestic economy, which in turn leads to

19

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

441

a reduction of the demand and of the product, thus fulfilling the initial negative expectations. Therefore, if the fiscal adjustment is accompanied by an increase rather than a reduction of the default risk, then the results for the economy as a whole and in particular for debt sustainability, will be extremely negative.

19.4 Over-Indebtedness and the Debt Supercycle Hypothesis Debt management is one of the most critical determinants of growth conditions. Two fundamental issues arise and they concern: 1. The relationship between public debt and fiscal deficits with current and future economic activity and, hence, economic growth. 2. Long-term management and, hence, exiting problematic debt. The historical development of government debt as a percentage of GDP in developed countries is shown in Fig. 19.3. AŌer WWII

140

Covid-19 Pandemic 120

Global Economic Crisis

Great Recession

100 Great ModeraƟon

80

60

40

Great AccumulaƟon

Series2 Series3 Series1

20

1925 1928 1931 1934 1937 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018 2021

0

Fig. 19.3 Advanced Economies: Debt to GDP, 1925–2021 (Source IMF Historical Public Debt Database and author’s own creation)

442

P. E. PETRAKIS

Reinhart and Rogoff (2010a, 2010b) analyzed data relating to 44 countries for over 200 years for the debt and growth ratio. They identified a critical level, the debt-to-GDP ratio above 90%, which is critical for the relationship between the two figures. This finding was crucial for the European Union, because, following the 2008 crisis, the European Union and the Eurozone seem to have approached it. The correctness of this view would inevitably mean that the European authorities would have to take action to de-escalate debt. Kumar and Woo (2010) explore the impact of high government debt on long-term macroeconomic growth. Over the course of four decades, they identify a reverse relationship between initial debt and subsequent growth. Controlling for other determinants of growth, an increase of 10 percentage points of the initial debt-to-GDP, is associated with a slowdown in real per capita GDP by 0.2 percentage points annually, with the effect being somewhat smaller in advanced economies. The theoretical interpretation of the findings of Reinhart and Rogoff (2010a, 2010b), to do with the negative effects of debt increase on growth (not necessarily at the particular level of 90%), is associated with the principle of Ricardian Equivalence.3 A line of reasoning running counter to the logic of Ricardo’s equivalence is provided by Krugman (2013) who argues that the efficient market hypothesis is difficult to implement in the real world. But even in the case that assumptions are present (perfect connections within a generation, non-distorting taxation, perfect rationality), the increase in expenditure does not have to be permanent. It is sufficient for governments to ensure that the debt grows at a rate lower than the tax base. This was how the developed countries came out of debt in the past by essentially applying Keynes’ views, at a time when, for example, Great Britain’s debts compared to its GDP between 1914 and 1956, they were much larger than in the period 2008–2010. Reinhart and Rogoff’s paper received further criticism. Lowrey (2013) pointed out that it is difficult to lay straight lines between growth and debt given the plexus of factors involved, while T. Herndon, Ash, and Pollin (2013) identified several elements that radically changed the final results (coding errors, selective exclusion of available data, and unconventional weighting of data). Their findings specifically show that the average real GDP growth rate of countries with debt levels above 90% of GDP is 2.2, rather than −0.1, as Reinhart and Rogoff had estimated. At the same time, after some errors had been corrected, the critical figure

19

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

443

of 90% ceased to be decisive for growth. The research of Reinhart and Rogoff contained, moreover, a serious conceptual problem: it did not provide any evidence for the direction of causality between high debt and growth. The possibility of debt increase due to recession rather than causing it, is considered to be actually greater (Irons & Bivens, 2010). In conclusion, Krugman (2013) who sees a connection between high debt and slow growth, cites the example of Italy and Japan which, as he states “historically have high debts due to the slowdowns in the growth, not the other way around.” In general, the debt problem has two sides, both of which are equally important. The first one concerns the formation of deficits (flows) that reflect the outcome of economic policies and add up to debt. The second, concerns accumulated government debt (stocks). It can be considered that the debt-to-GDP ratio—influenced mainly by the height of the debt—is unusual, given that there are times when it is considered as a key criterion for making a decision (in the case of small European peripheral countries), whereas at other times, its importance is disregarded (as in the case of Great Britain and Spain). The deficit-to-GDP ratio is more stable, as the ability to repay it significantly affects expectations. However, it is characteristic that the deficit, growth rate and this cost of capital create the so-called Snow Ball Effect which changes a country’s risk profile. This phenomenon describes how to increase the ratio of public debt to GDP, even if the primary deficit (fiscal deficit minus interest payments) is zero, i.e., even if there is no new borrowing by the public sector. Given that the debt has to be serviced every year, when a country pays interest to creditors, the rate of change of the existing debt, when there is no new borrowing, is the same as the interest rate. Thus, when the rate of change in nominal GDP becomes less than the interest rate, the government debt-to-GDP ratio increases (i.e. the numerator increases faster than the denominator). The debt-to-GDP ratio in the Eurozone increased significantly after 2008, mainly as a result of fiscal restraint measures. Given that the policies implemented (overall, but quite specifically in Europe) aggravate the debt-to-GDP ratio in the short term, the question that arises is: what can the possible economic policy be of long-term containment of the debt? There are five options: 1. Achieving high growth. This is the hardest choice of all, especially in the aftermath of a financial crisis, when the possibilities of the private

444

P. E. PETRAKIS

and public portfolio are limited. The problem is, however, exacerbated when state entities, such as monetary unions, are involved (i.e. the Eurozone). 2. Fiscal and structural adjustments. These have a long-term horizon with short-term adverse effects. These policies have been largely implemented in Europe since the 2008 crisis. 3. Monetization of debt/inflation. The increase of quantity of money in circulation is the least dangerous solution for borrowers, although it is not a satisfactory solution for households, businesses, and those who have savings. 4. Linear debt reduction. This includes debt readjustment, mainly in the direction of expansion or restructuring, including explicit default options (with all this may entail). 5. Implementation of a fixed installment financial repression policy.4 This may be accompanied by stable, though not very high, inflation levels. The last method worked extremely effectively in the case of the United Kingdom (UK) and, more generally, in the case of debts which the victorious powers had accumulated after the Second World War. The use of inflation as a tool for devaluing debt is not a new concept. The main objective of financial restrictions is to reduce real interest rates. The increase in inflation reduces real nominal interest rates and, therefore, debt. At the same time, the likelihood increases of negative real interest rates (i.e. liquidation effect). Such possibilities may lead to a reduction in debt and deficits, especially in heavily indebted countries. Essentially, it is a transfer of wealth from creditors to lenders. However, the expected benefits (i.e. the reduction of government debt) will be balanced by the negative effects of such a policy (i.e. high inflation, uncertainty, transaction costs and transaction difficulties). Years after the Great Recession, all major economies continued to have higher debt levels, as a percentage of GDP, than in 2007. Rogoff (2015) argues that the issue of debt overhang and debt accumulation is behind what happened after the outbreak of the Great Recession in 2008. The deleveraging process will however reduce the dangerous overindebtedness to a sustainable level. As he states “some argue that we live in a world of insufficient demand, doomed to decades of secular stagnation. Maybe so. But another possibility is that the global economy is in the

19

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

445

final stages of a Debt Super Cycle and is being crushed under the weight of a load which has been accumulated through years of flexible regulations and financial excesses.” Rejecting the notion that the global economy is in a condition of secular stagnation, this view (Rogoff, 2015) argues that the super cycle of the debt is not forever. When deleveraging and adverse lending abate, expected growth trends may prove to be higher than mere projections of recent performance may show.

19.5 Increasing Supply Opportunities, Structural Changes, Ordoliberals and Neo-Mercantilism When theory is led to the conclusion that it is not possible long term to use macroeconomic tools for influencing the real economy, because this is not effective as: (a) there is no fiscal space available and (b) state intervention should be kept to a minimum in order not to cause structural impact on the economy, that opens the way for the logic of structural changes. These can be a tool with which dynamics of development can be created. Structural changes relate to the process of deregulation of product and labor markets, and seek to create incentives that will improve the investment climate and productivity and reduce transaction costs. At the same time, they seek the reduction of subsidies and social transfers, since they claim that these create disincentives for work and productivity. The supporters of this theory reached the height of their influence during the Reagan presidency (1981–1989) in the United States and formed the so-called Reaganomics. The term supply side was used for the first time in the USA after 1975 and was supported by two important economists Arthur Laffer with the help of the Laffer curve, showed that the reduction of tax rates would create more revenue, as it would be beneficial for the increase of production and taxable income and Mundell (1971), who, however, did not receive the Nobel Prize for his contribution, but for his contribution to the development of Optimal Currency Areas. The logic of the economic policies of the supply side is based on theoretical considerations that form an organized platform with a range of economic policies named Austerity Policies. These views can be summarized in the following points:

446

P. E. PETRAKIS

1. Debts, whether national or private (as a percentage of GDP), must be reduced, because, once above a certain level, they pose a threat to medium-and long-term growth. 2. Structural measures (including internal devaluation) are needed to deregulate production and increase confidence in the economic system. In this case, future taxes will be reduced, current consumption will increase and the problems caused by fiscal adjustment will be addressed. 3. If there is an increase in the current taxes or debt (and therefore taxes in the future), the level of demand will remain unchanged, reflecting the Ricardian Equivalence: an increase of savings for the payment of future taxes that will be imposed for the repayment of the debt and, therefore, reduce consumption. Expansionary fiscal policy is therefore not a sustainable solution. 4. Monetary policies that stimulate excessive investment lead to increased risks of inflation and debt costs (i.e. see threat to growth). 5. The reduction of the deficit of Net External Investment Position is a top priority. Fiscal and external deficits need to be reduced. This is the reason for imposing internal devaluation, since the choice of external devaluation is not available. The implementation of a supply-side policy program requires a series of structural reforms relating to production, the consumption of economies and consumer sensitivity to price changes. Structural reforms are based on the adjustment of the current account balance and aim to restore sustainability. In more detail, structural reforms should follow three main directions (Goldman Sachs 2012a): 1. increase in the share of tradable goods in production, 2. improving price elasticity between non- tradable goods and tradable goods; and 3. labor market reforms to change the inclination of the Phillips curve or shift it to the right. Structural adjustment can occur through changes in demand between tradable and non-tradable goods. The greater the production of tradable goods in a country of a periphery country, the easier it is for it to make

19

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

447

the necessary adjustment in the current account balance and to regain its lost competitiveness. Regarding the relationship of prices and unemployment (Phillips curve) in terms of reducing the cost of fiscal adjustment—both in terms of loss of product and in terms of employment—the implementation of structural changes in the labor market is expected to contribute in this direction. As we know, for each economy, the Phillips curve captures the relationship between inflation and product based on specific parameters (the ratio of tradable and non-tradable, elasticities, etc.), even if this relationship is not linear. As a result, the ever increasing decline in GDP is not matched by a corresponding fall in inflation and does not bring the expected benefits for regaining competitiveness. Change in the cost of fiscal adjustment can occur by changing the inclination of the Phillips or through shifting it. Figure 19.4 shows how the situation can be changed if the Phillips curve does not become flatter as the productive gap becomes negative. Structural changes in labor can change the inclination of the curve and improve the exchange ratio between unemployment and inflation. For a given level of loss, in terms of output or unemployment, the improvement InflaƟon 8 7 6 5 4 3

b

c

a

2 1

b' -8

c'

-6

-4

Output

0 -2

-1

0

2

4

6

-2

Fig. 19.4 The Phillips curve and macroeconomic adjustment (Source Goldman Sachs [2012b] and author’s own creation)

448

P. E. PETRAKIS

in competitiveness (inflation reduction) is greater. Similarly, the downward and right curve shift results in a higher output for a given inflation level. Those who are in favor of austerity and supply-side programs, consider that problematic economies should be able to soundly increase Net External Investment Position or reduce the ratio of Net External Investment Position to GDP. However, the extent and speed of such a policy should be such as to achieve the Required Adjustment (RA). Obviously, the achievement of this objective depends on the size of the levels of private and public debt (stocks), and net balance of the current transactions account (flows) (Roubini, 2011) and in particular, on the net balance of international tradable goods. So, then, the last size, the flow, should become positive, so as to also reduce the stock. If there were floating exchange rates, an initial depreciation of the real exchange rate would be sufficient (ceteris paribus). As there is not a possibility of a change in the exchange rate, the supporters of Austerity policy argue that devaluation should be done mainly through the reduction of labor costs (internal devaluation). This reasoning applies where there is a system of fixed exchange rates. When everything else remains stable, the Required Adjustment, the extent and speed, i.e., the intensity with which the economy will have to adapt to the program, given the logic of supply side, depends on five key parameters: 1. the share of tradable goods and services in production 2. the share of non-tradable goods in consumption 3. the elasticity of demand for tradable versus non-tradable goods and services 4. the share of domestic production in total tradable goods and services 5. the elasticity of demand for domestically produced tradable products against externally produced products. The sum of factors determining the extent and the speed of adjustment of the economy can be described in Fig. 19.5. Fundamentally, in the transition period of the achievement of the RA, the resulting restructuring produces signals (changes in relative prices, destruction of certain areas and sectors) that reactive entrepreneurship which will shape the new model. It is obvious that this interval will not be

19

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

449

Fig. 19.5 Required adjustment (Source Author’s own creation)

less than 3 to 5 years. The reason is very simple, namely that to organize and deliver a new business effort takes 3 to 5 years. If we include in this period one to two years of implementation of policy models, we conclude that the efficiency interval cannot be less than two to six years provided there are no external disruptive effects. The greater the RA, the greater the sacrifices required and the longer the time to achieve it. Conversely, if we try to shorten the time too much, then the annual amount of sacrifices that will be required (adjustment speed) will grow too. Structural adjustment can occur through changes in demand between internationally tradable (commercial products) and internationally nontradable goods (houses, land). For this reason, structural changes should take place, notwithstanding the structural rigidities observed. However, these structural changes involve and lead to resource shifts (between tradable and non-tradable sectors), while they also take time. This, however, creates unemployment and underemployment of capital. In the economy, there will be a reduction in wages, relative price changes, unemployment and underemployment of capital. These leads to a decline in demand in the economy and to recession. Demand reduction is therefore ultimately an intended and expected result, which accompanies the process of restructuring economies. From analyzing the thinking of the adherents of the policy of austerity that preceded, it becomes clear that the overall evolution of the relationship of the Net International Investment Position (NIIP) and the GDP, whose size needs to be reduced, requires its own time. This is mainly because the denominator, GDP, is also falling which makes it very difficult for the NIIP/GDP ratio to stabilize at a steady decline.

450

P. E. PETRAKIS

It is often said that the German approach to tackling the debt crisis in the Eurozone area, after 2010, which is largely an approach of increasing the possibilities of supply side, with a particular emphasis on price stability, is based on the influence of the Ordoliberals and on the historical experience of the hyperinflation during the Weimar Republic. Ordoliberalism is closely connected with the first phase of the social market economy from 1948 to 1966, with main exponents economists such as Walter Eucken, Franz Böhm, Leonhard Miksch, and Hans Grossmann-Doerth. The spread of ordoliberalism was initially a reaction to the uncontrolled neoliberalism of the first years of the twentieth century, and later to the financial and monetary interventionism of the Nazis. At the same time, due to the strengthening of reconstruction in Germany and the improvement of living standards, the social economy of the market remains very high in the German political debate. German economic thinking on price stability through the application of countercyclical policies, is summarized in the following points (Dullien & Guérot, 2012): 1. Economic policy coordination: while several countries in the Eurozone, such as France, believe in a common economic policy, the Germans have their reservations. 2. External imbalances: The German mainstream sees current account imbalances in the Eurozone as a consequence of the loss of competitiveness and excessive consumption in the countries presenting fiscal deficits. 3. Fiscal consolidation: fiscal consolidation must be achieved by reducing government expenditure and, to a lesser extent, by increasing taxes. Difficulties in achieving fiscal targets are considered by Germany as a failure of the political class to make the necessary cuts or tax increases. 4. ECB purchases bonds: Germany is concerned that the ECB will not be able to restrict bond markets, with the result that the ECB will become the permanent financier of the Eurozone countries’ fiscal deficits. This triggers moral hazard and inflation. The creation of the external surpluses which was associated with the economics of supply and ordoliberalism essentially had the form of a neomercantilism, where, however, the accumulation of valuable reserves by means of the accumulation of hard currency and the concept of national

19

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

451

sovereignty (possibly including an aspects of a national military defense) had been replaced by the concept of national economic superiority. Otherwise, though, neo-mercantilism does provide a vision in which the state and private companies are allies and cooperate in pursuit of common goals. Consumers can hope to increase employment and to introduce the most economic goods and services, because of their strong currency and thanks to external suppliers. Can significant primary surpluses solve debt problems? It is doubtful. The work of Eichengreen and Panizza (2014) shows that this rarely happens. Using a sample of 34 developed and developing countries for the period 1973–2013, they try to identify the factors associated with the appearance over time of high primary surpluses. As they note, GDP growth of 1% leads to an increase of 7.5% in the likelihood of long-term high surpluses. They arrive at the same results regarding the balance of current account (increase of 1.8% of the probability) and the debt-toGDP ratio (increase in the debt-to-GDP ratio by 10% leads to an increase in the likelihood of a surplus by 2.4%). From an economic perspective, in times of recession, the maintenance of primary surpluses is even more difficult, as reduced tax revenues and cutting spending creates a vicious circle of low income and economic activity. Regarding political factors, Eichengreen and Panizza (2014) identify a positive effect of a left-wing government on the occurrence of surpluses (an increase in the likelihood of a surplus by 7.7%). But why is a leftist government more likely to be able to manage public finances better? Answering such a question is not easy and requires a great deal of research. Although authors do not attempt a definitive answer, there appear to be four possible ways of approaching this task: The first relates to the principle of inclusivity. This is the political process of including in political participation and incorporating in the exercise of the power, strata of the population that were previously cut off from the political processes. Through political incorporation, they improve their fiscal consciousness. This, of course, implies improved liquidity conditions in the economy. The second relates to the possibility of pursuing a more disciplined fiscal policy, given that strong opposition voices are now disappearing, at least for a time. The third relates to the inclusion of nationalist elements of independence in the pursuit of economic policy. The fourth is related to the possible disengagement from political commitments toward strata that have traditionally and massively evaded tax, thus broadening the tax base. All this, of course, is true provided that policies are exercised by an effective public administration.

452

P. E. PETRAKIS

Notes 1. Eichengreen and O’Rourke (2010) argue that one should not be surprised by the magnitude of the error of IMF calculations, as the calculations are in agreement with the theory that “the fiscal multiplier will usually be large when there is little monetary response in fiscal stimulus, either because interest rates are at zero lower bound, or for other reasons.” 2. The occurrence of bad equilibriums mainly affects countries belonging to a monetary union which have no control over their exchange rates. Emerging countries face a similar problem, which, due to the underdeveloped domestic financial market, are forced to issue foreign currency debt (Eichengreen, Hausmann, & Panizza, 2005). 3. This principle argues that if consumers are fully predictable and fully accessible to the capital markets, then, any increase in debt will lead to a reduction in their current consumption because they will take into account the future burden of tax increases. Indeed, their reduction in consumption will be so large as to undo the benefits of an expansive fiscal policy. The simple thought behind the theorem is that rationalists realize that substituting taxes today with future taxes plus interest rates through debt financing, is the same thing (Barro, 1974). 4. The term financial repression first appeared after 1970 in the works of the Shaw (1973) and McKinnon (1973) in the form of systematic debt reduction using certain tools (Reinhart & Sbrancia, 2011). These tools include: (a) Direct limits on debt interest rates (e.g. administrative or legislative restrictions on lending rates or the maintenance of a targeted monetary policy by institutions and banks). (b) Mandatory debt financing from internal sources of savings, such as social insurance funds, under certain conditions which ensure the long-term depreciation of the fiscal load. (c) Imposition of taxes and duties on financial transactions. (d) Other instruments, such as the nationalization of banks and restrictions on the administrative framework of the financial sector.

References Alesina, A., & Ardagna, S. (2010). Large changes in fiscal policy: Taxes versus spending. In J. R. Brown, Tax policy and the economy. Cambridge, MA: National Bureau of Economic Research. Auerbach, A. J., & Gorodnichenko, Y. (2012a). Fiscal multipliers in recession and expansion. In A. Alesina & F. Giavazzi (Eds.), Fiscal policy after the financial crisis. Chicago: University of Chicago Press.

19

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

453

Auerbach, A. J., & Gorodnichenko, Y. (2012b). Measuring the output responses to fiscal policy. American Economic Journal: Economic Policy, American Economic Association, 4(2), 1–27. Auerbach, A. J., & Gorodnichenko, Y. (2014). Fiscal multipliers in Japan (NBER Working Paper No. 19911). Barro, R. J. (1974). Are government bonds net wealth? Journal of Political Economy, 82, 1095–1117. Batini, N., Callegari, G., & Melina, G. (2012). Successful austerity in the United States, Europe, and Japan (IMF Working Paper No. 12/190). Batini, N., Eyraud, L., & Weber, A. (2014). A simple method to compute fiscal multipliers (IMF Working Paper No. 14/93). Baum, A., Poplawski-Ribeiro, M., & Weber, A. (2012). Fiscal multipliers and the state of the economy (IMF Working Paper No. 12/286). Blanchard, O. J. (2011). Blanchard on 2011’s four hard truths. IMF direct. Blanchard, O. J., & Leigh, D. (2012). Growth forecast errors and fiscal multipliers (NBER Working Papers No. 18779). Botev, J., Fournier, J., & Mourougane, A. (2016). A re-assessment of fiscal space in OECD countries (OECD Economics Department Working Papers, No. 1352). http://dx.doi.org/10.1787/fec60e1b-en. Canzoneri, M., Collard, F., Dellas, H., & Diba, B. (2012). Fiscal multipliers in recessions. Bern: University Bern. Corsetti, G. C. (2012). Has Austerity gone too far? VoxEU.org. De Grauwe, P., & Ji, Y. (2012). Mispricing of Sovereign risk and multiple equilibria in the Eurozone (Economic Policy CEPS Working Documents). Dullien, S., & Guérot, U. (2012). The long shadow of ordoliberalism: Germany’s approach to the Euro crisis (European Council on Foreign Relations, ECFR/49). ECB. (2012). Monthly Bulletin. Eichengreen, B., Hausmann, R., & Panizza, U. (2005). The pain of original sin. In B. Eichengreen & R. Hausmann (Eds.), Other people’s money: Debt denomination and financial instability in emerging market economies. Chicago: Chicago University Press. Eichengreen, B., & O’Rourke, K. (2010). A tale of two depressions: What do the new data tell us? VoxEU.org. Eichengreen, B., & Panizza, U. (2014). A surplus of ambition: Can Europe rely on large primary surpluses to solve its debt problem? (CEPR Discussion Paper No. 10069). Giavazzi, F., & Pagano, M. (1990). Can severe fiscal contractions be expansionary? Tales of two small European countries. Cambridge: MIT Press. Goldman Sachs. (2012a). Achieving fiscal and external balance (Part 1): The price adjustment rewuired for external sustainability (European Economics Analyst, Issue No: 12/01).

454

P. E. PETRAKIS

Goldman Sachs. (2012b). Achieving fiscal and external balance (Part 4): Escaping the vicious circle (European Economics Analyst, Issue No: 12/04). Heller, P. (2005). Fiscal space: What it is and how to get it. Finance and Development, 42(2) Herndon, T., Ash, M., & Pollin, R. (2013). Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff (Political Economy Research Institute Working Paper No. 322). University of Massachusetts Amherst. IMF. (2010). Recovery, risk and rebalancing. IMF World Economic and Financial Surveys, World Economic Outlook. IMF. (2012). Coping with high debt and sluggish growth. World Economic Outlook. Irons, J., & Bivens, J. (2010). Government Debt and economic growth: Overreaching claims of debt “threshold” suffer from theoretical and empirical flaws (Economic Policy Institute, Briefing Paper No. 271). Krugman, P. (2011). A note on the Ricardian equivalence argument against stimulus (Slightly Wonkish). The New York Times. Krugman, P. (2013). How the case for austerity has crumbled. The New York Review of Books. Kumar, M., & Woo, J. (2010). Public debt and growth (IMF Working Paper No. 10/174). Lowrey, A. (2013). A study that set the tone for austerity is challenged. Economix. Retrieved from http://economix.blogs.nytimes.com/2013/04/ 16/flaws-are-cited-in-a-landmark-study-on-debt-and-growth/. McKinnon, R. I. (1973). Money and capital in economic development. Washington, DC: Brookings Institute. Mohl, P., & Sondermann, D. (2013). Has political communication during the crisis impacted sovereign bond spreads in the euro area? Applied Economics Letters, 20(1), 48–61. Mundell, R. A. (1971). Monetary theory, pacific palisades. Pacific Palisades, CA: Goodyear. Owyang, M. T., Ramey, V. A., & Zubairy, S. (2013). Are government spending multipliers greater during periods of slack? Evidence from 20th century historical data (NBER Working Paper No. 18769) Reinhart, C. M., & Rogoff, K. S. (2010a). Growth in a time of debt (NBER Working Paper No. 15639). Reinhart, C. M., & Rogoff, K. S. (2010b). From financial crash to debt crisis (NBER Working Paper No. 15795). Reinhart, C. M., & Sbrancia, M. B. (2011). The liquidation of government debt (NBER Working Paper No. 16893). Rogoff, K. (2015). Debt supercycle, not secular stagnation. VoxEu.org, Retrieved from http://voxeu.org/article/debt-supercycle-not-secular-stagnation.

19

THE MACROECONOMIC AND DEVELOPMENT DEBATE …

455

Roubini, N. (2011). Four Options to Address the Eurozone’s stock and flow imbalances: The rising risk of a disorderly break-up. Roubini.com. Shaw, E. S. (1973). Financial deepening in economic development. New York: Oxford University Press. Stiglitz, J. (2014). Reconstructing macroeconomic theory to manage economic policy (NBER Working Paper No. 20517).

CHAPTER 20

Growth and Development Implications of Covid-19

20.1

Introduction

The chapter1 identifies the new issues raised in the global economy by the emergence of Covid-19 and its impact on economic development and growth. The Covid-19 crisis started from China (Hubei, 59 million inhabitants) at the end of 2019 and beginning of 2020. When Covid-19 extended to the West, it raised issues on supply and demand, and increased uncertainty. The epidemiological crisis has brought a rapid sudden stop to the world economy for the main economies that is comparable to the crisis of 1929 and 2008. The recession was characterized as short term (2020 and 2021) but is estimated to have medium-long-term effects. This chapter, after presenting a small history of the pandemics over the last two centuries (Sect. 20.2), analyzes the economic effects of Covid19 (Sect. 20.3) with an emphasis on the effects on growth rates. A number of changes expected to take place in the world after the 2020 crisis (Sect. 20.4) and the impact on the financial sector (Sect. 20.5) are highlighted below. The Sect. 20.6 presents the parts of the economic theory triggered by the advent of Covid-19. Finally, Sect. 20.7 presents the most significant impacts of Covid-19 on the most important areas of economic policy, while Sect. 20.8 lists the long-term economic effects of the Covid-19 crisis. © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_20

457

458

P. E. PETRAKIS

20.2

Pandemics and Economy in the Human History

Since the early days of humanity, diseases have been in line with human nature and evolve along with it. However, the creation of organized societies and the rise in trade has favored both communication and interaction between people and animals, which in turn has encouraged the creation of diseases. It is typical that diseases such as malaria, tuberculosis, leprosy, influenza, and smallpox started to emerge at that time. So as the communication between individuals, organizations and thus ecosystems increases, with particular emphasis on disrupting the natural life of different societies, the more likely was that epidemics would develop that would be turned into pandemics. These diseases are a vulnerability of people, but scientific progress has achieved remarkable successes against their spread. The main reason we are interested in the history of pandemics is because we are interested in identifying similar cases of the Covid-19 crisis and learn from past experience. The most important epidemiological and pandemic crises of the last two centuries are shown in Table 20.1. It is clear that the most important recorded historical pandemics and epidemics that affected and still affect the twentieth and twenty-first centuries show that such phenomena pre-existed and will continue to exist and form part of the history of mankind. In fact, pandemics appear to have a number of identical characteristics (Davies, 2020): (a) they Table 20.1 The main epidemics and pandemics that have occurred in the period 1918–2020 Pandemic name

Period

Deaths (million)

Spanish flu Asian flu Hong Kong influenza HIV/AIDS Swine flua SARS Ebola MERS Covid-19 (until 5/3/2020)

1918–1919 1957–1958 1968–1970 1981–present 2009–2010 2002–2003 2014–2016 2015–present 2019–present

100 2 1 25–35 0.2 0.00,077 0.011 0.00,085 0.244

Note a The numbers of the dead from swine flu are subject to discussion on the basis of new data Source Jorda et al. (2020), LePan (2020), Johns Hopkins University (2020) and author’s own creation

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

459

occur after prolonged periods of increasing economic prosperity; (b) first outbreaks are found at centers of trade and/or governance; (c) they break out in waves where the second wave is usually stronger; and (d) they appear in natural or social places where people come in close and continuous contact with nature. However, despite their common features, significant changes in the world economy over the last 50–60 years (changes in international interactions, speed of travel and supply chain dynamics) and in the structure of societies (women entering the labour market coupled with a change in the way they care for the elderly) have strengthened the likelihood and dynamics of pandemics (Davies, 2020). The rapidly evolving Covid-19 pandemic makes this situation historically difficult to compare. The parallels of the Covid-19 pandemic with world wars are limited, but it has been observed that over the past 200 years, when major disasters occur, countries have decided to generate substantial amounts of money through loans as economic support. And it is a matter of time to see whether this time the situation will be different or not (Horn, Reinhart, & Trebesch, 2020). The precise impact of the Covid-19 pandemic is currently unknown,2 but the experience of the Spanish flu of 1918–1919 has shown that important economic policies should be adopted to address it. This opens a major debate on the trade-off between mortality and economic recession (Barro, Ursúa, & Weng, 2020). The matter from the part of the economic policy is the impact these have on the economy as such major events lead to large macroeconomic policies that need to be studied.

20.3

Covid-19 Infects the Economy

The Covid-19 crisis has a number of features that allow us to separate it from previous financial crises and approach the elements that affect the economic impact of this phenomenon. It is a health crisis which initially broke out in China but has spread so fast to the G7 countries that it is considered to have burst almost simultaneously in some parts of the world.3 The Covid-19 crisis did not start in the economic field; it turned out unexpectedly, depriving economists of any predictive capacity, while it does not show any typical signs of concentric circular effects like in earlier crises but seems more like “entangled websites” (Baldwin & Weder di Mauro, 2020). The characteristic of all the major financial crises of the past is that they are strengthened by the movements of the “players” of the system

460

P. E. PETRAKIS

itself and “as a tropical storm on a hot sea, they gain more energy as they develop” (Danielsson, Shin, & Zigrand, 2009; Danielsson, Macrae, Vavanos, & Zigrand, 2020). The 2008 crisis, like the crises of 1866, 1766, and 1914, was an intrinsic risk crisis, as it essentially began due to interactions between market participants who, through synchronized decisions, sold assets causing a large liquidity reduction. But the Covid19 shock is an exogenous impact on the economic system. But because, as previous experience shows, in any systemic crisis (even if caused by an external shock), the risk to the economy is being intrinsically re-created (as it was the case in the 1914 crisis for example), we should expect this shock to be absorbed by the financial system as is the case with other exogenous shocks. But there is a possibility that the shock created by the coronavirus exposed the weaknesses of economies and markets, thus leading to a systemic financial crisis. However, the indications (May 2020) are reassuring—in part—about the long-term impact of this phenomenon as the shock from Covid-19 is extrinsic in nature since it is not caused by the weaknesses of the system, the banking sector and supervisory authorities are better organized and informed after the recent financial crisis of 2008 and high-risk lending is now also provided by non-banking institutions (Danielsson et al., 2020). There are therefore inevitable similarities between the 2008 crisis and the Covid-19 crisis, such as the business failures that are unfortunately expected to occur, the liquidity shortages and the great challenge for financial institutions where some may cease to operate. But in general terms, and with the main point of reference that the coronavirus is extrinsic and not intrinsic to the financial system, the problem arises in the real economy and outside the financial sector. The big issue, however, is that all this storm that break up over the real economy will require support from the financial system, which should be very stable so that it does not collapse in turn (see Sect. 20.5). Thus, the Covid-19 crisis is quite complex because it is essentially a simultaneous shock to supply and demand, while it increases uncertainty. One way in which the coronavirus damages the economy and productivity is the cessation in the supply of labor, goods, and services. People are sick, schools are closed and parents stop working and stay at home to take care of their children. Thus, quarantine can force workers to work from their home or even entire factories to suspend their operations. The strict restrictive measures introduced in China and Italy have aggravated this effect through the channel of supply.

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

461

The restrictions on people’s movement create a negative shock to labor supply (in fact they create an increase in unemployment). It is assumed that these conditions will last for at least one or two quarters in China and in other countries with large outbreaks (Italy, Germany, France and Spain) depending always on the situations observed. At the same time, as China—which is one of the world’s largest interconnected hubs—faces problems with the inflow of manufacturing products because its suppliers (Korea, Japan and Taipei), which serve as the centers of the global supply chain in this sector have also been affected by the virus; the supply and supply chain problem is becoming a major problem for Asia in particular. However, a similar picture can be found at Europe’s biggest hub, Germany (ranked 6th globally in terms of cases, as on 29 April 2020), which is the link with the other European countries. A similar picture is drawn in the USA, the third largest node, concerning manufacturing products (WTO, 2019). In addition, on the demand side, people buy less goods from shops than usual, travel transports are decreasing while they are not visiting food stores thus reducing food consumption from outside. Public health measures also limit economic activity. The impact on travel receipts is expected to be grave, given the imposed travel restrictions and the generally vulnerable climate in this sector. In addition to external demand, the spread of the coronavirus is expected to affect domestic demand as well. Private consumption is expected to decrease in the countries due to a deterioration in consumer confidence, preventive measures to prevent the dissemination of the coronavirus and the squeeze of household disposable income as a result of the decline in economic activity in general. Also, the increase in uncertainty and the deterioration of the investment environment should have a deterrent effect on new investment projects and risk-taking. Companies are subject to increased risk due to weak aggregate demand, while the pandemic is causing adverse effects. Uncertainty is likely to remain and feed the slowdown in productivity growth with delayed investment decisions by companies. Another important channel for transmission is the deterioration in international and domestic financial conditions. The increase in uncertainty is fuelling major turbulence in international financial markets, leading to a deterioration in the conditions for financing economies and a reconsideration of investment positions globally.

462

P. E. PETRAKIS

The simplified form of the circular money flow figure of the economy (see Chapter 4) shows the channel through which the health crisis is impacting the economic system. To be brief, in the flow of money graph, households sell their work to businesses which in turn sell the products/services to households. Also, households buy products/services from businesses and businesses pay wages and profits to households. The circular flow of money of the economy and the channels through which the circular flow of money is disrupted and thus the economic system, due to Covid-19, are described below (Baldwin & Weder di Mauro, 2020). Starting from the households, it is clear that if household wages are reduced or even worse, then this will lead to economic hardship and/or bankruptcy while reducing their consumption expenditure on business and also the flow of money to the government (taxes). But domestic demand problems will then also affect import payments, creating a shock to international demand. In a similar way, the decline in domestic demand in the rest of the world is affecting export payments. The fall in demand and supply disruptions can lead to disruption of the domestic supply chain, leading to further output reductions - especially in the manufacturing sector (Baldwin & Weder di Mauro, 2020). Unemployment is on the rise (Covid-19 “kills” jobs); as a result, the now unemployed consumers even when they continue to receive unemployment benefit or have another source of income, tend to reduce their expenditures. The first economic impact is determined by the scale of the restrictive measures imposed on each country, which have become increasingly pronounced in recent days. The subsequent impacts will be determined by the structural economic vulnerability of each country to Covid-19, which vary widely. By assessing (Oxford Economics, 2020a) a range of structural factors, including sectoral structure, business sizes, demographics, and health sector skills, it appears that the countries of northern Europe, as well as the German and French economies, have a better perspective to cope with the economic shock. The countries of the periphery of the Eurozone are considered to be more vulnerable. The southern economies of the Eurozone also tend to have the least fiscal space to respond and are in weaker cyclical positions. This reinforces the need for a coordinated European fiscal policy.

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

463

10 5 0 World

USA

Eurozone

China

Japan

-5 -10 -15 Pre- coronavirus baseline

Current baseline

Downside baseline

Fig. 20.1 World GDP growth (Source Oxford Economics/Haver Analytics [May 2020] and author’s own calculation)

Based on the global economic model of Oxford Economics (May 2020), two scenarios are created: The current baseline and the downside baseline, i.e., a scenario in which all countries have severe lockdowns, where these extend to the third quarter (possibly due to a second wave of the virus) and domestic activity is even more difficult to recover than as shown in China’s case, which is exacerbated by a weak global environment (Fig. 20.1). The analysis then focuses on the current baseline scenario. The magnitude of the shock in demand is dominated by any upward pressure on prices due to the supply chain being cut to such an extent that inflation is becoming negative for 2020. Only due to the aggressive policy is it expected to be positive in most economies, including China, Eurozone, US, in early 2022 (Continuum Economics, 2020). In labor markets, although wages and working hours are part of the adjustment, the rise in unemployment is widespread and rapid, with global unemployment reaching 10% at the end of 2020 from 5.2% in 2019. Thus, on the one hand, there are some people who expect that factors such as lower commodity prices, low oil prices, and labor market pressures will lead to a reduced rate of inflation. As Blanchard notes (2020), looking at the expected level of inflation through developments in the labor market, inflation expectations, shocks in commodity and food prices, as it has been the case in recent years, confirming the inflation rates actually achieved, no inflation growth is expected in the global economy as a result of the Covid-19 pandemic crisis. In fact, Krugman (2020) says that under

464

P. E. PETRAKIS

low interest rates and at the same time under the need for better living conditions (infrastructure, health, etc.) it is considered that stimulating economies takes the form of public investment. He therefore suggests that economies rather than using non-conventional monetary policy, and perhaps fiscal stimulus, should use large-scale public investment financed by deficits on an ongoing basis. On the other hand, there are those who argue that the very large increases in the budget deficits of the economies (at war levels) and in the balance sheets of the central banks, the massive expansions of currency reserves and long-term supply reductions and the sharp recovery of demand, may lead to high inflation levels (Miles & Scott, 2020). In fact, Goodhart and Pradhan (2020) note that the Covid-19 pandemic crisis is expected to mark the dividing line between the deflationary forces of the last 30–40 years, and of the emerging inflation rate of the next two decades, as this is the case after war periods. They also note that the significant increase in inflation will end when the economies’ debt returns to sustainable levels (see the issue of high debt, Chapter 19). Bruegel (2020) notes that if the overall supply side effects outweigh the demand-side effects, this will lead to a reduction in the product that is being produced, combined with an increase in prices, leading to stagflation conditions. The high cost of the Covid-19 pandemic to economies should also be expected to be linked to an increase in preventive savings as balance sheets are rebuilt. The early stage of recovery will be reinforced by political responses. In the medium-term, we see the global economy suffering from a loss of output of 4 percentage points. However, there are still risks as to whether this figure will be confirmed. An obvious risk of such a massive downturn is that it is causes a financial crisis, with all the medium-term effects that a prolonged period of reduced credit supply would have. This scenario requires that policymakers be able to effectively protect the global economy and the financial system. The bad scenario assumes a much higher output depression in line with the forecasts for the three scenarios (pre-Covid-19 scenario, baseline scenario after Covid-19 and downside scenario after Covid-19) according to Fig. 20.2 (the indicator where the pre-crisis quarter is t = 100). With regard to the main causes of the global slowdown, it is noted (FitchSolutions, 2020) that the pressure points are as follows:

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

465

120 Global Financial Crisis 115 110 105

Pre-Global Financial Crisis (January 2008) Current Baseline Pre-Coronavirus baseline (January 2020) Downside Scenario

100 95 90 85

Fig. 20.2 Production losses in the medium-term could be much higher (Source Oxford Economics/Haver Analytics and author’s own calculation)

– The delay in the growth of the Chinese economy, which is expected to lead to weaker demand for goods and commodities, supply chain problems and reduced tourism expenditures around the world. – The shock of supplies and demands in the global economy due to the large number of lockdowns. The effects of this phenomenon are job breaks, travel and transport restrictions, lower consumption, and lower profits. – The large and sharp increase in the stress on financial markets is expected to lead to a negative path to the global economy as the negative effects on wealth have started (sales of equity and negative effects on wealth, credit conditions are becoming more tight at a global level and currency values are undervalued). – Governments’ responses to economic policy that are uncoordinated are expected to lead to a prolonged period of uncertainty and are expected to affect consumption and the business climate.

466

P. E. PETRAKIS

20.4 Pandemic and Economic Recession Interactions The targeting of the epidemiological/preventive measures imposed around the world is aimed at smoothing the outbreak curve and allow as little recession as possible, mainly related to lockdown measures. Figure 20.3 shows the relationship between these two policy objectives: the flattening of the epidemiological curve and the flattening of the recession curve (Baldwin & Weder di Mauro, 2020; Gourinchas, 2020). At the top of the diagram is the evolution of the new cases without the imposition of restrictive measures and with the imposition of measures. Correspondingly, at the bottom of the figure, there is the depth of the recession without the imposition of restrictive measures and with the imposition of measures. The curve of the lower figure showing the recession with the existence of restrictive measures is sharper and deeper than the curve showing the recession without the existence of restrictive measures, i.e., the exact opposite is observed in relation to the upper part of the diagram. New cases

0.5 0.4 0.3 0.2 0.1 0

0

1

2

3

4

5

6

7

8

9

-0.1 -0.2 -0.3 -0.4 -0.5

Recession

New Cases without containment policies New Cases with containment policies Recession with containment policies Recession without containment policies

Fig. 20.3 The pandemic and recessionary curve (Source Baldwin and Weder di Mauro [2020], Gourinchas [2020] and author’s own creation)

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

467

It is obvious that—at least in the short term—the attempt to flatten the curve of the cases is hurting the economy. Restrictive measures, although necessary for the survival of society, cause a sharp economic pause. It is important to note, however, that even if the restrictive measures were not imposed, the recession would occur because it would be self-fed by the preventive measures and panic behaviors of households and businesses that would experience uncertainty and would have to deal with the pandemic without having a corresponding adequate response from the public health system (Gourinchas, 2020). In the modern and complex world, a state of economic pause, which stems from the rational behavior of individuals in an effort to protect and comply with restrictive measures, may cause chain interactions that negatively affect the economy. Even if science manages to reduce or even eliminate the virus, the impact on the economy as well as on the way economic decisions are made will be felt. So the point is to find the right mix of economic policy that works effectively to prevent significant economic effects while at the same time flattening the pandemic curve (see Sect. 20.7).

20.5

Finances of Covid-19

Dealing with the effects of the pandemic requires action from governments, which, however, can be characterized by significant challenges as they require an increase in government spending and a reduction in government revenue. These actions, due to their size but also the sudden need to implement them—where it is not possible to have a proper strategic plan ready from the previous years—reduce the fiscal space or make it negative, require help from central banks and from international and domestic organizations. This section presents the pressures on the state of the economy, the economic situation of businesses and the international economic situation due to the outbreak of the Covid-19 pandemic. 20.5.1

The Economic Situation Under Pressure

State interventions to prevent the spread of the virus but also to reduce its effects on people, businesses and the economy as a whole, is something that has been a priority not only during the Covid-19 pandemic as it is something that has taken place in similar cases of pandemics or epidemics

468

P. E. PETRAKIS

in the past (Hughes, 2020). However, in order for governments to be effective under these conditions, they must be able to sustain their finances despite their interventions, regardless of the intense pressures. Thus, in addition to the effects of the recession on the real economy, serious financial effects may also arise; if this is not taken into account, it may lead to a deepening of the risk and an expansion of the negative effects of the pandemic on the product produced (Oxford Economics, 2020b). Hughes (2020) presents—on the basis of experience with the management of previous pandemics in the last century—a series of lessons that we have learned. He notes the following: – Governments should expect a significant (even two-digit) reduction in the annual rate of GDP change. According to Brahmbhatt and Dutta (2008), previous influenza pandemics have shown that 60% of the economic loss is due to efforts to avoid transmission of the virus, while only 28% of the economic loss is due to sickness and absence and 12% to mortality. – Economic impacts could last for many months, if not years, if social distancing policies are to be maintained for extended periods. Past experience suggests that on average economies have not been able to return to a pre-crisis level until after 3 years. – Government deficits are expected to fall even in two-digit figures as a percentage of GDP, as economic shocks reduce revenues and tax compliance, healthcare costs are rising, while businesses and individuals benefit from tax relief, and the provision and support of salaries and loans. – Governments should aim at economic support and avoid universal or open offers to society and avoid fiscal policies that seek—without being necessary—to halt supply. One-off universal payments to all ( “helicopter money”) are administratively time-consuming, inefficient and unlikely to quickly stimulate the consumption, especially when most retail outlets are closed, and global supply chains are disrupted. On the contrary, budget support should focus on filling gaps in social security, ensuring that everyone has a minimum level of support and helping businesses to hold people and capital. – The priorities should consist of the expenditures in support of the health system and support for individuals and businesses, while

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

469

governments should look at how they themselves can succeed in selffinancing for extended periods, when spending is likely to exceed revenues by a large amount. – Central banks may need to provide temporary liquidity directly to governments to finance their deficits, especially as sovereign bond markets are temporarily disrupted. – Governments should resist the application of capital controls to protect their sources of funding, as this would further aggravate the global liquidity crisis, and further disrupt cross-border investment; trade and supply chains thereby putting the recovery of economies at risk. – Regional and international financial institutions (such as the IMF and the World Bank) must play a vital role in ensuring that governments are able to finance themselves through the pandemic. In this way economies will be able to cope more effectively with a pandemic even in its next wave, as there may be—as in the case of the Spanish flu—a second up to a fourth wave of the pandemic. 20.5.2

State Finances

As the global economy has been hit hard by the Covid-19 pandemic, governments are offering significant help to households and businesses to help them survive the lockdowns. At the same time, with lockdowns tax revenues are falling. Governments may therefore act directly to limit the effects of the pandemic today, but this should lead to major problems in their future economies (Boot et al., 2020). Of course, this does not mean that governments are mismanaging the response to the pandemic, as limiting aid to households and businesses would be disastrous (Economist, 2020). Moreover, the main objective of governments should be to provide maximum certainty and inspire confidence (Beck, 2020). But they must go on a difficult path between stimulating the economy today and showing prudence for the future, while success is not guaranteed. The consequences of a large increase in expenditures and a large reduction in public revenue have already started to emerge and are expected to remain in the economies for a long time. Debt in the rich world is expected to increase by $6 trillion (Economist, 2020). This is an increase from 105% of the GDP to 122% of the GDP, i.e., more than the increase

470

P. E. PETRAKIS

in debt in any year during the 2008 global financial crisis. In fact, the longer the lockdowns remain, the higher this increase is expected. Although markets expect low interest rates to remain at these levels in the long term, and central banks have recently reduced inflation targets, this is something that should be treated with caution since the precise economic impact of the pandemic is not yet known. Indeed, some estimate that as soon as the effects of the virus are reduced, then a spiral effect on prices and interest rates may break out toward the supply chains destroyed by the pandemic (Economist, 2020). In fact, higher inflation levels increase nominal growth and when this rate is higher than the borrowing rate this leads to debt reduction as a percentage of the GDP. Some economies have introduced tax systems that allow them to receive the bulk of income from high-income taxpayers, which in circumstances where capital gains (the main source of income of these taxpayers) have been particularly affected, makes tax revenues collapse. At the same time, economies that rely heavily on the tourism sector or energy are expected to bear a major impact as the pandemic accompanies large reductions in travel (either business or leisure) and large reductions in oil prices. In addition, the impact on the sustainability of the insurance system is high, as in many economies the insurance system was already underfunded as a result of the 2008 financial crisis (as it had not had the chance of recovering) and post-pandemic pressures are expected to exacerbate the problem. Especially in the case of Europe, as claimed by Boot et al., (2020) measures taken by governments to provide liquidity for businesses and banks are essential, but there should be a coordinated fiscal plan at a European level to directly support weaker economies. Finally, this plan (750 billion euros) was announced on May 27, 2020. 20.5.3

Corporate Finances

Sharp decreases in the product produced usually lead to an increase in delays and business loan failures, but this relationship cannot be fully predictable. There are several reasons why delays and business loan failures may increase more than expected as a result of the recession associated with the Covid-19 pandemic (Oxford Economics, 2020b):

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

471

– As interest rates are already exceptionally low, the margin for policymakers to reduce corporate debt through interest rate cuts is much lower than ten years ago. – The net debt-to-equity ratios are now at the level before the crisis and interest coverage has fallen despite low interest rates. – There is a deterioration in the quality of credit in the business sector, which is evident from the emergence of a large number of lowgrade and leveraged bonds and from the decline of large numbers of companies at very low rating grades by rating agencies; something that will probably disrupt credit markets. – There is also deterioration in the liquidity of firms (cash-to-debt ratio) and especially in smaller firms. – In addition to the above effects, there are also sectoral challenges affecting businesses, as there are several sectors of the economies which have been affected by the pandemic. The sectors with a continuous consumer interaction are the most vulnerable financial sectors with lower cash ratios and higher debt than average. For reasons such as these, the outbreak of the Covid-19 pandemic could reveal financial weaknesses and create a large number of companies facing severe cash flow problems as revenue reductions and liquidity reserves are rapidly decreasing for businesses. It is also true that low interest rates and low credit spreads have led to complacency about debt levels following the global financial crisis of 2008 and so there has been no significant deleveraging (Becker, Hege, & MellaBarral, 2020). Thus, the Covid-19 pandemic crisis finds the balance sheets of businesses and households enlarged and bank lending at an all-time high (IIF, 2020; Graham, Leary, & Roberts, 2015). In addition, it should be noted that the Covid-19 pandemic affected not only small and medium-sized enterprises but also large enterprises (De Vito & Gomez, 2020). De Vito and Gomez (2020) point out that while small and medium-sized enterprises and micro-enterprises are likely to have much lower liquidity reserves and less access to credit, it is also important to analyze the readiness of listed companies to address this crisis. In fact, as the Bank of International Settlements (BIS, 2019) notes, large public companies have to deal with a huge amount of corporate debt leading to the need for discussions on debt restructuring plans (Becker et al., 2020).

472

P. E. PETRAKIS

20.5.4

International Finances

International markets are particularly affected by the emergence of the Covid-19 pandemic. The Covid-19 pandemic has a very strong impact on international financial markets, as the value of the shares has fallen, and market volatility has been global (Baker et al., 2020). As in this pandemic, during crises, wars, or other external shocks, it has been observed that governments are transferring very large amounts of borrowing and subsidies to allies and others in need (Horn et al., 2020). Thus, economic crises have always been cases of state funding, including at international level (Kindleberger, 1984; Bordo & Schwartz, 1998; Eichengreen, 1995). Official creditors have played a particularly important role in international finance over the past two centuries (Horn et al., 2020). Horn et al. (2020) conclude that official lending by governments, central banks and multilateral institutions is much higher than we think and believe that this will probably also be the situation in the Covid-19 pandemic, significantly increasing the debt of economies. As economies are essentially suffering from a sudden stop of capital flows and extreme exchange rate volatility, the access to foreign currency liquidity (SWAPS) is necessary to prevent a health crisis in an economic downturn. As Yeyati notes (2020) the economies that may need more support from international organizations are emerging markets, especially after considering voices that “this time it is really different” (Reinhart, 2020) and that in order to avoid a debt crisis in emerging markets, a “whateverit-takes” approach (Ghosh, 2020) should be followed, including exceptional liquidity facilities in dollars (Lowery, 2020). As he notes, the reason for this is that emerging markets are losing quality by facing issues such as sudden disruptions in capital flows, currency pressures, credit spreads and reduced global demand. In fact, the Institute for International Finance notes that by March 2020 investors had already “drawn” $42 billion from emerging markets, a decrease that is the largest outflow ever seen. Although the management of the 2008 financial crisis now provides some experience for economic policymakers, there are still no clear answers to address all issues. The FED activated the dollar-swap lines with central banks of a few economies, similar to 2009 (Bahaj & Reis, 2018).4 Also, bringing these practices to emerging markets facing issues could be a success if the IMF managed the existing swap agreements on a large, strong currency liquidity network (Bahaj & Reis, 2018).

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

473

20.6 The Covid Moment, Monetization of Debt, Helicopter Money and Modern Money Theory Minsky (1986) took the view that three types of financing were found in the economies (see Chapter 16, Sect. 16.6): (A) compensatory financing, that is to say, when businesses rely on their future cash flows in order to repay the amounts borrowed; (b) speculative financing, where companies rely on their current cash flows to repay interest on their loans but should pass on their debt to pay the initial capital; (c) the most risk-prone case is the one called ponzi-type financing; where the cash flows are insufficient to finance either interest or loan capital. The “Minsky moment” in which a ponzi-style funding bubble breaks down results in a reduction in the value of assets and credits. There are not few people who consider that the Covid-19 pandemic crisis could be a case of a Minsky moment, even though it has not been characterized yet as such (May 2020). Such a possible development, which gives rise to considerable concern to economic policymakers and to the market, is causing budgetary and monetary policy to intervene in the foreseeable future in order to prevent it from happening. UNCTAD (2020) points out that a combination of deflation in asset prices, weaker aggregate demand, increased debt pressures and deterioration in income distribution could lead to a further downward trend. A case of widespread insolvency and possibly a “Minsky moment,” a massive collapse of asset values that would mark the end of the development phase, cannot be ruled out. In response to the effects of the Covid-19 pandemic, most governments around the world have started to implement various emergency actions (Baldwin & Weder di Mauro, 2020). As a result, probabilities of large-scale currency monetizations of the deficits created have increased, which is expected to result in a major high inflation episode (Blanchard & Pisani-Ferry, 2020). As pointed out by Blanchard and Pisani-Ferry (2020) the problem of large-scale currency-monetisation is caused by the tendency of central banks to trade in government bonds aiming to the sustainability of public economics rather than macroeconomic stability objectives. If interest rates are zero then there is no problem,5 but if there is in future an increase in monetary policy rates then the central banks will have to make incredible high interest payments. Of course, despite the fear that government practices will lead to largescale monetisation and thus to large-scale inflation incidents, there are

474

P. E. PETRAKIS

some who propose that Central Banks should “helicopter money” to their economies (Galí 2020). In fact, there are some who have been characterizing “helicopter money” as a monetary policy tool well before the onset of the Covid-19 crisis (Grenville, 2013; Reichlin, Turner, & Woodford, 2019). Of course, what is happening under the conditions of the Covid19 pandemic is that governments should provide capital to households and businesses and in a sense they do what is called “helicopter money,” although in a much more targeted way than that the central banks would do (Blanchard & Pisani-Ferry, 2020). Galí (2020) argues that “helicopter money” as fiscal interventions are particularly powerful tools, as they have a significant positive impact on the production and sales of businesses or even sectors facing supply or demand issues. However, there are reservations about their use as a policy tool and therefore they should only be used if they are very necessary and the other economic policy options are expected to have effects either on the short or on the long term. For this reason, Galí (2020) concludes that Covid-19 is perhaps the time to use them. The slowdown in developed economies in recent years has stimulated the so-called Modern Monetary Theory (MMT), which challenges conventional economic thinking on debt management, deficits, and other economic issues. Of course, this is a vision that began to draw the attention at the beginning of the 1990s, but the decade of fiscal adjustment following the 2008 global financial crisis and the depletion of formal monetary policy strategies and the increasing income inequality have salvaged it at a great extent recently (Fullbrook & Morgan, 2019). In fact, the recent large QE program from the FED that aimed at stimulating recovery and financing deficits for the US due to the existence of Covid19 and its economic impact such as ECB and BoJ, essentially imitates actions on which MTT is concentrated but not actually embracing them (Oxford Economics, 2020b). MMT focuses on countries with their own currency (Wray, 2019). It argues that a country with the possibility of printing its own currency can create and spend money freely as long as inflation remains under control. This does not force the country to stop paying its debts, since it can always print money to pay its creditors. It essentially requires a drastic increase in public spending to fight unemployment and promote social policy programs, but it also wants to see ECB support in this direction. It supports the printing of money for the financing of public programs, which will be directed directly to the real economy and not for money,

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

475

designed to stimulate liquidity in the financial markets, in the hope that this will then pass on to economic growth (Fullbrook & Morgan, 2019). Nersisyan and Wray (2020) note that MMT provides an analysis of fiscal and monetary policy that can be applied in countries with their own non-convertible currencies. Based on MMT, the sovereign currency issuer: (i) does not have an income restriction; (ii) cannot be left without money; (iii) fulfills its obligations by paying in its own currency; and (iv) can set the interest rate for any obligations it issues. However, the MMT also finds solutions for countries where the currency in circulation is issued by an institution outside the country, as is the case in the countries of the euro area. As Andresen notes (2019) this can be resolved by the introduction of a parallel national currency (Andresen, 2012, 2018; Andresen & Parenteau, 2015).

20.7

Economic Policies in the Time of Covid-19

World-wide management of the Covid-19 crisis has been built up on the trade-off between the functionality of the economy and the value of human life. Other leaderships favored the first against the second option more. In countries where the political leadership has chosen to safeguard society immediately, this has proved to be an excellent policy. The opposite option in favor of the functioning of the economy has had serious effects which quickly caused the collapse of economies with serious social hardship. A wait-and-see behavior which involved the development of economic policy in waves and the gradual development of the “defence” of the economic policy was preferable, for a number of reasons: (a) By early April 2020, in the majority of countries, there was a low epidemiological and economic load of information, making it difficult to shape the image of the immediate future. So we knew too little about the epidemiological characteristics (behaviours, drugs, tests, etc.). As time passes, information completeness improves and allows the formulation of a roadmap to exit restrictive social policies. (b) There was not enough analysis of the cost of the sudden stop of capital flows of economies since it was almost unannounced for epidemiological reasons.

476

P. E. PETRAKIS

(c) There was no image of the international and, in particular, of the European economic response to the crisis, but only national efforts. However, as time progresses in all three of the above, information has accumulated, and the availability of options is more visible. It is therefore advisable to replace the waiting period with an approach that uses concrete future scenarios, one of which is the dominant one and at least one will be the worst. If conditions change for any reason (extension of closed businesses, discovery of tests, medicines, vaccines, etc.), the prevailing scenario will be replaced by a better/worse scenario. An important issue that arises in relation to the economic policy to be followed is whether the primary issue of the economy is a fall in overall demand or a disruption in product supply. It is clear that supply problems are the first to emerge in the economic system and then the problems of overall demand were added (see Sect. 20.3). In this way, policies should initially be put in place to flatten the economic curve. As a result of such policies, they extend the length of time in which the phenomenon is still taking place, but reduce its intensity, thereby giving time to the state organization to proceed with strategic planning and implementation. Thus, appropriate time can be provided for the development of drugs and vaccines to deal with the virus or to prepare the health system and to produce medical masks, gloves, and other species for the protection of the population (Budish, Kashyap, Koijen, & Neiman, 2020). Policies to flatten the economic curve should therefore aim at the following (IMF 2020; Baldwin & Weder di Mauro 2020): (A) Ensuring the functioning of the main sectors of the economy. It should be ensured that companies—and especially those in sectors of the economy that have been hit more by the effects of Covid-19—continue to be viable. They may be strengthened by borrowing on favorable terms, with suspensions or even by discounts on tax payments, suspension of loan payments or even direct economic assistance. (B) Securing the livelihoods of the people affected by the crisis. It is important to ensure employment and pay for workers even if they should remain quarantined at home or stay at home to care for

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

477

family members. Households should be able to cover basic costs such as rent, utilities, insurance, etc. (C) Avoidance of widespread economic disruption. It is important that the financial system is also strengthened because, due to the economic difficulties of households and businesses, nonperforming loans are expected to increase. It must be ensured that the crisis does not turn into a long-term economic crisis. Central banks can provide emergency liquidity to the financial sector (e.g. the ECB has moved on among other actions to the TLTRO-III, the Pandemic Emergency Purchase Programme (PEPP), and the Corporate Sector Purchase Programme (CSPP). Their amount is estimated at around 1.3 trillion euros). Fiscal stabilizers (reduction of fiscal revenues and increase of transfer payments) also contribute to the bankruptcy of households and businesses. (D) Effective and transparent information for all members of society. During the onset of the phenomenon and after the emergence of most of the social consequences of the pandemic, governments should provide a framework to shape smooth living under social distancing measures. Thus, all critical information should be made known to the members of society by all means, and good practices and the functioning of institutions should be disseminated to provide for the lowest possible degree of the spread of the disease, while ensuring safety and the productivity of individuals. The policy mix needed to stimulate households, businesses and the financial sector includes both liquidity and solvency measures. Table 20.2 presents a number of policy proposals by the IMF (2020). The main objectives of policies should be to halt negative feedback and channels of transmission of the crisis since the recession is already in place. In the short term they will be monetary and budgetary, and in the medium- and long-term restructuring. The difference with the policies of the 2008 crisis lies in the fact that fiscal policy is now playing a more serious role because, firstly, monetary policy is almost exhausted (except for the extent of the debt monetisation) due to a zero-lowerbound approach, and secondly, because fiscal policy can better address supply distortions. The overriding objective of fiscal policy should be to improve the health system as this also means increasing the availability of intensive care units. Such a strategy plays a dual role as the system

478

P. E. PETRAKIS

Table 20.2 Policy measures to stimulate households, businesses, and the financial sector

Households

Undertakings

Financial sector

Liquidity

Solvency

Suspension of mortgage payments, student loans Deferrals of tax liabilities and social insurance contributions

Transferring cash

Extension of the maturity of loans Deferrals of tax liabilities and social insurance contributions Purchase of commercial securities and bonds Direct provision of credit by the central bank Credit guarantees Liquidity provision for financial intermediaries Actions to maintain market liquidity

Unemployment insurance Meal vouchers for pupils away from school Capital injection Subsidies to maintain employability Direct subsidies based on past sales (based on taxation)

Capital injection State guarantees

Note Liquidity measures include borrowing or deferrals of payments. Solvency measures include transfers, waivers from payments and non-refundable goods or services Source IMF (2020) and author’s own creation

has the potential to treat more patients at the same time, while the lockdown measures are being reduced. Let us not forget that one of the main reasons for restricting individuals and lockdowns is to enable the health system to respond to all incidents as required by medical rules and not in order of age priority. Of course, such support to the health system brings high budgetary costs. In addition, it is particularly important for markets and their functioning to make it clear to all that governments and supranational organizations (e.g. the European Commission) will be able to significantly support efforts to tackle pandemic phenomena. This can be done by sending strong signals in all directions, which may smooth the reactions of the markets. Also, as Gourinchas notes (2020), international organizations (such as the IMF, the World Bank, etc.) should be involved, with the help of developed economies offering necessary support to economies in need, and in particular to emerging economies.

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

479

An important issue remains the time to implement appropriate economic support policy. It is important that economic support packages are targeted, especially at the time of lockdowns and be extended to the period after, if the devastating consequences of the health crisis are not reduced. It is important that they act as a deterrent to the collapse of the economy (Baldwin & Weder di Mauro, 2020).

20.8

The Long-Term Effects of Covid-19

In addition to short- and medium-term effects, pandemics appear to have long-term effects which are significant. Major efforts to mitigate and contain the immediate effects of pandemics by governments lead to future uncertainty in economies. In an attempt to calculate these long-term effects, Jorda, Singh, and Taylor (2020) use data on long-term government debt yields from the fourteenth century (Black Death) onwards (Schmelzing, 2020) and estimate the effects of fifteen large pandemics on the European balance rate. They use the balance rate as it is an important variable for central banks and serves as a barometer for economies (Eggertsson, Mehrotra, Singh, & Summers, 2016). They conclude that pandemics have effects that can last for several decades: (A) after a pandemic, the natural interest rate falls by about 1.5 percentage points about 20 years later and returns to a pre-pandemic level about 40 years later. (B) Unlike pandemics, in the case of wars, the relative deterioration in capital relative to labor increases interest rates for about 30–40 years. (C) In addition, in line with the neoclassical growth model, the impact of pandemics on wages is contrary to the one on interest rates. As opposed to the Black Death, Mukherjee (2020) draws relevant conclusions on the real interest rate trend, noting that the Covid-19 pandemic could affect economic life for much longer than we expect. In fact, markets may well underestimate the long-term effects of the Covid-19 pandemic. The impact on the labor market of even entire sectors can be devastating for a huge number of employees, while at the same time, despite the fact that the pandemic may subside, markets may fail to assign proper prices with the expectation of a more slow longterm growth that can be the legacy of the Covid-19 pandemic (Oxford Economics, 2020b). In fact, the state of an economy and the level of the GDP depend significantly on the prior experience of the effects of external shocks, as is

480

P. E. PETRAKIS

the case with Covid-19. This is essentially the concept of hysteresis (Cerra, Fatas, & Saxena, 2020). There appears to be clear empirical evidence that fluctuations in GDP have a long-term impact on the future GDP trend (Cerra et al., 2020). The reason is that the cyclical shocks do not concern movements on the GDP trend but changes in this trend. Thus, the persistence of cyclical fluctuations can be seen as the trauma of an external shock in economies. These conclusions feed into the thought of low interest rates in the long term, strengthening the case of a secular stagnation hypothesis (Hansen, 1939; Summers, 2014) for at least two decades to come (see Chapter 18). A prolonged period of low real interest rates will probably provide fiscal space for governments to mitigate the consequences of interventions to combat the pandemic. In fact, secure government debt issues can help prevent a further downward trend in real interest rates (Jorda et al., 2020).

Notes 1. I would like to thank Dr. Kyriaki I. Kafka for her valuable contribution in the development of this chapter. 2. This book is authored in May 2020. 3. A number of recent health findings questions the start (spatial and temporal) of the pandemic. 4. In fact, this happened for the first time in 2001, when US money markets unexpectedly closed down and foreign banks with significant investments in dollars were in crisis. At that time, the FED created an emergency liquidity facility, lending the Bank of Canada, the Bank of England and the ECB up to USD 90 billion via a swap line to the domestic currency, and then these central banks lent their domestic banks. The consequences of this action were rapid, since after the opening of markets the swap line closed and the liquidity crisis was averted (Bahaj & Reis, 2018). 5. The purchase of bonds by the central bank in exchange for money—which is essentially the extent to which public debt is monetized—does not affect the dynamics of public debt (Blanchard & Pisani-Ferry, 2020).

References Andresen, T. (2012). A parallel emergency currency via the mobile phone network. Berlin: Studie des Bundesverbandes Mittelständischer Wirtschaft (BVMW).

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

481

Andresen, T. (2018). On the dynamics of money circulation, creation and debt—A control systems approach (PhD thesis). Norway, NTNU. Andresen, T. (2019). Initiating a parallel electronic currency in a eurocrisis country—Why it would work (Real-World Economics Review, Issue No. 89). Andresen, T., & Parenteau, R. W. (2015). A program proposal for creating a complementary currency in Greece. Real-World Economics Review, 71, 2–10. Bahaj, S., & Reis, R. (2018). Central bank swap lines. VoxEu.org. Baker, R. S., Bloom, N., Davis, J. S., Kost, K., Sammon, M., & Viratyosin, T. (2020). The Unprecedented Stock-Market Reaction to COVID-19 (NBER Working Paper No. 26945). Baldwin, R., & Weder di Mauro, B. (2020). Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes. A VoxEU.org eBook, CEPR Press. Barro, R., Ursúa, J., & Weng, J. (2020). Coronavirus meets the Great Influenza Pandemic. VoxEU.org. Beck, T. (2020). Finance in the times of coronavirus. In R. Baldwin & B. Weder di Mauro, Mitigating the COVID economic crisis: Act fast and do whatever it takes. VoxEU.org eBook, CEPR Press. Becker, B., Hege, U., & Mella-Barral, P. (2020). Corporate debt burdens threaten economic recovery after COVID-19: Planning for debt restructuring should start now. VoxEu.org. BIS. (2019). Annual economic report. Bank for International Settlements. Blanchard, O. (2020). Is there deflation or inflation in our future? VoxEu.org. Blanchard, O., & Pisani-Ferry, J. (2020). Monetisation: Do not panic. VoxEu.org. Boot, A., Carletti, E., Kotz, H.-H., Krahnen, J. P., Pelizzon, L., & Marti, S. (2020). Coronavirus and financial stability 2.0: Act jointly now, but also think about tomorrow. VoxEu.org. Bordo, M. D., & Schwartz, A. J. (1998). Under what circumstances, past and present, have international rescues of countries in financial distress been successful? (NBER Working Paper No. 6824). Brahmbhatt, M., & Dutta, A. (2008). On SARS-type economic effects during infectious disease outbreaks (Policy Research Working Paper No. 4466). World Bank. Bruegel. (2020). Three macroeconomic issues and Covid-19. Post by L. Cadamuro & F. Papadia, European Macroeconomics and Governance. Budish, E., Kashyap, A., Koijen, R., & Neiman, B. (2020). Three pillars of the economic policy response to the Covid-19 crisis. VoxEU.org. Cerra, V., Fatas, A., & Saxena, S. (2020). Hysteresis and business cycles (Centre for Economic Policy Research, DP14531). London. Danielsson, J., Macrae, R., Vavanos, D., & Zigrand, J.P. (2020). We shouldn’t be comparing the coronavirus crisis to 2008—This is why. WEF in collaboration with VoxEU.org.

482

P. E. PETRAKIS

Danielsson, D., Shin, H. S., & Zigrand, J.-P. (2009). Modelling financial turmoil through endogenous risk. VoxEU.org. Davies, S. (2020). The history and economics of plastics, going viral, iea, a Covid Briefing. Retrieved from https://iea.org.uk/publications. De Vito, A., & Gomez, J.-P. (2020). COVID-19: Preventing a corporate cash crunch among listed firms. VoxEu.org. Economist. (2020). Government finances after the disease, the debt. Eggertsson, G. B., Mehrotra, N. R., Singh, S. R., & Summers, L. H. (2016). A Contagious Malady? Open economy dimension of secular stagnation. IMF Economic Review, 64(4), 581–634. Eichengreen, B. (1995). Golden Fetters: The gold standard and the great depression 1919–1939. New York: Oxford University Press. FitchSolutions. (2020). Global economy in recession, but recovery likely to emerge by late year end. Fullbrook, E., & Morgan, J. (2019). Introduction: Whither MMT? (Real-World Economics Review, Issue No. 89). Galí, J. (2020). Helicopter money: The time is now. VoxEU.org. Ghosh, J. (2020). The COVID-19 Debt Deluge. Project Syndicate. Goodhart, C., & Pradhan, M. (2020). Future imperfect after coronavirus. Vox Eu.org. Gourinchas, P. O. (2020). Flattening the pandemic and recession curves. In R. Baldwin & B. Weder di Mauro, Mitigating the COVID economic crisis: Act fast and do whatever it takes. VoxEU.org eBook, CEPR Press. Graham, J. R., Leary, M. T., & Roberts, M. R. (2015). A century of capital structure: The leveraging of corporate America. Journal of Financial Economics, 118(3), 658–683. Grenville, S. (2013, February 24). Helicopter money. VoxEu.org. Hansen, A. (1939). Economic progress and declining population growth. American Economic Review, 29(1), 1–15. Horn, S., Reinhart, C., & Trebesch, C. (2020). Coping with disasters: Lessons from two centuries of international response. VoxEu.org. Hughes, R. (2020). Safeguarding governments’ financial health during coronavirus: What can policymakers learn from past viral outbreaks? VoxEu.org. IMF. (2020). Economic policies for the COVID-19 war. IMF Blog. Institute for International Finance (IIF). (2020). Global debate Monitor. Jorda, O., Singh, S., & Taylor, A. (2020). The longer-run economic consequences of pandemics. VoxEu.org. Kindleberger, P. C. (1984). Financial institutions and economic development: A comparison of Great Britain and France in the eighteenth and nineteenth centuries. Explorations in Economic History, 21(2), 103–124. Krugman, P. (2020). The case for permanent stimulus. VoxEU.org. LePan, N. (2020). The history of pandemics. Visual Capitalist.

20

GROWTH AND DEVELOPMENT IMPLICATIONS …

483

Lowery, C. (2020). 5-step policy response plan for COVID-19. Washington, DC: Institute of International Finance. Miles, D., & Scott, A. (2020). Will inflation make a comeback after the crisis ends? Vox CEPR Policy Portal. Minsky, P. H. (1986). Stabilizing an unstable economy. Hyman P. Minsky Archive. Retrieved from https://digitalcommons.bard.edu/hm_archive/144. Mukherjee, A. (2020). Black Death Makes Us Think About Interest Rates. Bloomberg. Nersisyan, Y., & Wray, L. R. (2020). What MMT is, and why we should not for the next crises to live up to our means. Retrieved from http://multiplier-effect.org/what-mmt-is-and-why-we-should-not-waitfor-the-next-crisis-to-live-up-to-our-means/. Oxford Economics. (2020a). Coronivirus fallout threatens financial stability. Research Briefing by Adam Slater. Oxford Economics. (2020b). Macro Musings. Research Compartaary by Schwartz B. Reichlin, L., Turner, A., & Woodford, M. (2019). Helicopter money as a policy option. VoxEu.org. Reinhart, M. C. (2020). This time Truly is different. Project Syndicate. Roubini, N. (2020). A Greater Depression? Project Syndicate. Schmelzing, P. (2020). Eight centuries of global real interest rates, R–G, and the ‘suprasecular’ decline, 1311–2018 (Bank of England Staff Working Paper No. 845). Summers, L. H. (2014). U.S. Economic prospects: Secular stagnation, hysteresis, and the zero lower bound. Business Economics, 49(2), 65–73. UNCTAD. (2020). Coronavirus: Can policymakers avert a trillion-dollar crisis? Wray L. R. (2019). Alternative means to modern money theory (Real-World Economics Review, Issue No. 89). WTO. (2019). Global Value Chain Development Report. Yeyati Eduardo Levy. (2020). COVID, Fed swaps and the IMF as lender of last resort. VoxEu.org.

PART IV

International Financial Architecture and the Consolidated Financial Transaction Framework

CHAPTER 21

The International Economic Architecture

21.1

Introduction

The evolution of international economic relations is interwoven with the existence of a globalized environment and a multidimensional world. Waves of globalization and international movement of individuals and capital have been happening throughout history. Many of these were of a cultural or militant character, but they all lead to the same outcome, the unification of the world. The first wave of modern globalization is believed to have occurred in the early nineteenth century, before 1914. Over the years there has been a huge increase in world trade, because new technological inventions such as steamships, the railway, canals, and the telegraph have significantly reduced the costs of trade. In addition, capital flows have increased and huge populations have moved. Liberalism and the Gold standard prevailed to a considerable degree and imperialism also advanced, which was, among other things, a mechanism of enforcement of trade-friendly regulations (Rodrik, 2011). So, inevitably, populations and national economies—at macroeconomic level—began to communicate, interrelate and influence one another. Globalization gave substance and universality to the way in which policymakers understood the world. The channels through which globalization grew and is still growing wider were the establishment and cooperation of the Central banks, transnational agreements and intergovernmental organizations. The promotion © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_21

487

488

P. E. PETRAKIS

of transparency and regulation of the markets in products and capital and the relocation of persons also promoted globalization.

21.2

International Economic Architecture

Observing the evolution of the institutions that develop around the international economic architecture (Fig. 21.1) one realizes the universality of their effects and, therefore, the way the course of global economy is being shaped (Stiglitz, 2002). The creation of institutions of international governance serves four different purposes: 1. limiting power concentration only in specific countries 2. providing information and reducing transaction costs between countries 3. facilitating reciprocity (natural dependence) 4. the promotion of national structural reforms which in turn serve international cooperation (Milner, 2005). The Second World War also created monetary instability. So, at the end of the war, the Bretton Woods Conference was held at which it was decided to introduce a system of fixed exchange rates. In addition, Keynes (1883– 1946) and White (1892–1948), who were actively involved in these initiatives, contributed to the creation of two international structures which were to play an important role in the development of the world economy. These were the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which is now called the World Bank (WB). These institutions were set up to prevent a further major recession in the future. They were designed

Fig. 21.1 International economic architecture (Source Author’s own creation)

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

489

to help developed countries create a more stable global economy with an emphasis on cooperation between economies. In 1930 was founded the Bank for International Settlements (BIS) to assist the Central Banks in the pursuit of monetary and financial stability, to promote international cooperation in these areas, and to operate as a bank for Central Banks. In addition, the Financial Stability Board (FSB) was established in 2009. A descendant of the Financial Stability Forum (FSF) aimed at the active shaping of the regulation of the global financial market. With regard to trade, the General Agreement on Tariffs and Trade (GATT), was created which supervised and ensured the liberalization of world trade. Since 1995, GATT has been represented by the World Trade Organization (WTO). The action and role of these institutions have changed since the time of their creation. Regarding trade transactions, international partnerships between countries have been created at a global level with the aim of smoothing barriers to trade and investment. Such partnerships are the Transatlantic Trade and Investment Partnership—(TTIP) and the Trans-Pacific Partnership (TPP), which represent the main trade negotiations activities of the current global economic system. International governance bodies complement the international economic architecture. In 1975, the G7 (later G8, with Russia’s participation) was created to discuss current international issues, such as the oil crisis. In the same context, in 1999, the G20 was established to deal with economic crises in the late 1990s. In addition, the role of international transnational partnerships is of importance. Around the issue of monetary cooperation the phenomenon emerged of the currency peg, i.e., the connection of weak currencies with other more powerful and stable ones, as well as transnational and monetary unions, such as arise through the pooling of national economies with the aim of economic integration. Figure 21.1 describes the international economic architecture as discussed in this chapter.

21.3

International Economic Institutions

The changes taking place at global level have brought about significant changes in the functioning of economies and in their interactions. In terms of international economic institutions, international governance agencies are created (International Monetary Fund, World Bank, Bank for International Settlements), as well as councils and cooperative models

490

P. E. PETRAKIS

(Financial Stability Forum, Financial Stability Board) to enhance and safeguard financial stability and to create coalitions among the strongest of the more powerful states and the Central Banks. 21.3.1

Established Organizations

The International Monetary Fund Following its creation in 1945, the International Monetary Fund has subsequently become an organization that now lists 188 member states and seeks to ensure international stability through policies1 that are related to the macroeconomic and financial sector. Its main objectives are: • Promoting international monetary cooperation, • Facilitating the expansion and balanced development of international trade, • Promoting exchange rate stability, supporting the establishment of a multilateral payment system, and • The availability of resources to members experiencing balance of payment difficulties (IMF, 2015). Until the 1970s, specifically, during the 1950’s—when the IMF was established as a body—and 1960s, the main borrowing countries were the developed economies which borrowed (short-term loans) in order to cope with the lack of foreign exchange reserves, requiring comparatively mild adjustments of the exchange rate (Reinhart & Trebesch, 2016). The basic mission of the IMF was the promotion of a stable monetary system, with a priotitization of economic growth and trade, acting as a lender of last resort, preventing currency wars and giving short-term loans to countries that found it difficult to maintain their exchange rates stable. The IMF issued in the 1970s the Special Drawing Rights—SDRs2 as an additional international reserve asset under the Bretton Woods fixed rate system. However, imbalances related to external trade balances, led to the deregulation of exchange rates and, inevitably, in 1971, to the collapse of Bretton Woods. This had the effect of shrinking the role of the IMF as

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

491

a stabilizing factor of the international financial system, while part of its functions was replaced by private international financial institutions. Following the abolition of the fixed rate system and the prevalence of floating exchange rates with the maintenance of monetary independence, the IMF’s main borrowers changed. From the 1980s onwards, it financed—with interest rates below those of the market—mainly to developing economies and markets experiencing financial difficulties of any kind, while to most of them it also offered long-term development assistance. It again played a particularly active role during the third world debt crisis, especially Latin America, in the 1980s. It offered financial support to countries facing crises of banking and sovereign debt, given that these types of crises, unlike the crises in the liquidity of foreign exchange, have resulted in long-term problems, so that the interventions of the IMF began to have an increasingly longer duration. The countries’ economic rescue policies are based on conditionalities3 which are the tactic of the IMF’s financial intervention in the countries requesting its assistance, including institutional reforms and cash interventions. The conditionalities are necessary in order to proceed with the financing of projects that will support the economies and act as a guarantee that the implementation of macroeconomic and structural policies in the countries of the intervention will correct distortions, or will make more efficient the market in question. In this way, the final role of IMF interventions4 was shaped in terms of development and growth. Its role became very active once again in 1990 and 2000, decades in which it was called upon to play a part in central capitalist countries. Following the outbreak of the global financial crisis in 2008, the IMF was called upon to redefine its role, as it would have to adapt to a more complex world. It began to intervene in economies in Europe, where debt sustainability problems were particularly acute, providing high loans. Although it was present in the geographical area of Europe before the last crisis, after 2008, its interventions in Greece, Portugal and Ireland strengthened its role.5 The recent remobilization of the IMF includes negotiating programs with more and more countries with interventions in their domestic policies and institutions through Structural Adjustment programs. It should be noted that at the beginning of 2000 it had programs in about one third of the countries of the developing world.

492

P. E. PETRAKIS

The World Bank At the beginning of its operation, the World Bank undertook to provide loans for long-term and low-performance infrastructure projects such as hydroelectric projects, road and port construction, i.e., projects that promoted development, creating favorable conditions for the development of private entrepreneurship. Today, its central objective is to promote economic and social progress in developing countries in order to increase their productivity and, hence, their standard of living. With the participation of more than 188 member countries, the World Bank focuses on: • Aid to poor countries, aiming to achieve sustainable development, and to countries emerging from conflict. • Assistance to vulnerable countries, middle-income countries (where it provides development solutions, through adapted services and adapted funding) and countries of the Arab world. • Addressing problems at local and global level, such as climate change, communicable diseases and international trade. • The promotions of knowledge that can support global development. The WB developed five separate institutional entities that have distinct roles but share the aim of achieving its overall goal (Milner, 2005; Ravallion, 2016). 1. The International Bank for Reconstruction and Development (IBRD) founded in 1944 to help European countries after the Second World War, today mainly provides loans and help to middleincome countries. 2. Founded in 1960, the International Development Association (IDA) offers an alternative borrowing option (soft loans). These loans are interest-free and extend for several decades, with a ten-year grace period before the beginning of repayments by the borrowing country. 3. The International Finance Corporation (IFC), founded in 1956, provides loans, equity, risk management tools, and structured financial instruments, to facilitate sustainable development by improving investments in the private sector.

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

493

4. The Multilateral Investment Guarantee Agency (MIGA), established in 1988, is intended to provide insurance and credit guarantees for private investors. 5. The International Centre for Settlement of Investment Disputes (ICSID), established in 1966, is a forum for settling disputes between investors and governments. Although the existence of the WB has been highly criticized (Wapenhans, 1992)—either because its efforts are meaningless, as poor countries face non-economic constraints that hinder their development, or because its role can now be replaced by the markets themselves—the need for the WB still exists. While it is no longer the main conduit of funds from high-income countries to low-income countries, it still has an important role serving the public interest through the promotion of knowledge on matters to do with development. The Bank for International Settlements The Bank for International Settlements is the oldest international economic institution, founded in 1930, and was created by an international treaty, the Hague agreement of 1930. It consists of 60 members which are central banks and monetary authorities. The BIS is based in Switzerland and does not provide financial services to individuals and businesses. It was established to “assist Central Banks in their pursuit of monetary and financial stability, promote international cooperation in these areas and act as a bank for Central Banks.” It fulfills this objective through: • promoting discussion and facilitating cooperation between central banks, • supporting dialogue with other authorities responsible for promoting financial stability, • analyses and surveys on monetary and financial stability issues, • taking actions that make the BIS a key counterparty for Central Banks and their financial transactions. • having activities as an agent or manager in international financial operations.

494

P. E. PETRAKIS

In more detail, the BIS carries out the following activities: 1. It provides financial services to Central Banks and assists them in the management of their exchange reserves in foreign currency and gold. Holds deposits owned by around 130 Central Banks and international financial institutions from around the world. In addition, it provides credit facilities usually in the form of secured loans, against gold and other guarantees, and, in collaboration with the World Bank, the IMF and Central Banks, provides financial support to states facing major structural problems. 2. Promotes international financial stability. It is the seat of international conferences6 relating to financial stability, during which it provides secretarial and technical support. The Financial Stability Institute (FSI) has also been operating since 1999. Through the FSI, the BIS seeks to gain a sound understanding of supervisory standards and practices globally and to assist in their implementation, as well as to promote cross-sectoral and cross-border supervisory cooperation, facilitating discussions on policies and the sharing of supervisory practices and experiences. The aim of these efforts is to contribute to global monetary and financial stability and the smooth functioning of cross-border payment systems. 3. It is a research and regulatory Center for the supervision of the financial system. In 1974, the Governors of the G10 established the well-known Basel Committee on Banking Supervision, the secretariat of which was undertaken by the BIS. 4. It is a center for monetary and economic research. It compiles and publishes information on developments in international financial markets and maintains an economic database accessible to the participating central banks. Under the Basel Process,7 the functions of the BIS are based on three main features: • Synergies. The BIS hosts the secretariats of nine different groups, which have the aim of achieving financial stability, with the result that synergies are created and there is wide-ranging and constructive exchange of ideas.

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

495

• Flexibility. The limited size of these groups is conducive to the facilitation of, and transparency in the exchange of information, aids better coordination and prevents duplication or gaps in the work programs of the groups. At the same time, the results obtained are much larger than what one would expect based on the groups’ size, since they can draw on the experience of the international community of central bank governors, the financial regulatory and supervisory authorities and other international and national public authorities. • The supporting expertise and experience of the BIS. The BIS, through the financial investigation conducted and, where appropriate, with the practical experience gain from the application of regulatory standards and financial controls on banking activities, informs about the work of the committees of Basel. In addition, the work of the teams involved in the Basel process is more widely communicated in various ways (through the FSI, committee reports, etc.). 21.3.2

Councils and Cooperative Models

The nine different groups and models of cooperation mentioned above for achieving synergies are: 1. Basel Committee on Banking Supervision, a global standards regulator for prudential supervision of banks, providing a forum for cooperation on matters of banking supervision. 2. The Committee on the Global Financial System, which monitors and analyzes general issues relating to financial markets and financial systems. 3. The Committee on Payments and Market Infrastructures, which analyzes and sets standards for payment, clearing and settlement infrastructures. 4. The Markets Committee which examines the functioning of financial markets. 5. Central Bank Governance Group, which facilitates the exchange of information on institutional arrangements (Central Bank Governance Network) and discusses issues related to the design and functioning of central banks.

496

P. E. PETRAKIS

6. Irving Fisher Committee on Central Bank Statistics, which deals with statistical issues of interest to the central banks, including issues of the economic, monetary, and financial stability. 7. The International Association of Deposit Insurers, which contributes to the stability of financial systems, by promoting international cooperation and communication between Deposit guarantors. 8. The International Association of Insurance Supervisors, which promotes effective and globally coherent supervision of the insurance industry. 9. The Financial Stability Board, which seeks to strengthen financial systems and increase the stability of international financial markets. The Financial Stability Board (FSB) was established in 2009, following an announcement of the G20, and is the next stage of development of the Financial Stability Forum (FSF).8 The reason for the establishment of the FSB was the active restructuring of the regulation of the global financial market. Unlike the FSF, the FSB aims to improve global regulatory standards rather than merely supplement them. In particular, the objective of the FSB was to promote international financial stability by encouraging cooperation between national financial authorities and international standard-makers, as they work to develop regulatory, supervisory, and other policies for the financial sector. Participants in FSB conferences are senior policymakers from finance ministries, the central banks and G20 supervisory and regulatory authorities and international bodies such as the European Central Bank and the European Commission. The financial centers of Hong Kong, Singapore, Spain, and Switzerland also participate. The involvement of key players, who determine the policies of financial stability in different sectors of the financial system, enhances the power of the FSB, although the policies promoted by the FSB are not legally binding, nor are they intended to replace the normal national and regional regulatory process. On the contrary, it acts as a coordinating body, using the exercise of moral pressure and peer pressure to set internationally agreed policies and minimum standards which its members need to implement at the national level.

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

497

Box 21.1 Reasons for establishing the FSB The FSB was established in order to: 1. to assess vulnerable points that affect the global financial system and locate in the macroprudential framework the necessary regulatory and supervisory actions needed to address these vulnerabilities, 2. to promote cooperation and exchange of information between authorities pursuing financial stability, 3. to monitor and advise on best practices as regards regulatory standards and market developments affecting regulatory policy, 4. to undertake joint strategic assessment studies of the international organizations that define the standards and to coordinate the relevant policies of their development project, in order to ensure that this work is timely, coordinated, focused on priorities, and addresses existing gaps, 5. to establish guidelines for the establishment and support of supervisory bodies, 6. to support transnational crisis planning, 7. to cooperate with the IMF in conducting Early Warning Exercises; and 8. to promote the implementation of agreed commitments under the jurisdiction of its members, as well as policy standards and recommendations, by monitoring implementation, peer review, and disclosure.

21.4

Global Trade Institutions

The rapid changes which have taken place in the last century in the global economic system and the growing importance of international trade and increasing international financial flows taking place through the free movement of goods, people and capital, have led to the need for the creation of some of the trading organizations—such as the World Trade Organization (transformation of the GATT)—and trade agreements—such as the Transatlantic Trade and Investment Partnership (TTIP) and the Trans-Pacific Partnership (TPP)—which facilitate and protect international trade and multiply the economic benefits of trade.

498

P. E. PETRAKIS

21.4.1

Recognized Organizations

The World Trade Organization The WTO aims to reduce trade barriers, reduce protectionism and provide information on countries’ trade policies. WTO members have increased significantly over the years, from 23 members participating in the early version of the General Agreement on Tariffs and Trade (GATT)9 in 1947, to 162 member countries presently (November 2015). More specifically, today, the WTO is designed to promote the liberalization of international trade, and through this, to raise the standard of living, ensuring full employment, increasing real income and active demand, the growth of production and trade of goods and services, the optimal use of global production resources, sustainable development, conservation and protection of the environment, and to ensure for developing countries a share in the growth of international trade that is consistent with their needs and level of economic development. The significant influence of the WTO is shown in the interconnection of economic policies such as trade barriers, through currency policies, and also in the fact that, with the reduction of tariff quotas, and through domestic policies such as laws on intellectual property, environmental policy, domestic subsidies and tax laws, trade flows are affected. The WTO therefore has a significant impact on domestic policies. 21.4.2

International Trade Agreements

As far as trade between countries is concerned, certain international partnerships have been set up worldwide to remove barriers to trade and investment. Such partnerships, representing the main movements of trade negotiations of the current world economic system and which are expected to significantly assist the work of the WTO are: 1. The Transatlantic Trade and Investment Partnership (TTIP): it has been designed as a trade agreement between the European Union (EU) and the United States (USA), to help the societies and businesses of the EU and the US, and to enable the opening up of American companies to European ones and conversely, as well as to reduce barriers when companies try to export or to import, to

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

499

open up the services market on both sides of the Atlantic, and to create a set of rules for trading between the two regions, and for investment from one region to another. The TTIP has been under negotiation since June 2013. According to its supporters, the TTIP is expected to result in significant benefits such as to create jobs and generate growth on both sides, provide more options for consumers at lower prices and become a reference point for future international rules, in a world where developing countries are constantly gaining ground. 2. The Trans-Pacific Partnership (TPP) is a free trade agreement, which includes 12 countries of North and South America and the Pacific Ocean (United States, Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam), and focuses mainly on the opening up of markets and the elimination of tariff barriers to trade and investment. It is a partnership comprising some of the world’s strongest economies, which together account for around 40% of the world GDP. TPP negotiations were successfully concluded in October 2015, after five years of intensive talks. The main scope is to promote economic growth and social benefits for these countries, the reduction of tariffs, the creation and maintenance of high-level jobs by increasing exports, creating new opportunities for workers and businesses, the strengthening of regional supply chains and competitiveness, improving the quality of life and reducing poverty. In general, we could argue that TTIP is more ambitious than the TTP, as the stronger link between the US and the EU is expected to have greater geostrategic effects. Unlike the TPP, TTIP concerns two regions with developed and integrated markets and a strong defense relationship based on the North Atlantic Treaty Organization (NATO). Also, the two areas included in the TTIP are the “locomotive” of innovation in the global economy and, therefore, this agreement will play a particularly important role for future global economic growth. Nevertheless, the TTIP and TPP are strategically interconnected, as they are a response of the economies included in the two partnerships to emerging global economies such as China. It should be noted that among the countries included in the two partnerships, reactions have already been observed in relation to how other

500

P. E. PETRAKIS

members of the agreements manage the trade of specific products. These reactions may be indicative of how these partnerships might promote an agenda that contrasts with free trade, as trading terms in these partnerships are made to promote the interests of the most powerful business lobbies, putting into question the goal of free trade and thus endangering the future of a well-functioning cooperation within the context of these partnerships. The TPP was designed as a trade block that would counterbalance China, so that the US had control of how the framework for trade in the Pacific was to be defined. This trade agreement was signed in 2015 but was not ratified by the US Congress. If the USA leaves, the possibility opens of a new trading framework being created with China as the main player. China faces the opportunity to negotiate a regional trade agreement which will essentially be a Chinese-centered version of TPP, leading to “China shock.”10 This could increase the dynamics of the Chinese economy in World Trade. On the other hand, in the US, supporters of leaving the agreement hope to increase domestic employment. However, American workers who are harmed by competition with China have been dealt the deeper and longer-term blows. It is therefore difficult to reverse this situation. Critics of the US’s non-participation in the agreement argue that the US, by having its ability to sell to the vast majority of consumers worldwide undermined, is losing access to possible new markets. This would result in expensive products being sold cheaply in the USA because they were manufactured abroad, while, respectively, American companies would likely lose some of their profitability based on agreements for selling their products abroad. However, a quantitative assessment is difficult of the impact of breaking an agreement between countries making up 40% of the world economy—both in terms of jobs maintained and in terms of businesses closing down. So, the future of the TPP looks uncertain as it is likely to be replaced, at least in part, by the Regional Comprehensive Economic Partnership (RCEP),11 a commercial block created by China as a response to the TPP, with the participation of the United States.

21

21.5

THE INTERNATIONAL ECONOMIC ARCHITECTURE

501

International Governance Bodies

The Group of G7/The Group of G8 (G7/G8) The group of eight or G8—the group of seven (G7) today—is an “informal” group of countries formally described as the most industrially developed countries in the world. Initially, in 1975, at the initiative of France and Germany, a group of six countries met to discuss current international issues (such as the oil crisis). These were the countries which were characterized as the most industrialized economies (France, Germany, Italy, Japan, the United Kingdom and the United States). A year later this group expanded with the invitation of Canada, thus forming the group of seven (G7). From 1997 to 2014, the group consisted of 8 members (G8) as Russia also participated - after the disintegration of the Soviet Union. However, in 2014 Russia, disagreeing with the United States, the United Kingdom and Germany, left the group, while in the same year, China refused to participate in the group, condemning the US and EU sanctions against Russia. The G7 deal with international economic problems and developments, with environmental and political issues (global economic prospects and macroeconomic management, international trade, energy, climate change, relations with developing countries), as well as with issues of global security and human rights. The decisions taken are usually unanimous. Although the decisions taken are not binding or mandatory for the member states, they do, nevertheless, act as common guidelines and proposals for the international economy. The first meetings of the G7 were also attended by the ministers for Foreign affairs and Finance of the member states, however, from 1998 onwards, the ministerial meetings were separated from the meeting summit (while being carried out simultaneously), so that the summit session is an informal meeting in a more closed circle. The meetings of the G7 are also attended by the European Commission, the European Central Bank (ECB), the president of the Eurogroup, and by Russia, while there is close cooperation with other organizations—such as the IMF and the Organization for Economic Cooperation and Development (OECD), as

502

P. E. PETRAKIS

well as with other countries—such as Brazil, China, India, Mexico and South Africa—who are present in the meetings in an observer capacity. The Group of 20 (G20) The G2012 (which includes the G7/8) was created in 1999 as a meeting of finance ministers and governors of Central Banks, in order to cope with the financial crises in the late 1990s (the Mexican, the Asian and the Russian financial crisis) and in order to set the institutional framework for dialogue, as there was a perception that developing countries were inadequately represented in global governance. So, the G20 promotes open and constructive dialogue between industrial countries and countries with emerging markets, on key issues related to global economic stability. The G20 members are the United States, Germany, France, Britain and Italy, as the four largest EU economies, from among the developed market economies Australia, Canada, Japan and South Korea, Saudi Arabia, as the largest oil-producing country in the world, China, India, and Indonesia, as the three largest developing economies of Asia, Mexico, Brazil and Argentina, as the three largest economies of Central and Latin America, South Africa as a unique country in Africa, as well as Russia, Turkey and the European Union (represented by the European Commission and the European Central Bank). Both the International Monetary Fund and the World Bank are unofficial members of the G20. The decisions of the G20 make it one of the main drivers of economic and financial development at the global level. The G20 initiatives in many areas mobilize the international community and international organizations, often resulting in new international contractual rules. The president-in-office has stated that the G20 “will focus on the effort to transform the benefits of globalization into higher incomes and better opportunities for each region” and that “essentially, any significant aspect of the global economy or international financial system will be included in the competence of the Group” (Beauchesne, 1999). Key objectives of the G20 are to achieve global economic stability and sustainable growth, to promote financial regulations that reduce risks, prevent future financial crises as well as to modernize the international financial architecture, through the coordination of policies of the member states.

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

503

Box 21.2 The G20 and the Great Recession of 2008 The collapse of Lehman Brothers in September 2008 and fear of the crisis’ spreading, motivated the leaders of the G20 states to make important decisions to avoid such a possibility. Characteristically, at the G20 summit in London (April 2, 2009) there was an agreement to increase funding by 850 billion dollars through the global financial system so as to stimulate growth following fiscal expansion. However, in the subsequent summits of the G20—and once there the collapse of the financial system had been avoided—the focus was on the continuation of reforms, while at the Seoul summit reference was made to the adoption of macroeconomic policies and, particularly, fiscal consolidation measures (11–12 November 2010). The change of attitude of the G20 becomes even more evident in the adoption of the framework of the Financial Stability Board (FSB) for moral hazard, which put to rest the perception that financial institutions are “Too-Big-To-Fail.” As regards the crisis aid granted to the financial sector by the member states, the recapitalization and support for impaired assets amounted to EUR 31.7 billion euros by the end of 2011. The total average outstanding guarantees, including new guarantees and liquidity measures, amounted to EUR 682.9 billion, i.e., 5,4% of the EU’s GDP. (State Aid Scoreboard, European Commission, 21 December 2012). In February 2012, the amount of funding amounted to EUR 80 billion for Greece, EUR 317 billion for Spain, EUR 270 for Italy, And EUR 50 billion for Portugal. In fact, the Emergency Liquidity Assistance (ELA) mechanism, despite its short-term nature, was a tool for rescuing systematic banks and thus their economies. At the end of November 2008, the US Federal Reserve launched the purchase of $ 600 billion in mortgages. Until March 2009, it held $ 1.75 trillion in bank debt, mortgage securities and government bonds. This reached a peak of $ 2.1 trillion in June 2010. As the economy started to improve, further purchasing ceased, which, however, resumed in August 2010, when the Fed decided that the economy wasn’t growing dynamically. After the break in June, the financing started to decline, naturally, as the debt expired and they were expected to fall to $ 1.7 trillion by 2012. On June 19, 2013, Bernanke announced a gradual reduction in some of Fed’s quantitative easing policies in line with the continued emergence of positive economic elements. In particular, it was said that the Fed could, during the forthcoming policymaking meeting in September 2013, limit its bond purchases from EUR 85 billion to 65 billion dollars a month.

504

P. E. PETRAKIS

Their initial approach was to stabilize the financial markets by adopting exceptional measures, i.e., providing liquidity, strengthening the funds of financial institutions and protecting deposits.

21.6

International Transnational Partnerships

Monetary Cooperation The pursuit of currency stability is a common goal of economies which have their own currency. This ensures a reduction in the uncertainty associated with exchange rate volatility. Sometimes, economies seek to attach their currency to stronger currencies to ensure this objective. This is usually done through pegging, i.e., fixing the exchange rate for the currencies that are used in the main commercial transactions of an economy or by pegging it to a stable or strong currency, thus ensuring that the goods and services produced will not be affected by the continuous fluctuation of the exchange rate of a floating currency. Pegging is usually done to currencies such as the United States dollar, the euro or the yen -or even to a basket of currencies, which usually consists of these three currencies, thus bringing more certainty and stability in the fluctuations of the weak currencies. By the end of the Second World War and up until about 1971, most currencies were linked to the US dollar, which was in turn tied to changes in the price of gold. Following the collapse of the Bretton Woods fixed exchange rate system in the early 1970s, economies began to fluctuate their currencies. So, today, there is the floating exchange rates, which primarily relate to strong currencies like the US dollar, the euro and the yen, and the fixed exchange rates, where the price of a currency results from the fixed exchange rate against strong currencies like the US dollar and the euro, or from connecting attaching it to these currencies. Countries such as the Caribbean islands (for example Aruba, the Bahamas, Barbados and Bermuda, etc.), have pegged their currency to the US dollar, as the primary source of revenue comes from tourism, which is paid in U.S. dollars. Also, Middle Eastern countries, such as Jordan,

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

505

Oman, Quatar, Saudi Arabia, and the United Arab Emirates, rich in oil fields, have also pegged exchange rate to the US dollar, as their main trading partner for oil is the US (Table 21.1). Djibouti and Eritrea, unlike the other African countries pegged to the euro, are also associated with the US dollar, as are Macao and Hong Kong in Asia. In addition, many economies outside the European Union have linked their currencies to the euro. The member states outside the Eurozone, link their currencies to the euro through the Exchange Rate Mechanism (ERM II), as a preparation for entering the Eurozone. However, other countries outside the euro area have linked their currencies to the euro, supporting an exchange rate against the euro with a permitted fluctuation only within defined limits. Examples of such countries are Serbia, Bulgaria, Bosnia and Herzegovina, the Czech Republic, Croatia, Romania, Hungary, and Tunisia. Some economies link their currencies with a “basket of currencies”, which consists of currencies like the US dollar, the euro and the Japanese yen. Such countries are Botswana, Jordan, Libya, Morocco, the Seychelles, and Vanuatu. Table 21.1 List of national economies that have chosen to peg their currency to the United States dollar Country

Currency

Bahrain Cuba Djibouti Eritrea Hong Kong Jordan Lebanon Oman Panama Quatar Saudi Arabia United Arab Emirates Venezuela

Dinar Bahrain Convertible Peso Franc of Djibouti Nakfa Hong King Dollar Jordanian Dinar Lebanese Pound Rial Oman Panama Balboa Riyal Quatar Saudi Arabia Riyal Dirham UAE Bolivar

Source The World Bank and author’s own creation

Peg rate

Rate since

0.376 1.000 177.721 15.000 7.84 0.709 1507.5 0.3845 1.000 3.64 3.75 3.673 6.05

2001 2011 1973 2005 1998 1995 1997 1986 1904 2001 2003 1997 2013

506

P. E. PETRAKIS

Transnational and Monetary Unions Monetary unions arise through the unification of national economies with a view to their economic integration. A monetary union is created with the purpose of contributing to economic integration, increasing the reliability of an economy for investors, increasing confidence and allowing the participation of the economy in economic policymaking in the context of a wider union of countries. The literature has been actively engaged with the concept of Optimal Currency Areas (Kenen, 1969; McKinnon, 1963; Mundell, 1961). In the process of transnational integration there are five stages (Balassa, 1961, 1976): in the first stage there are no customs duties between countries. The second is the establishment of a customs union with external customs duties for economies outside the Union of countries. In the third stage, an internal market is organized, mainly through the elimination of restrictions and the liberalization of capital mobility. In the fourth, a form of coordination of national economic policies is developed. In the fifth stage, monetary, fiscal, social and countercyclical policy integration is achieved. In the early stages of economic integration, it is not easy to distinguish whether the incentives for development are merely commercial or political (Sapir, 2011). The political nature of unification is established at the highest stages of unification. However, history has taught us that the creation of a common monetary union without simultaneous political unification is a dangerous undertaking. At the final stage, decisions of the Union of states take precedence over decisions of national governments. However, between the last two stages, interim transitional forms such as political integration, transfer union, monetary integration, or fiscal integration may occur. Notably, in the case of fiscal integration, five key features should coexist (Sorens, 2008): 1. It consists of sub-entities that have autonomy to decide on taxes and expenses. 2. Individual governments face fiscal strictness and there are no rescue procedures (bailout rule). 3. There is a common market based on free trade in goods and services, and labor and capital mobility within the fiscal union.

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

507

4. There is a specific institutional framework for the operation of the system, so there is the ability to change at will from any government of a member state. 5. There is a common currency. • The United States of America (USA) is now a union of 50 states with the US dollar as the common currency. In the early stages of the creation of the union, banking supervision was done by a Central Bank (founded in 1791), and then by a second bank (founded in 1816 and operated until 1832). However, by 1860, more than 10,000 different currencies were in circulation, and the transactions between them were carried out at a price either higher or lower than their value. So, during the civil war of 1863, a national monetary law was voted, while in 1914 established the Federal Reserve Bank, which issues and regulates the modern national currency of America. Today, the union assumes the form of the final and most mature stages of unification. • A successful example of how an economic union can lead to a political union is the German Union (German Zollverein) in the early nineteenth century. It started in 1818 with the Union of Northern Germany, to increase trade and therefore political unity among the fragmented states of the German Confederation, and then, in 1834, and 1866, other countries were added. The German Zollverein proved to be a highly successful union and no doubt helped to ensure the political unification of Germany in 1871, at the end of the Franco-Prussian war. Several researchers argue that the German Zollverein influenced those who conceived of the euro. • In 1865, France, Belgium, Italy, Switzerland, and Greece created the Latin Monetary Union, in which the currencies of these countries were freely circulating. In the early years, the union was very successful, and many other currencies were formally incorporated into it. In 1927, it fell apart because of differences relating to the financing of public debt, with the increase in the money supply, but also due to the pressures of the wars and the increasing difference between the value of gold and silver. • In 1872, the Scandinavian Monetary Union was created between Denmark, Sweden and Norway, inspired by the Latin Monetary Union. The union was characterized by stable exchange rates and

508

P. E. PETRAKIS

monetary stability, while countries continued to issue their own currencies. In the early years a political union was created between Sweden and Norway, but it was dissolved in 1905, without affecting the functioning of the Union. The union was dissolved officially in 1924, for similar reasons as the Latin Monetary Union, as, after the First World War (1914), Sweden stopped the fixing of its currency against the gold and, without a fixed exchange rate, no free circulation could not be achieved. • Two other attempts, along the logic of creating a common monetary union without simultaneous political union, which failed, were the system of fixed exchange rates, mainly in the form of interconnection with the gold standard, which prevailed after 1914 and was maintained until the Great Depression of the 1930s, and also the system of the post-war fixed exchange rates of Bretton Woods which dissolved in 1973. • The most recent example of economic integration is that of the Eurozone. Initially, it should be stressed that the European Union is a post-war creation, after 1951, of French inspiration, with main objective the avoidance of future war crises in Europe. The European Economic Community (EEC) decided in 1972 to create a first attempt at a European Monetary Cooperation, called “the snake in the tunnel”. The association consisted of Germany, France, Italy, Belgium, Luxembourg, the Netherlands, the United Kingdom, Ireland, Denmark, Norway, and Sweden. It was a mechanism for managing the fluctuations of [their] currencies (the snake), within narrow limits, against the dollar (the tunnel). The fluctuation limit for their currencies was limited to 2.25%, which meant that the maximum change between two currencies would be 4.5%, with all currencies moving together against the dollar. Global events, such as the oil crises and the weakening of the dollar, had negative effects. This resulted in members leaving the system which eventually became a German mark zone, comprised of Germany, Denmark and the Benelux countries. The effort, however, for a European monetary union continued, and so, in 1979, the European Currency Unit (ECU) was adopted, a currency basket based on the weighted average of the currencies of the European Monetary System (EMS)13 which was created in 1977 and prevailed until 1999, when the euro replaced it. However, the fall of the

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

509

Berlin Wall, in 1989, changed the character of European integration, as Germany agreed to give up the deutschmark and accept a new common currency, i.e., the euro. In 1990, the concept of “one Market, one Money” was established in order to address the triple contradiction between free movement of capital, fixed exchange rates and monetary policy. This policy was incorporated into the Maastricht Treaty in 1993. The upshot was the adoption of the euro on 1 January 1999. Today in the Eurozone the concept prevails of Union of Redistribution of Resources, while the Political Union is at an embryonic stage of development and the Fiscal Union is in an even earlier form, while efforts have been to introduce aspects of a political and, particularly, a fiscal union. A small economy can greatly benefit from joining a monetary union, due to convergence with the more developed economies. For example, the reduction in the risk premium is expected to reduce both nominal and real interest rates (ceteris paribus). At the same time, the elimination of exchange rate risk is expected to lead to a strengthening of domestic investment and faster economic growth in the long term. It is also important that speculation related to currency devaluation should be eliminated. However, due to the participation in a monetary union, limitations arise from the fact that the member states of the monetary union are users and not creators of money. Participation in a monetary union, therefore, means that a significant part of the sovereignty of a country is lost. For example, in the case of the Eurozone, the members of the Union should have the ability to “acquire” the euros they use, because they cannot make new money. If they fail to do so, they are exposed to a serious risk of bankruptcy.14 On the contrary, a state which can create new money calculates the taxes it wants to collect and issues the currency required to carry out the design. Such a state has an infinite possibility of issuing payment orders, without fear of bankruptcy. In states which create their own money, the control of the currency created is carried out through fiscal and monetary policies. Regarding the external sector of a monetary union like the Eurozone, the union must acquire the foreign currency through exports, lending, sales, capital asset and capital that have been poured into it. Individual entities move their external transactions through accounts held with the

510

P. E. PETRAKIS

Central Bank of monetary union. Basically, they do not have the option of changing the exchange rate, since each entity needs to acquire the ability to secure the extra euros needed to fulfill its obligations. Thus, while monetary policy in the euro area is central (a discount rate for all), fiscal policy is different for each member state. One of the most important consequences of this system is that euro member states tend to operate concentrically. Thus, it appears that monetary unions are much more sensitive to external shocks and present a higher systemic risk. Finally, an additional issue that concerns the functioning of a monetary union is the phenomena of spillover and contagion which occur with observed economic recessions or crises in some of the member countries. A recent example is the case of the Eurozone, where, with the start of the financial crisis of 2008, countries of the European south had serious vulnerabilities which had effects on the functioning of the entire union. However, the Eurozone developed for this purpose, a series of institutional changes such as the establishment of the European Stability Mechanism (ESM) and the Banking Union, in order to protect itself to some degree against problems of transmission.

Notes 1. During the first years of its presence it was considered to implement policies compatible with the Keynesian view (Bird, 2007). So, then, according to the well-known “Polak Model,” attention was focused on fiscal and monetary policy for the purpose of stabilization of external trade, given the fixed exchange rates (Petrakis, Kostis, & Valsamis, 2013). 2. A country participating in this system needed official reserves—government or bank reserves in gold or in a strong foreign currency—which could be used to buy domestic currency in world foreign exchange markets so as to maintain the exchange rate. However, the international supply of two key reserve assets—gold and the US dollar—proved inadequate for supporting the development of world trade. The international community therefore decided to create a new international asset reserve, under the auspices of the International Monetary Fund. 3. There are several reasons why international financial institutions set terms and conditions for providing assistance through lending (Ohler, Nunnenkamp, & Dreher, 2012). Conditions are imposed on countries in order to be able to monitor and evaluate the course of the economies in which they intervene and promote the use of measures which, however, do not jeopardize prosperity at national and global level.

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

511

4. This expanded policy was criticized by the left (Bird & Willet, 2004; IEO—Fiscal Adjustment in IMF—Supported Programs, 2007) for inefficiency and by the right for non-implementation of its terms (Abbott, Andersen, & Tarp, 2010). A more centrist criticism (Stiglitz, 2004; Vreeland, 2006) highlighted the issue of “one size fits all” and, by extension, demonstrated its ineffectiveness. As a result, a whole forum of discussion emerged which concluded that IMF interventions should be flexible and based on local knowledge (Easterly, 2008). Thus, the new guidelines issued by the IMF (Conditionality Guidelines, 2002) state that the texts of IMF’s cooperation with the local authorities of the country should be prepared by the beneficiary countries, with the help of the IMF, and should reflect the objectives of the country in which the IMF intervenes. In effect, the IMF began to create a perception that the objective of external balance and macroeconomic stability is an intermediate objective serving the final objective, which is economic growth (IEO—Fiscal Adjustment in IMF—Supported Programs, 2007). However, has the IMF achieved this most recent objective, or would the economies of the countries would be in a better situation in terms of growth i without its intervention? As can be surmised, in order to answer that, an analysis is required which is extremely complicated (Przeworski & Vreeland, 2000). Abbott et al. (2010) summarizing the relevant debate, concludes that the conclusions do not favor a positive response. 5. Indeed, the Eurozone area is fertile ground for its interventions as, due to stable exchange rates, it is very close to the implementation of its well-known intervention model of the 1960s and 1970s, characterized by stable exchange rates. 6. These are meetings of the Group of Ten (G10), the Committee on Payment and Settlement Systems (CPSS), the Committee on the Global Financial System and of the International Association of Insurance Supervisors (IAIS). 7. The Basel process refers to the role of the Bank for International Settlements (BIS) in hosting and supporting the work of international secretariats on setting standards and the pursuit of financial stability. The Joint Seat of the BIS facilitates the communication and cooperation of these groups and their interaction with central bank governors and other senior management within the framework of the regular conference program of the BIS. The BIS also supports the work of these committees and associations with its expertise in financial research and practical experience in the banking sector. 8. The FSF was founded in 1999 in a period of economic turbulence, due to the collapse of the American mutual hedge fund (Long Term Capital Management [LTCM]), which was threatening to impact both the American and the European economy. The purpose of its creation was to

512

P. E. PETRAKIS

prevent crises and not to manage current crises. It was an institution created by the finance ministers and the governors of the central banks of the G7 countries. The FSF was to form a coalition: (a) national authorities responsible for financial stability in major international financial centers, i.e., funds, central banks and supervisory authorities, (b) sector-specific international groupings of regulators and supervisors engaged in developing standards and codes of good practice; international financial institutions charged with surveillance of domestic and international financial systems and monitoring and fostering implementation of standards, (c) committees of Central Bank experts dealing with infrastructure and the functioning of the market. 9. GATT, like the IMF and the World Bank, in the early years of operation was an institution that only concerned developed economies, while the emphasis on developing economies was placed over the years. In fact, it significantly affected economic developments as its action was particularly effective, since trade barriers in developing countries fell significantly until 1980. 10. The term “China shock” describes the situation in which the dynamics of the Chinese economy in World Trade will increase, thus constituting a trade shock which is expected to significantly affect the level of employment in the USA. 11. H RCEP is a trade agreement (a free trade agreement—FTA) between the ten member states of the Association of South East Asian nations— ASEAN (Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam) and six countries with which ASEAN currently has free trade agreements (Australia, China, India, Japan, South Korea and New Zealand). 12. The G20 was founded as “a new mechanism for informal dialogue in the framework of the institutional system of the Bretton Woods institutions, with a view to widening the debate on key issues of economic and fiscal policy among the systemically important economies and to promote cooperation to achieve stable and sustainable world growth, to the benefit of all” (G7, 1999). 13. Within the EMS, currency fluctuations were controlled through the exchange rate mechanism and remained within ±2.25% of central rates, except for the Italian lira, which allowed fluctuations of ±6%. Although the primary objective of the EMS was to reduce exchange rate volatility for trade, investment and economic growth, its creation was undoubtedly facilitated by consensus among EU countries that the control and reduction of inflation should become an economic priority. Based on the EMS,

21

THE INTERNATIONAL ECONOMIC ARCHITECTURE

513

exchange rates could only be changed by mutual agreement between the participating EU countries and the European Commission—an unprecedented transfer of monetary autonomy (European Commission, 2010). 14. In the case of the monetary union of Europe, all government transactions are made in euro, prices are expressed in euro, banks create loans and deposits in euro, the government spends in euro. While it is not possible for individual sector entities, private or public, to create new euros, payment promises may be made in euro. Essentially the banks’ liabilities are free to move, but not the assets, which remain largely local property. So, when local bubbles burst (as bubbles in the real estate market in Spain or Ireland) and the European banking system is sensitive and deleverages, it then becomes the subject of major “capital drains” (Shin, 2011).

References Abbott, P., Andersen, T. B., & Tarp, F. (2010). IMF and economic reform in developing countries. The Quarterly Review of Economics and Finance, 50, 17–26. Balassa, B. (1961). The theory of economic integration. London: Richard D. Irwin. Balassa, B. (1976). Types of economic integration. In M. Fritz (Ed.), Economic integration: Worldwide, regional, sectoral, proceedings of the fourth congress of the International Economics Association in Budapest. London: Macmillan Barro, R. J., & Lee, J. W. (2005). IMF programs: who is chosen and what are the effects? Journal of Monetary Economics, 52(7), 1245–1269. Beauchesne, E. (1999). Martin warns against complacency. Montreal gazette, A9. Bird, G., & Willet, T. D. (2004). IMF conditionality and the new political economy of ownership. Comparative Economic Studies, 46(3), 423–450. Bird, G. (2007). The IMF: A bird’s eye view of its role and operations. Journal of Economic Surveys, 21(4), 683–745. Easterly, W. (2008). Institutions: Top down or bottom up? American Economic Review, 98(2), 95–99. European Commission. (2010). One currency for one Europe: The road to the Euro. G7. (1999). Statement of G7 Finance Ministers and Central Bank Governors. Washington, DC. IMF. (2015). Factsheet. The IMF at a Glance. Kenen, P. B. (1969). The theory of optimum currency areas: An eclectic view. In R. A. Mundell & A. K. Swoboda (Eds.), Monetary problems of the international economy (pp. 41–60). Chicago: University of Chicago Press. McKinnon, R. I. (1963). Optimum currency areas. American Economic Review, 53, 717–725.

514

P. E. PETRAKIS

Milner, H. V. (2005). Globalization, development and international institutions: Normative and positive perspectives. Perspectives on Politics, 3(4), 833–854. Mundell, R. (1961). A theory of optimum currency areas. American Economic Review, 51(4), 657. Ohler, H., Nunnenkamp, P., & Dreher, A. (2012). Does conditionality work? A test for an innovative US aid scheme. European Economic Review, 56, 138– 153. Petrakis, P. E., Kostis, P. C., & Valsamis, D. G. (2013). European economics and politics in the midst of the crisis, from the outbreak of the crisis to the fragmented European Federation. New York and Heidelberg: Springer. Przeworski, A., & Vreeland, J. R. (2000). The effect of IMF programs on economic growth. Journal of Development Economics, 62, 385–421. Ravallion, M. (2016). The World Bank: Why it is still needed and why it still disappoints. Journal of Economic Perspectives, 30(1), 77–94. Reinhart, C. M., & Trebesch, C. (2016). Sovereign debt relief and its aftermath. Journal of the European Economic Association, 14(1), 215–251. Rodrik, D. (2011). The globalization paradox: Democracy and the future of the world economy. New York and London: W.W. Norton. Sapir, A. (2011). European integration at the crossroads: A review essay on the 50th anniversary of Bela Balassa’s theory of economic integration. Journal of Economic Literature, 49, 1200–1229. Shin H. S. (2011). Global banking glut and loan risk premium. Presentation presented at the 12th Jacques Polak annual research conference hosted by the International Monetary Fund, Washington, DC. Sorens, J. (2008). Fiscal federalism: A return to theory and measurement (Working Paper). Department of Political Science, University of Buffalo, State University of New York System. Stiglitz, E. J. (2002). Globalization and its discontents. New York: W. W. Norton. Stiglitz, E. J. (2004). The parties’ flip-flops on deficit spending: economics or politics? The Economists’ Voice, 1( 1), https://doi.org/10.2202/1553-3832. 1001. UniCredit. (2012). Digging into ELA. Economics & FI/FX Research, Economic Special. Vreeland, J. R. (2006). Self reform: The IMF strategy. Wall Street Journal. Wapenhans, W. (1992). Effective implementation: Key to development impact. World Bank: Report of the World Bank’s Portfolio Management Task Force.

CHAPTER 22

Central Banks, Reserve Currencies, International Chains, and International Interactions

22.1

Introduction

Universality in the implementation of the policies necessitated by globalization brings to center stage and reinforces the role of Central Banks. This chapter analyzes the role, independence and cooperation of the Central Banks. It outlines some critical concepts directly related to the global governance of the multidimensional world, which are the result of the conditions of globalization, and analyzes international monetary management. Issues such as offshore outsourcing and others dealing with the operation of a monetary union are raised, as well as the issue of reducing the supply of safe assets.

22.2

Central Banks and Cooperation

One of the most important players in the international financial system is the Central Banks, which are the monetary, credit and exchange rate policy centers. Their decisions shape the level of interest rates, the size of financial leverage and, above all, the money supply. Therefore, the liquidity of an economy is, for the most part, the task of the Central Bank, which in turn directly affects not only the money markets but also enters as a key driver of macroeconomic performance and stability through domestic aggregate production and inflation. At the same time, the Central Banks oversee the operation of domestic banks in order to © The Author(s) 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9_22

515

516

P. E. PETRAKIS

safeguard the proper functioning of the banking system and they may provide liquidity to the financial system in times of crisis. A major issue regarding the functioning of the Central Banks is their independence. Central Bank independence means that they have the exclusive ability to make monetary policy decisions without being guided by political leadership. The concept of independence (Alesina & Summers, 1993; Grilli, Masciandaro, & Tabellini, 1991) relates to: – Economic independence, which is the ability of a Central Bank to define and to choose the means of conducting monetary policy independently, without interference from the government, and – Political independence, which is the ability of a central bank to choose the objectives of monetary policy autonomously, without the intervention of the government. Closely connected with the independence of central banks was/is the adoption of the target for inflation in the context of the formulation of monetary policy. The monetary authorities in the 1980s and 1990s in the Western world were facing high inflation and unabated unemployment (contrary to the Phillips Curve), a problem that occurred particularly in Europe. The concept of dynamic inconsistency of monetary policy (Kydland & Prescott, 1977) is an interpretation of what was happening, while the solution, as expressed in the literature, was the choice of an independent Central Banker, who abhors inflation and gives a larger weight to price stability. Alesina and Summers (1993) have shown that central bank independence is associated with lower level of inflation, without any significant increase or variation in the level of unemployment. Cukierman (2008) argues that “inflation and the real independence of CBs are negatively related figures, both in developed and developing countries.” The independence of Central Banks has received particular criticism in terms of the goal of low inflation set by the Central Banks and the weakness of monetary policy in response to the financial crisis of 2008. The reasons why the independence of Central Banks is in question (Den Haan, Martin, Ilzetzki, McMahon, & Reis, 2017) are linked with:

22

CENTRAL BANKS, RESERVE CURRENCIES …

517

1. The prevalence of populism in the Western world in 2016. 2. The role of the Central Bank and its independence in the light of a changing world. 3. The loss of credibility due to recent central bank policies. This creates a heated debate as to whether or not independence should exist and whether it is a sufficient and necessary condition for monetary stability. Nowadays, modern political developments bring monetary policy issues to the fore highlighting its weakness and thus questioning the independence of banks. Of course, the independence of the ECB is explicitly provided for by European legislation and, as a monetary union does not have a government on which the central bank depends, it cannot be shaken, at least, not easily as could happen with the Central Banks of the USA and the United Kingdom. The issue at stake is basically the replacement of the Central Bankers with persons who are not technocrats but will be more political. This controversy over the independence of the Central Bank has been a field of interest to the relevant literature for the past 40 years. Politicians, if we consider that they influenced the decisions of the Central Bank, could accept a more relaxed policy and an increase in inflation in order to reduce unemployment. This would trigger higher inflationary expectations in society, leading to higher inflation, without increasing employment, while a high inflation premium would be paid as borrowing costs by national governments, as fiscal authorities would be tempted to reduce debt through inflation. Independent Central Banks are less prone to the financing of fiscal deficits through the issuance privilege while, at the same time, an independent Central Bank is the best means of balance in an economy where there are different political views on the distribution of income. We will therefore proceed to analyze the operation, purpose and conduct of the monetary policy of the central banks of America (Fed), Europe (ECB), and Japan (Bank of Japan). Federal Reserve Bank (Fed) The U.S. Federal reserve (Fed) was founded in 1913, with the enactment of the Federal Reserve Act, as a reaction to a series of financial panic

518

P. E. PETRAKIS

events (bank runs)—and especially the banking crisis of 1907—in order to bring about the restoration of the financial system. Its purpose was to provide the U.S. economy with a more stable but also safe and flexible monetary and financial system. The role of the Fed has evolved and expanded considerably. The objectives of the Fed’s monetary policy are to pursue high employment rates, economic growth, price stability, fixed interest rates, stability of financial markets, and stability of foreign exchange markets. However, in cases such as the outbreak of an economic crisis, the main objectives of monetary policy conflict, because the Fed would need to ensure low unemployment and stable low inflation. However, exercising expansionary monetary policy reduces unemployment but creates inflationary pressures, while a contractionary monetary policy reduces inflation but increases unemployment. Through open market operations1 and standing facilities,2 the Fed provides liquidity to financial institutions and seeks to influence the level of short-term interest rates on the money market. At the same time, it imposes on banks the obligation to keep mandatory reserves, i.e., the obligation to keep a part of their deposits in accounts with the Federal Bank and it thereby affects the available liquidity in the market. Today, the responsibilities of the Federal Reserve are focused on the following general categories (Ryan & Kolb, 2011): – the conduct of monetary policy to promote the objectives of full employment and price stability. – the supervision and regulation of financial institutions, to protect and strengthen the banking and financial system and consumer protection. – maintaining the stability of the financial system. To this end, efforts shall be made to address possible systemic risks. – other financial services relating to the government, the economy, the public, financial institutions and foreign official bodies. The Fed consists of the 12 Regional Federal Reserve Banks, the Board of Directors and the Federal Open Market Committee (FOMC). The Board of Governors supervises the regional Federal Banks. FOMC decides and imposes open market operations at the national level and makes important decisions on interest rates and the growth of the US money

22

CENTRAL BANKS, RESERVE CURRENCIES …

519

supply. Its decisions are considered independent, as the Central Bank of the United States has the power to act freely, without its decisions having to be ratified by the president of the United States, Congress or any other executive member of the government. The European Central Bank (ECB) The European Central Bank (ECB) is the Central Bank of the 19 countries of the European Union that have adopted the euro. The ECB is one of the official EU institutions and is the core of the Eurosystem as well as the Single Supervisory Mechanism (SSM) for banking supervision. Its main functions focus mainly on the formulation and implementation of monetary policy in the euro area. In addition, foreign exchange operations, the holding and management of foreign reserve assets of the Eurozone member countries are the tasks of the ECB, as well as of the National Central Banks. The Eurosystem’s operations include the issuance of banknotes in euro member countries. It monitors developments in the banking sector, supervises the work of financial institutions, collects information on the economy of any country and, by preparing reports and studies, promotes the smooth implementation of monetary policy. The ECB is required to ensure transparency and to inform the public of its decisions and acts. No political body is allowed to intervene in the scheduling of its activities and the implementation of its monetary policy and it is, as such, an independent authority. Its main task is to maintain price stability in the euro area and thus safeguard the purchasing power of the single currency. Specifically, a constant price level allows consumers and entrepreneurs to make decisions in an economic environment which operates based on the transparency of relative prices, the information and the smooth functioning of the transactions. The Governing Council of the ECB aims to keep inflation rates below, but close to, 2% over the medium-term. To achieve its primary objective, it bases its decisions on a two-pillar monetary policy strategy and implements them using the monetary policy framework. Under these pillars, the main objective, namely price stability over the medium-term, is met and monetary policy is also implemented with a view to this objective. Pillar I of the ECB is about the amount and circulation of money. Its monetary policy is based on the quantitative theory of money and the

520

P. E. PETRAKIS

role of money in the economy. Pillar II of the ECB defines the factors that may affect price stability over the short term. Concerning the objectives of monetary policy set by the Fed and the ECB, a substantial diversification is apparent in the targeting of the policies of the two Central Banks. The ECB’s mandate to pursue price stability differs from the objectives set out in the Fed’s mandate. So, the Fed is required to “maintain the long-term growth of monetary and credit aggregates, depending on the capabilities of the country to increase production, so as to promote effectively the goals of full employment, price stability and the containment of long-term interest rates.” This is the Full Employment and Balanced Growth Act of 1978 which is more commonly known as the Humphrey-Hawkins Law. On the contrary, the Maastricht Treaty states that “the primary objective of the Eurosystem is to maintain price stability. With prejudice to the objective of price stability, the Eurosystem supports the general economic policies of the European community.” In addition, Article 2 of the Treaty states that “the EU’s objective is to promote economic and social progress and a high level of employment and achieve balanced and sustainable development.” The Eurosystem contributes to achieving these objectives by maintaining price stability and, in the event of a conflict of objectives, the ECB gives priority to maintaining price stability. So any intervention by the ECB on employment cannot be made directly, but only through indirect policy objectives, which differentiates it considerably from the Federal Reserve. The conventional tools used by the ECB to implement its strategy are mainly: 1. Open market operations, which lead to a change in liquidity and thus to the formation of interest rates. The National Central Banks executes these operations on behalf of the ECB. This category includes four different types of operations, which are divided into reversible and permanent, depending on their policyholders. 2. Standing facilities designed to absorb or provide liquidity to credit institutions that need it on a daily basis. 3. Compliance with minimum reserve requirements, which each financial institution is required to have some minimum reserves with the National Central Bank of the country where it is located. This instrument is intended to control the capital circulating in the market.

22

CENTRAL BANKS, RESERVE CURRENCIES …

521

Decisions on monetary policy are taken by the institutions of the European Central Bank. The implementing bodies are the Governing Council, the Executive Board and the General Council. The basic responsibility of the Governing Council is to take decisions on monetary policy through interest rates, with the aim of price stability across the Eurozone and it is the only body of the ECB which may define monetary policy and establish the means to carry it out. The Executive Board implements decisions on monetary policy, while its responsibilities include guidelines and the tasks to be performed and applied by the National Central Banks. Finally, the General Council is the body presenting research and advisory studies on the enlargement of the Eurozone. The decisions and implementation of monetary policy are undertaken by the Eurosystem through the banking system. Credit institutions are the instrument for implementing decisions of the ECB’s monetary policy. The results can be seen in financial products and, in particular, in bank lending to EU citizens. The stability and effective functioning of the single banking system are essential elements for the appropriate and correct implementation of monetary policy in the Eurozone. So, then, the ECB monitors developments and supervises the operations of the banks, notably through the National Central Banks. It should be noted that the ECB appeared to be unable to respond quickly and effectively to the financial crisis of 2008. The tools at its disposal did not enable her to do so. So, valuable time was lost in the early stages of the crisis. In an effort to address the crisis and prevent its spread, the ECB has taken a series of measures which could be characterized as non-contractual policies. This led to intense debate on the ECB’s competences and whether they deviated from the Maastricht Treaty. The injections of liquidity to rescue the banking system and the purchase of government bonds from the secondary market did not appear to have the expected results. The intervention of the ECB, as lender of last resort has sparked intense disagreement, not only as to the effectiveness of the effort, but also as to the possible side effects such a move may be expected to have in the future for the budgetary discipline of the member countries. The Bank of Japan (BoJ) The Bank of Japan (BoJ) was established by the Bank of Japan Act, which was passed in June 1882 and became operational on 10 October

522

P. E. PETRAKIS

1882, as the Central Bank of the country. It was reorganized in 1942, with the Law of 1942, on the occasion of the war, with the bank’s aim being “the regulation of the currency, control and facilitation of credit and financing, as well as the maintenance and strengthening of the credit system following national policy, in order to be able to improve sufficiently the general economic activities of the country” (Law of 1942, article 1). Since then, the 1942 law has been amended several times and in 1949, the Policy Council was created, which became the bank’s supreme decision-making body. The council lays down the procedures for monetary control, lays down the basic principles governing BoJ’s operations and supervises the performance of the bank’s executives’ duties, with the exception of auditors and consultants. A full reform of the 1942 law was carried out in 1997—and put into effect a year later—along the main principles of independence and transparency. Nowadays, the objectives of the BoJ are: “to issue banknotes and to carry out currency and monetary control” as well as “to ensure smooth settlement of funds between banks and other financial institutions, thus contributing to the maintenance the stability of the financial system” hence laying the foundations for healthy economic development. In order to achieve these two objectives, the Bank of Japan carries out the following operations: 1. Issuance and management of banknotes. 2. Monetary policy. BoJ’s mission is to pursue price stability, thus contributing to the stability of the economy as a whole. 3. Provision of settlement services and ensuring the stability of the financial system. The Bank of Japan conducts various activities for the maintenance of the infrastructure: it provides and maintains the settlement system, monitors and examines the financial and management conditions of financial institutions, and acts as a lender of last resort. 4. Operations related to government bonds and securities. 5. International activities. BoJ operates internationally in the following areas: (a) international financial transactions and operations; (b) foreign exchange intervention; and (c) exchange of views at international level.

22

CENTRAL BANKS, RESERVE CURRENCIES …

523

6. Data collection, economic analysis and research. In addition to the above activities, the BoJ is also active in the field of theoretical research, with a more long-term perspective on topics such as monetary policy and the financial system. It should be noted that—almost 8 years after the outbreak of the financial crisis of 2008—the BoJ has revised the framework of monetary policy, focusing on the target of interest rates and by putting aside the policy of mass money printing which it had followed the next years, which had not helped the country’s economy exit the stagnation on which it had stood for decades. It avoided further reducing the already negative interest rates further and increasing the target of purchasing of assets, as the modification of its policy aims at the restructuring of the support programs as to achieve and maintain inflation at 2%.

22.3

Reserve Currencies

Reserve currency is a currency held in significant quantities by governments and institutions to be used for payments and transactions made internationally. It is often considered a safe currency. The reason for creating a reserve currency is to help trade and activities on the global product markets and financial markets, or it can be used as an anchor currency, in order to protect a country from financial market turmoil. Individuals living in a country which has a national currency as a reserve currency, obtain cheaper imports and loans as no currency conversion is required. By the end of the 1860s, more than 60% of international transactions were in sterling, with the United Kingdom the leading exporter of processed goods and services worldwide, while the British banking system was expanding and UK capital was the main source of foreign investment worldwide. This came to an end after World War II and Bretton Woods’ dominance, when the United States dollar replaced the British pound sterling as a world reserve currency. In fact, for some decades now, the US dollar has been equal to about two-thirds of the world’s stocks. Moreover, despite the fact that the euro accounts for about 20–25% of world reserves, the international pricing currency for oil, gold and other raw materials is still the US dollar. Figure 22.1 shows the currency shares as global foreign exchange reserves for the period from the first quarter of 1999 to the fourth quarter of 2019.

524

P. E. PETRAKIS

100 90 80 70

Shares of other currencies Shares of Swiss francs

60

Shares of Australian dollars 50

Shares of Canadian dollars Shares of Japanese yen

40

Shares of pounds sterling 30

Shares of euro Shares of U.S. dollars

20 10

1999Q1 1999Q3 2000Q1 2000Q3 2001Q1 2001Q3 2002Q1 2002Q3 2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1 2011Q3 2012Q1 2012Q3 2013Q1 2013Q3 2014Q1 2014Q3 2015Q1 2015Q3 2016Q1 2016Q3 2017Q1 2017Q3 2018Q1 2018Q3 2019Q1 2019Q3

0

Fig. 22.1 Shares of global official foreign reserves (first quarter of 1999–fourth quarter of 2019) (%) (Source IMF Currency Composition of Official Foreign Exchange Reserves—COFER and author’s own creation)

Hence, the US dollar over time presents the 60–72% of global official foreign exchange reserves (63.8% in the fourth quarter of 2019), followed by the euro (20.54% in the fourth quarter of 2019 and, over time, between 17 and 28%), the pound sterling (4.62% in the fourth quarter of 2019, over time between 2 and 5%) and the Japanese yen (5.70% in the fourth quarter of 2019, over time between 3 and 7%). For economists, there is a matter of debate whether, in the modern multidimensional world, the dollar will continue to be the strongest reserve currency (Chinn & Frankel, 2007; Krugman, 1984; Lindert, 1969) or whether several different reserve currencies will prevail (Eichengreen & Flandreau, 2010; Lane, 2016). The former base their claims on network externalities which characterize the international financial sector. More specifically, they argue that all parties involved have an interest to maintain a single reserve currency: the country of which the currency is being used as a reserve has an interest to maintain this situation as there are strongly increasing returns, and those who engage in trading benefit from the prevalence of a currency, as there is no confusion created in international trade. Similarly, for Central Banks, holding stocks in the same currency as other Central Banks entails more liquid assets. While there is always the possibility to reach a turning point, where everyone will

22

CENTRAL BANKS, RESERVE CURRENCIES …

525

move from one international currency in favor of another, the externality of a network that characterizes the international monetary system means that there is only room for one truly international currency unit. The latter, nevertheless, argue that the prevalence of a single reserve currency may not have application in the international monetary system which is becoming increasingly multi-polar, as the global economy itself is growing more multi-polar. More specifically, they argue that the prevalence of the dollar after World War II happened because the U.S. controlled the majority of industrial production, which, they argue, is not expected to prevail in the future, as economies, such as Japan and China, have developed a special dynamic. Thus, the prevalence of many different currency reserves is based on the premise that “countries that trade with and borrow from the Eurozone will increasingly seek to have the euro as a reserve currency. Similarly, countries trading with and borrowing from China will want renminbi yuan as reserve currency, if not today, then in the near future” (Eichengreen & Flandreau, 2010). Of course, despite the more intensive involvement of other currencies apart from the U.S. dollar, in international trade, there is a strong view that no indications are present of an impending shift away from the dollar toward an alternative currency. “The United States of today is not the United Kingdom of the era after the end of World War II. And neither the Eurozone nor China are in as strong a position as that of America in 1945” (Eichengreen, 2014).

22.4

Currency Management and Manipulation

Until the beginning of the twentieth century, there was a prevailing perception that an undervalued currency was a sign of a weak government. However, under conditions of globalization and an open financial system, there are now, worldwide, sharp and deliberate currency depreciation, in order to exert pressure to increase exports and reduce imports in order to return to growth. More specifically, this is about global currency wars, or competitive depreciation, whereby economies devalue their currency aiming to make the products they send to foreign countries relatively cheaper. When the price of a country’s currency decreases, the price of exportable goods and services also decreases, while at the same time the price of imports to the country increases. The term “currency war” has prevailed because it is not possible at the same time to

526

P. E. PETRAKIS

disregard all currencies at a global level, since when a currency depreciates, another becomes stronger (Bénassy-Quéré, Gourinchas, Martin, & Plantin, 2014). It should be noted that such a policy may harm the purchasing power of citizens, and even lead to a general decline of international trade. In particular, it can reduce the standard of living, due to the increased price in imported products and the incremental costs for traveling abroad, create inflationary pressures and make for higher interest payments on international debt, when this debt is denominated in foreign currency. Also, the depreciation of a currency can lead to a depreciation of other currencies, in order for them to remain competitive, with the result that unexpected changes in exchange rates reduce international trade. Nevertheless, depreciation is applied as a quite efficient solution by the IMF, when economies have less income from exports in relation to their expenditure for imports or when an economy wants to significantly increase its exports or is experiencing high levels of unemployment. The depreciation increases domestic production and employment in order to meet demand from abroad, thus improving the level of the economy’s Gross Domestic Product. Therefore, it is considered an efficient policy for tackling high levels of unemployment, when public expenditure can’t grow any further, or when there is a deficit in the balance of payments. In addition, the maintenance of the depreciation for a long period leads to the creation of reserve assets, which can be used to provide liquidity in future financial crises. During the twentieth century, three major currency wars took place (Rickards, 2012): – The first currency war (1920–1945) broke out when as countries were trying to recover from the effects of World War I (monumental depreciation of the German mark in 1921) and, in particular, the period after the Great Depression during the late 1930s, when countries abandoned the Gold Standard and adopted the policy of currency depreciation in order to boost their economies. France depreciated the franc in 1925, Britain moved to a depreciation in 1931, while in 1933 there was the infamous depreciation of the U.S. dollar against gold by the United States. – The second currency war (1967–1992) began after Great Britain depreciated the pound against the dollar, in 1967, and after the collapse of the exchange rate system of Bretton Woods, in 1971.

22

CENTRAL BANKS, RESERVE CURRENCIES …

527

In 1971, the US imposed national price controls and released the economy from the Gold Standard. It was an extreme measure intended to end the ongoing currency war, which had undermined faith in the U.S. dollar. The pressure on the dollar was very large from other countries, such as France, with the result that was greatly devalued in the 1970s, while it regained its value at the beginning of the 1980s in the context of the policy of the US Federal reserve during the chairmanship of Paul Volcker. Other currencies, like the Japanese yien and the mark of West Germany, have also lost a large part of their value, and there have subsequently been other fluctuations in the value of the dollar, as happened in the cases of the Plaza Accord in 1985, and the Louvre Accord in 1987. – The third monetary war is the one that started recently, in 2010, following announcement by the US of its intention to double exports within five years, while a wave of quantitative easing was implemented in the same year. The main participants in the third currency war were the US, Europe, China and Japan. The Central Banks of these economies use a combination of policy tools, either directly through government intervention or indirectly through quantitative easing policies, in order to achieve price stability and full employment. Typical examples are the US-China yuan depreciation, between 2010–2011, Japan’s announcement of a depreciation of its currency in early 2013, which risked a currency war between Japan and the Eurozone, Japan’s ongoing quantitative easing policy in October 2014, the European Central Bank’s quantitative easing program in January 2015, and the depreciation of the Chinese currency in August 2015. Specifically, the Great Recession of 2008 led both the ECB and the US Federal Reserve in the period 2008–2010, to pursue monetary policy in the same direction, though using different tools. While both central banks have adopted interest rate cuts as their main principle, they have used different instruments. The ECB has adopted a policy of fixed rate and long-term refinancing operations (LTROs) against the quantitative easing and credit easing chosen by the Fed to tackle the crisis. At the same time, the ECB has chosen to play the role of lender of last resort, so as to provide liquidity to banks with higher debt maturities. By contrast, the Fed went directly into securities markets, directly affecting the prices of financial assets and having portfolio and wealth effects. Since 2010, the

528

P. E. PETRAKIS

Eurozone debt crisis has led to its fragmentation, with fiscal policy being particularly restrictive, as opposed to the policy adopted in the US. The widening of the ECB’s and the US Federal Reserve’s balance sheets after 2008 was accompanied by a gap in favor of the latter after 2012.

22.5

Extension of Global Supply Chains

Globalization has significantly increased the global chains of added value and now, production is done to a considerable extent is by means of off shoring activities, which reduce the cost of production and increase labor productivity due to specialization. Thus, international trade and the competitiveness of countries are affected by the rapid rise in Global Value Chains (GVCs). GVCs are an important opportunity for countries to integrate in the global economy at a lower cost, producing some intermediate goods and services, and no integrated end products, while more than half of the developing countries’ exports, in terms of value added, include GVCs. While with the use of traditional methods, there was the assumption that all the production activities of an economy are carried out using only domestic factors, nowadays new conditions have been created, since the production of an economy is highly fragmented, with a large part of production taking place outside the borders and there is use of production factors from abroad. Structural changes at a global level create changes in the way markets operate and become interlinked, as well as in the strategic choices of businesses and organizations. In particular, what is observed in many enterprizes in advanced economies, whose production structure is labor-intensive, but characterized by unskilled labor, is that they choose to transfer their production to developing economies with an abundance of low-skilled labor. This activity is designated as offshoring, meaning the geographical transfer of the activities of a company to a lower-cost foreign country. Over the past two decades, due to the high development of information and communication technologies, offshore outsourcing refers not only to inputs of materials but also to services. The aim of offshore outsourcing is primarily to increase revenue due to reduced production costs, as offshore outsourcing activities can reduce costs by up to 50%, while revenues may increase by even 20%, due to profits from the restructuring of the production process and the specialization of employees. The benefits of offshoring depend to a considerable extent on the level of globalization, either between economies, or within an industry, which,

22

CENTRAL BANKS, RESERVE CURRENCIES …

529

in turn, depends on factors such as technical limitations on the ability to share the added value activities, the regulatory environment and the organizational attitude toward change. Thus, only industries and sectors identified as being particularly globalized can develop appropriate structures and absorb global resources to make offshore allocation feasible and profitable.

22.6

Spillovers and Contagion Effect

The term contagion refers to the mechanisms created by a financial instability that spreads to the other components of the economic system which until recently worked well. The possibility of financial contagion is of great concern to policymakers. The global financial crisis of 2008 and its transformation into a debt crisis in the Eurozone countries, brought to the spotlight an important aspect of the crisis: the possibility of contagion and spillover into other European countries. The challenge faced by the ECB in 2008 resulted in the use of non-conventional monetary policies to mitigate the adverse effects of the over-indebted economies of the European periphery. Furthermore, to understand the effects of spillover, it needs to be understood that the global economy is a system of complex two-way interconnections. The increasing trend of world trade and cross-border financial activities indicate that the concept of diffusion can take many different forms. With economic conditions deteriorating, private sector debt became less credible, contaminating banks’ balance sheets and placing a heavy burden on governments. To the extent that the price of the risk of a government’s debt could not be explained on the basis of fundamental economic variables that implied that the risk had been guided by other factors, such as the climate in the financial markets, or that it was a product of contagion. In addition, the financial markets in the developing and developed economies of the Eurozone were significantly affected. Essentially a vicious cycle emerged between the state and the banks, with the result that the banking risk was being translated into higher sovereign risk, as governments were entrusted with the role of guarantor, while the deterioration of the creditworthiness of a member state affects the banking systems, as banks hold government bonds. Systemic risk arises from joint exposures, interbank links, pooling of liquidity sources, and other factors that may affect banks’ income, liquidity and capital adequacy.

530

P. E. PETRAKIS

Three types of contagion are identified (Beirne & Fratzscher, 2012): 1. Contagion on fundamentals, which is a result of increased sensitivity of financial markets to existing fundamentals. 2. Regional contagion from an enlarged spillover of the impact of sovereign debt risk between different countries. 3. “Herd” contagion, because of a temporary over-reaction of financial markets in different countries. A deterioration in the fundamentals of countries and contagion due to this deterioration, is the main reason for the increase in spreads of government bonds and credit default swaps (CDS) during the crisis. By contrast, peripheral contagion was less important during the European crisis. As for “herd” contagion, it has been condensed in time and happens in a few markets. The interactions of asset markets across countries or regions happen either in terms of interdependence, or through contagion between asset classes, such as bonds, shares, and currencies. Interdependence is the average relationship between asset classes over a period of time. Contagion is defined as a change in the transmission mechanism between asset classes in times of crisis. Financial shocks are transmitted extremely rapidly to the Eurozone by the US. Indeed, there is a negative correlation between stocks and bonds in periods of recession, but a positive one during the period of expansion between German, American and UK government bonds, shares, and exchange rates, depending on the developments in the United States. The interconnections between the Eurozone and the USA, concerning short-term interest rates, sovereign bonds, equity markets and exchange rates for the period 1989–2004 show that the United States determine the global financial markets, while asset prices are particularly sensitive to domestic turbulence elsewhere in asset prices. More recently, Chudik and Fratzscher (2011), examining changes in the transmission of crises of liquidity and risk in financial markets between the financial crisis of 2007–2008 and the sovereign debt crisis of 2010–2011, noted that the liquidity crises affect mainly the developed economies, while the reduction of the tendency for risk-taking has a more serious impact on developing economies.

22

CENTRAL BANKS, RESERVE CURRENCIES …

531

Interactions may also involve transmission in the foreign exchange market. In the Asian crisis, the transmission in the foreign exchange market was associated to a significant extent with a crisis of the banking system, in the sense that the pressure on the exchange rates may lead to liquidity problems in banks. In these cases, the crisis spreads through a large depreciation of the currency, which then affects other currencies, due to the diffusion of the effects, though also factors are present, not directly related to fundamental economic variables. However, transmission to the foreign exchange market does not arise only from crises in the banking system. Economic interactions may also involve an equity market contagion. Most of the research on contagion in the stock market focuses on the effects of stock markets after a shock. Other interactions may be those related to contagion to the fixed income market. Typical examples are the bond market contagion in emerging economies, since the purchase of government bonds is a particularly important asset market for emerging economies, given that such economies require greater relative support from the international financial community and government bonds are closely linked with the country’s risk of debt. Finally, there may be contagion across asset markets.

22.7

The Shortage of Safe Assets

In an environment where interest rates are at a historically low level and the Central Banks continually buy assets and provide credit (e.g. 2015– 2025) there is a strong/robust phenomenon of international liquidity shortage, which puts the global economy at risk. Eichengreen (2016a) notes that “international safe assets,—such as the widely acceptable highquality debt of public or supranational institutions—are an important part of “international liquidity,” which allows for the smooth settlement of international trade and capital flows. A Safe Asset is considered one that is expected to maintain its economic value even after a strong macroeconomic shock (Farhi & Caballero, 2014). In recent decades, a number of factors—e.g., the fact that international reserves have been transformed into an institutional mandate, regulation and demographic developments—have led to a steady increase in demand for assets which, at a certain point, were not sufficient to meet everincreasing demand. The result was a great shortage of safe assets in the global economy at the start of the global crisis.

532

P. E. PETRAKIS

There have been several attempts to measure the effect of the recent global financial crisis on the supply of safe assets. Supply of safe assets was 18% of world GDP in 2011, while four years ago, in 2007, it was 37% of the world’s GDP, with the main cause of this decline considered to be the sudden re-evaluation of the risk of the mortgage loans in the U.S. and the sovereign debt of the European periphery. Eichengreen (2016a) argues that international liquidity fell from 60% of world GDP in 2009 to around 30% of world GDP in 2016, mainly due to the downgrading of the rating of government bonds of countries over indebted due to the crisis, making their use unattractive for international transactions. So, then, safe assets on the global level have been significantly reduced, compared with the beginning of the crisis, due to the greater risk of many government bonds, while the fact that other components of the international liquidity, such as the monetary base and gold, were not extended, is possibly a factor that has contributed to the current downturn. In addition, actual returns on safe assets are significantly lower than actual returns on capital (Malinovskaya & Sheiner, 2016). The increase in demand and the reduction in the supply of safe assets decrease the natural real rate of interest. This mechanism has the effect of balancing the market for safe assets, because central banks are facing a reduction in real interest rates with a reduction in nominal interest rates. However, this adjustment collapses when nominal interest rates reach zero lower bound. At this turning point, distorted mechanisms take action resulting in economic recession. The shortage of safe assets is a factor which could resurface in full force during the next severe recession, while it may occupy us a lot in the future, as the shortage of safe assets is likely to deteriorate over time (Farhi & Gaballero, 2014). The shortage of safe assets will remain a structural barrier, pushing down real interest rates, exerting pressure on the financial system and putting a burden on monetary policy during periods of economic downturn.

Notes 1. Open market operation is conducted through the direct purchase-sale of government bonds on the capital market and/or on the stock exchange by the Central Bank, in order to influence interest rates and money supply. 2. Standing facilities are designed to provide or absorb liquidity at the end of the day. They consist of marginal lending and overnight facilities.

22

CENTRAL BANKS, RESERVE CURRENCIES …

533

References Alesina, A., & Summers, L. (1993). Central bank independence and macroeconomic performance. Journal of Money, Credit, and Banking, 25, 157–162. Beirne, J., & Fratzscher, M. (2012). The pricing of sovereign risk and contagion during the European sovereign debt crisis. Journal of International Money and Finance. https://doi.org/10.1016/j.jimonfin.2012.11.004. Bénassy-Quéré, A., Gourinchas, P.O., Martin, P., & Plantin, G. (2014). The euro in the ‘currency war (CEPR Policy Insight, No. 70). Chinn, M. & Frankel, J. (2007). Will the euro eventually surpass the dollar as leading international reserve currency? (NBER WP No. 11508). Chudik, A., & Fratzscher, M. (2011). Identifying the global transmission of the 2007–2009, financial crisis in a GVAR model. European Economic Review, 55, 325–339. Cukierman, A. (2008). Central bank independence and monetary policymaking institutions—Past, present and future. European Journal of Political Economy, 24, 722–736. Den Haan, W., Martin, E., Ilzetzki, E., McMahon, M., & Reis, R. (2017). The future of central bank independence: Results of the CFM–CEPR survey. Retrieved from Vox: http://voxeu.org/article/future-central-bank-indepe ndence. Eichengreen, B. (2016a). Financial scarcity amid plenty. ProjectSyndicate. Eichengreen, B. (2016b). Global monetary order, in the future of the international monetary and financial architecture (pp. 21–63). Proceedings of the ECB Sintra Forum on Central Banking, Frankfurt am Main: ECB. Eichengreen, B. (2014). I see no shift from the dollar. Will the dollar remain the reserve currency? The Magazine of International Economic Policy. Retrieved from http://www.international-economy.com/TIE_F14_ ReserveCurrencySymp.pdf. Eichengreen, B., & Flandreau, M. (2010). The Federal Reserve, the Bank of England, and the rise of the dollar as an international currency, 1914–1939 (IHEID Working Papers 16–2010). Farhi, E., & Caballero, R. J. (2014). On the role of safe asset shortages in secular stagnation. Secular stagnation: Facts, causes, and cures (pp. 111–122). London: CEPR Press. Grilli, V., Masciandaro, D., & Tabellini, G. (1991). Political and monetary institutions and public financial policies in the industrial countries. Economic Policy, 13, 341–392. Krugman, P. R. (1984). The international role of the dollar: Theory and prospect. In J. Bilson & R. Marston (Eds.), Exchange rate theory and practice (pp. 261–278). Chicago: University of Chicago Press. Kydland, F., & Prescott, E. (1977). Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy, 85, 473–490.

534

P. E. PETRAKIS

Lane, P. R. (2016). Multiple reserve currencies and the international monetary system. BIS, at the Seventh High-Level SNB-IMF Conference on the International Monetary System. Lindert, P. (1969). Key currencies and gold: 1900–1913 (Princeton Studies in International Finance, No. 24). Malinovskaya, A. & Sheiner, L. (2016). Hutchins roundup: Quantitative easing, upskilling, and more. Washington, DC, USA: Brookings. Retrieved from https://www.brookings.edu/2016/10/27/hutchinsroundup-quantitative-easing-upskilling-and-more. Rickards, J. (2012). Currency wars: The making of the next global crisis. New York, NY, USA: Portfolio. Ryan, J., & Kolb, R. W. (2011). The Greenspan and Bernanke Federal Reserve roles in the financial crisis. Wiley. https://doi.org/10.1002/978111826 6588.ch57.

Appendix: The Integrated Framework of International Financial Markets and Transactions

This appendix describes the framework in which international capital flows develop for financial purposes and international financial investments. Concepts such as the equivalence of interest rates, the International Fisher Effect (1930), the purchasing power equivalence and the real exchange rate, are presented. The theoretical framework consists of five fundamental relationships (theorems), which link interest rates, current rates, forward rates, and prices (or inflation rates). These relationships are: 1. Interest Rate Parity. 2. Purchasing Rate Parity. 3. The Fisher Effect. 4. The International Fisher Effect. 5. Forward Rate as Unbiased Predictor of Future Spot Rate. The validity of the above positions is based on the following assumptions: • Financial markets are perfect, meaning there are no taxes, transaction and information costs, barriers to moving capital between countries, oligopolistic situations. • Investors maintain a risk-neutral investor attitude. © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9

535

536

APPENDIX: THE INTEGRATED FRAMEWORK …

Fig. A.1 Presentation of the five fundamental relationship (Note The connection between the elements expresses equality. Source Author’s own creation)

Figure A.1 illustrates these five relationship and the connection between them. Nominal interest rates per currency are the percentage return on investment, either in fixed income securities or in simple bank deposits. Their differentiation by currency essentially refers to different returns for equal periods. However, the mere fact that the returns of different interest rates are realized in different currencies, is an element that must be seriously considered if we endeavor to estimate the overall return on investment. In particular, when seeking to compare interest rates on foreign currencies, it is necessary to estimate future spot rates. Such an action is subject to subjective considerations. Each investor may have a different view of how a financial investment is performing in a given currency. Therefore, investor appreciation is an act that involves foreign exchange risk, and the entire investment prospect is uncertain. The above description fits perfectly into the concept of speculation since the main aim is the realization of uncertain profit. From a purely technical point of view, such a form of investment implies the adoption of an “open position.” At the same time, when the investor on each occasion is indifferent to investing in domestic or international fixed income (interest rate) securities, this automatically means that, in his estimation, the change in the exchange rate shall be equal to the difference between the two interest

APPENDIX: THE INTEGRATED FRAMEWORK …

537

rates. Such an effect is referred to as uncovered interest rate parity and is defined by the following formula: i d − i f = st+1 where • i d : the domestic interest rate • i f : the foreign interest rate • st+1 : estimating the percentage of change in the exchange rate in the future  • st+1 = (st+1 − st ) st . By contrast to the uncovered interest rate parity or investment based on the estimation of the future exchange rate, using the forward foreign exchange rate market eliminates the presence of foreign exchange risk. Investing in domestic or foreign securities does not entail uncertainty, and the degree of freedom of movement of capital can determine whether domestic and foreign interest rates are equivalent. One such case is described by the following formula, known as covered interest rate parity: i d − i f = ft+1 where • ft+1 : refers to the percentage difference between the forward rate applicable for the period t + 1 (also known as forwarding discount or premium) and the corresponding prevailing equivalent rate. Further, the above formula is amended to take into account the duration of the comparative titles: id = if +

(F t, t+1 − St ) 365 × 100 × St n

where • St : the current spot exchange rate, • Ft, t+1 : the forward exchange rate for period t, for period t + 1, • n: the duration of the securities in a number of days.

538

APPENDIX: THE INTEGRATED FRAMEWORK …

A key feature of investing in domestic or international fixed income securities, is the fact that the returns are considered to be certain to the extent that, when any deviation from the above formula is observed, it automatically entails the transfer of funds from the domestic market to the outside and vice versa through arbitrage. The main reason for this result is that among investments with the same degree of uncertainty, the one with the highest return is preferred. The two previous formulas that we have analyzed relate to investing in future returns. At this point, we focus on the analysis of matters relating to the conduct of trade and in particular to the formation of international prices. In the present investigation, prices are treated in their purely macroeconomic dimension and not in the sense of the value of acquiring a good. The reason for such a choice is that, in the context of full competition, there is no comparison between different markets. The products and services being produced show several small and large differences in their country of origin. Consequently, their purchase cost is not always the best measure of comparison, relative to the purchasing power of a country’s currency. Specifically, purchasing power parity would apply if a prospective buyer had no incentive to prefer the market of one country over another. Otherwise, the consumer, seeking to maximize his or her individual profit, would have a good reason to prefer one market to another. In an internationalized world, where information is complete, the quality of goods and services is readily recognizable, the response of supply to demand immediate, any barriers to the movement of goods and services are eliminated, and then there would be a single international price for each good and service. Such an effect is known as the “law of one price.” However, it is clear that such an ideal situation is the definition of a utopian world, which differs significantly from the situation that we experience daily. On the other hand, there are many examples of specific goods being priced differently from country to country, even within the EU, which at this time is an example of the most complete form of international market integration. From a macroeconomic perspective, a comparison of this kind would provide specific national price indices. Again, overcoming any problems of comparison between consumption patterns and the level of development of the economies of different states, to adopt a homogeneous price index would provide the best indication of the economy with the greatest purchasing power, or in which the cost of buying a particular basket of

APPENDIX: THE INTEGRATED FRAMEWORK …

539

goods and services is more expensive. Such an indicator is no other than the price index, which is also the basis for calculating the inflation rate in each country. In both cases, the following two types describe the purchasing power parity: p d = pf × S t where • pd and pf : prices of specific goods and services in the domestic and international market and St : the current spot exchange rate, and

Pd = Pf × St where • pd and pf : the dominant price indices in the domestic market and foreign economies. Specifically for the macroeconomic parity of purchasing power, its degree of validity, either absolute or approximate, is indicative of the intensity of the diffusion of market signals from one economy to another, and in particular whether two economies, which are considered internationalized, present integration trends. In fact, the validity of purchasing power parity is the result of both institutional and purely economic factors. From the above formula of purchasing power parity, a significant result is obtained by a simple differentiation. Specifically, by solving the spot exchange rate and then varying the result, we arrive at the following relation: St = pd − pf From the above relation, it follows that for economies that have a significant degree of interdependence, the exchange rate formation is determined by the difference in rates of change of prices, that is, by inflation rates. Even more, this relationship may explain some of the reasons why economies with inflation differentials exhibit similar behavior

540

APPENDIX: THE INTEGRATED FRAMEWORK …

in exchange rate fluctuations. It is often observed that economies with a high inflation rate present a bigger depreciation of the currency than economies with a lower inflation rate. Regarding the statistical investigation of the purchasing power parity, the most important problem that arises is the adoption of a homogeneous comparative measure, both qualitatively and in terms of cost of production. The necessity of adopting such a good, produced in as many countries as possible, has led the authors of the Economist magazine to recommend the Big Mac Index. This indicator is nothing more than the comparison of spreads to the price gap of the known brand of hamburger in each country where it is produced and traded. The advantages of the index include the widespread of the specific product, the fact that it is produced under the same registered trademark and has homogeneous quality characteristics and packaging elements. The theory of purchasing power parity (Giddy, 1994) appears in two forms: 1. Absolute purchasing power parity It is the result of the law of one price. In the context of free trade and no shipping costs, the domestic price of a basket of goods must equal the price of the same basket of goods in any other country, expressing that value in a common currency using the current exchange rate between the domestic and foreign currency. The mathematical formulation of this version of the equivalence of the purchasing power is: St =

P P∗

where • St : is the current spot exchange rate denominated in domestic currency units per unit of foreign currency • P: the price of the basket in local currency terms • P∗ : the basket price expressed in foreign currency. It follows from this relationship that, if the domestic price level rises relative to the price level abroad, this will result in a depreciation of the domestic currency against the foreign currency, commensurate with the

APPENDIX: THE INTEGRATED FRAMEWORK …

541

relative increase in the domestic price level and vice versa. The adjustment takes place with arbitrage.1 The arbitrageurs will buy the basket on the market at the lowest price (overseas) and sell it on the market at the relatively higher price (domestic). Increased demand for foreign goods will increase demand for foreign currency, while foreign consumer purchases of foreign goods will increase the domestic currency supply. The combination of the increased demand for foreign currency and the increased supply of the domestic currency will lead to the depreciation of the domestic currency against the foreign currency. 2. Relative purchasing power parity: Because the absolute purchasing power parity is rarely valid, due to the existence of transport costs, the weaker version of the above theory is often used, the relative purchasing power parity, the validity of which does not require the absence of transport costs. The relative purchasing power parity argues that, in equilibrium, the expected change in the current exchange rate of the domestic currency should be equal to the difference between the expected domestic inflation rate and the expected inflation rate in the foreign country. For example, if the expected inflation rate in Europe is 10% and in the US 4%, we should expect the depreciation of the euro against the dollar by 6 percentage points. The rationale behind this theory is that if the country’s highest inflationary currency is not depreciated, its competitiveness will be affected by high relative prices, its exports of goods and services will decline, and its imports will increase causing an imbalance in the trade balance. The depreciation of the currency shall be such as to offset precisely the loss of competitiveness arising from the higher inflation. Although in the long term, there is a tendency for convergence to the relationship described by the relative purchasing power parity, in the short term, significant divergences are observed. Some of the factors that explain these differences are: 1. The speed of adjustment of prices in the foreign exchange market which is much higher than that of the commodity and labor markets. 2. The composition of consumer baskets and, thus, the structure of the indicators that measure inflation rates, vary from country to country.

542

APPENDIX: THE INTEGRATED FRAMEWORK …

3. Internationally tradable goods and services, as a percentage of all goods and services produced, show significant differences between countries, in particular, differences in preferences between countries. The Fisher Effect argues that, in equilibrium, the difference between nominal interest rates should be equal to the difference between the expected inflation rates, i.e., the real interest rates should be equal in all countries. According to Fisher, the nominal interest rate consists of two components: the real interest rate and the expected inflation rate. The first component constitutes remuneration for the lender, for deprivation of his funds and possibly credit risk. The second component compensates for the decline in the purchasing power of the currency, which is due to the expected increase in the price level. Applying Fisher’s Effect for two countries and currencies (Euro e and USD $) we can write: Ie =r e + e i $ = r $ + $ where Ie : Re : e : i $: r $: $ :

nominal interest rate of euro real interest rate of the euro expected inflation rate in Greece nominal interest rate of the dollar real interest rate of the dollar expected inflation rate in the United States

Subtracting the above two equations per side, we have:     i DR − i $ = r DR − r $ + e − e If markets are effective, i.e., the markets’ estimates of expected inflation are on average correct, and investors maintain a neutral risk-based attitude, then the expected real interest rates in both countries should be equal. If they differ, provided that there are no obstacles to the movement of capital, investors will withdraw funds from the country with the lowest real return and place them in the country with the highest real return,

APPENDIX: THE INTEGRATED FRAMEWORK …

543

until the two expected real returns are equalized. If the real interest rates are equal, the relationship becomes: Ie − i $ = e − $ This relationship is the mathematical formulation of Fisher’s Effect. Since capital transfers from one market to another are based on expectations of real interest rates, the effect of Fisher’s effect is achieved through speculation. Speculation means risk taking. Because the average representative investor shuns risk, in order to withdraw their capitals from one market and place them in the other, they will require some risk premium. The presence of this risk premium can lead to deviations between the real rates of the two sites and, consequently, to deviations from Fisher’s effect. The International Fisher Effect connects the difference between nominal interest rates to the expected change in the current exchange rate. The theory holds that, in equilibrium, the expected rate of change in the current exchange rate should be equal to the difference between the nominal interest rates. Competition between investors, based on their expectations of future spot exchange rates, having regard to current nominal interest rates and investing in their efforts to maximize their expected returns, leads to the equation of the expected rate of change in the current exchange rate with the difference between nominal interest rates. Consequently, the validity of Fisher’s international effect is achieved through speculation. This particular form of speculation is called Uncovered Interest Arbitrage. Fisher’s International Effect is based on the assumption that investors have a neutral risk attitude. However, in reality, the average representative investor shuns risk and requires a corresponding risk premium. This risk premium is inserted between the difference in the nominal interest rates and the expected rate of change in the current exchange rate and causes, sometimes in combination with other factors, small deviations from the relationship described by this theory. The fifth relationship asserts that forward rate is unbiased predictor2 of future spot rate, that is, in equilibrium, the forward rate or discount is equal to the expected rate of change in the current rate. In practice, there are deviations from the relationship described in this theorem and could be justified by the presence of some risk premium required by investors

544

APPENDIX: THE INTEGRATED FRAMEWORK …

in the foreign exchange market to make speculative transactions, which is sometimes positive and at other times negative. In conclusion, it should be noted that the five fundamental relationships, which form the simplified framework presented, are not only compatible but also internally consistent. Namely, if four of them apply, then, the fifth necessarily applies as well.

Notes 1. Arbitrage is the simultaneous purchase of the same product basket and its sale in two different countries at different prices. 2. To avoid misunderstandings, “unbiased prediction” means that the estimation is on average correct.

References Fisher, I. (1930). The theory of interest, as determined by impatience to spend income and opportunity to invest it. New York: Macmillan. Giddy, I. (1994). Global financial markets. Boston: Houghton Mifflin.

Index

A Abductionism, 24 Absolute advantage, 233, 261 Adaptive expectations, 173, 174, 179, 180, 182, 184, 189, 290, 315 The Adverse Selection, 353 Aggregate demand, 273, 282–284, 290, 291, 293, 298, 367, 370, 421, 427, 461, 473 AK models, 243, 299, 319, 328–330, 384 Animal Spirit, 45, 281, 285, 293 Assertiveness, 60 Austrian School of Economics, 270

B Backwardness model, 237, 310 Balance Sheet Recession, 245, 412–414 Bank for International Settlements (BIS), 246, 247, 424, 471, 489, 493–495, 511

Bank for Reconstruction and Development (IBRD), 488, 492 Bank liquidity panic, 169 Bank of Japan (BoJ), 474, 517, 521–523 Bankruptcy, 77, 200, 202, 218, 401, 406, 413, 414, 426, 439, 440, 462, 477, 509 Basel process, 494, 495, 511 Behavioral economics, 69, 70, 241, 304, 341, 348, 357, 360 Big Push Theory, 236, 304 Birth of Economics, 228, 229, 255, 264 BP line (balance of payments line), 421 Bretton Woods Agreement, 235 Bretton Woods Conference, 488 Business cycle, 45, 218, 234, 241, 242, 276, 279, 281, 368, 369, 373, 377, 378, 436

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2020 P. E. Petrakis, Theoretical Approaches to Economic Growth and Development, https://doi.org/10.1007/978-3-030-50068-9

545

546

INDEX

C Capital Asset Pricing Model, 335 Catching Up Argument, 237, 310 Ceremonial institutions, 275 Ceteris paribus, 7, 435, 448, 509 Classical economists, 228, 240, 274, 283 Comparative advantage, 113, 141, 199, 217, 239, 255, 260, 261, 263–265, 316, 355, 356 Confucian dynamism, 60, 93 Conjectural knowledge, 186 Convergence gap, 392 Coordinated Market Economies (CMEs), 115 Corporate Sector Purchase Programme (CSPP), 477 Covid-19, 163–166, 170, 457–460, 462–464, 467, 469–476, 479, 480 Creative destruction, 77, 80, 103, 204, 277, 278, 384, 386, 387, 391, 409, 411 Currency war, 245, 490, 525–527 D Darwinian metaphysics, 71 Debt-deflationary, 413 Debt-to-GDP ratio, 143, 245, 403, 436, 442, 443, 451 Debt-to-income ratio, 406 Deductivism, 5–8, 23, 24 Descriptivism, 16 Developmental Theory, 289 Disrupting technologies , 219 DSGE models, 44, 242, 372, 373 Dynamic Stochastic General Equilibrium (DSGE), 373 E Easterlin Paradox, 34

Eclecticism, 9, 10 Economic Complexity Index (ECI), 109, 110, 116 Economic Policy Uncertainty-EPU Index, 162 Economics of International Trade, 290 Effective demand, 178, 236, 280, 295 Efficiency-driven stage, 194 Efficiency Market Hypothesis (EMH), 113 Elasticity of expectations, 179, 295, 315 Employee-oriented, 208 Endogenous models, 38, 387 Endogenous variable, 257, 302, 359 Ergodic world, 181, 185 European Central Bank (ECB), 138, 246, 406, 424, 426, 428, 434, 436, 438, 450, 474, 477, 480, 496, 501, 502, 517, 519–521, 527–529 European Economic Community (EEC), 508 European Monetary System (EMS), 508, 512 Evolutionarists, 228, 229, 232 Evolutionary economic theory, 274 Exchange Rate Mechanism (ERM), 334, 505, 512 Expectations, 23, 45, 66, 78, 95, 102, 146, 153, 155, 173, 174, 176– 190, 219, 237, 238, 240, 241, 244, 246, 269, 276, 281–283, 285, 286, 290–293, 295, 297, 298, 300, 315, 320, 325, 326, 336, 337, 343, 347–351, 358, 359, 366–370, 372, 375–378, 383, 425, 428, 440, 441, 443, 463, 479, 517, 543 External economies, 308, 309 Extractive institutions, 19, 77

INDEX

Extroversion, 63 F Factor-driven stage, 194 Factor Endowment Theory, 235, 264 Federal Open Market Committee (FOMC), 518 The Financial Instability Hypothesis (FIH), 242, 376, 378 Financial Stability Board (FSB), 489, 490, 496, 497, 503 Financial Stability Forum (FSF), 489, 490, 496, 511, 512 Fiscal multipliers, 246, 434–436, 452 Freshwater school, 369 Full employment, 36, 240, 244, 247, 280, 283, 290, 291, 296, 299, 315, 351, 375, 416, 417, 498, 518, 520, 527 Future orientation, 60, 88, 89 G GDP growth rate, 29, 184, 442 Geary-Khamis dollar, 30 Gender egalitarianism, 60 General Agreement on Tariffs and Trade (GATT), 489, 497, 498, 512 General equilibrium, 17, 18, 42, 44, 47, 80, 101, 107, 108, 187, 228, 229, 233, 234, 236, 238, 240, 242, 269, 271, 272, 277, 278, 290, 293, 295, 328, 342, 348 Generalized Darwinism, 71 The Global EPU Index, 162, 163 Global Value Chains (GVCs), 128, 528 Goal-oriented, 207 Golden age of capitalism, 235 Gold standard, 324, 487, 508, 526, 527

547

Great Moderation, 229, 241, 243, 244, 365, 373, 374, 383 Great Recession, 19, 34, 38, 43, 44, 138, 146, 162, 163, 166, 173, 176, 229, 241, 243–245, 365, 373, 383, 399, 400, 402, 406, 408, 409, 413, 416, 422, 423, 426, 433, 435, 440, 444, 527 Gross domestic product (GDP), 29– 31, 33–36, 123, 129, 131, 132, 134, 154, 163, 169, 195, 234, 241, 244, 246, 293, 294, 362, 385, 391, 401, 409, 410, 412, 422, 423, 434–436, 441–444, 446–449, 451, 468–470, 479, 480, 499, 503, 532 H Harrod–Domar model, 299 Heckscher–Ohlin model (H–O model), 264, 265 Helicopter money, 423, 426, 474 Homo economicus, 33 Homo holisticus, 33 Homo socialis, 33 Human Development Index (HDI), 33–35 Human orientation, 60 I Imperfect adaptation, 186 Inductivism, 4–6, 22, 24 Industrial Revolution, 127, 140–142, 167, 228, 231, 232, 258 Inflation, 31, 36, 37, 42, 49, 110, 123, 125, 161, 184, 229, 235, 239, 240, 243, 247, 248, 279, 298, 336–338, 347, 365–367, 369, 370, 373, 374, 393, 412–414, 416, 417, 422, 424, 426–428, 438, 444, 446–448,

548

INDEX

450, 463, 464, 470, 473, 474, 512, 515–519, 523, 539, 541, 542 In-group collectivism, 60, 89 Innovation-driven stage, 194, 195 Innovation gap, 215 Input-Output model, 308 Institutional collectivism, 60 Interest rates, 46, 178, 200, 209, 219, 235, 237, 243, 244, 247, 278, 280–283, 291–298, 315, 321, 325, 326, 336, 337, 371, 374, 375, 401, 411–413, 416–419, 421, 424, 425, 427, 428, 435, 438, 440, 443, 444, 452, 464, 470, 471, 473, 475, 479, 480, 491, 509, 515, 518, 520, 521, 523, 527, 530–532, 535–537, 542, 543 Internal economies, 271 International Centre for Settlement of Investment Disputes (ICSID), 493 International Development Association (IDA), 492 International economics, 45, 212, 228, 229, 237, 290, 311–314, 333, 355, 467, 487–489, 493, 501 International Finance Corporation (IFC), 492 International Monetary Fund (IMF), 401, 422, 435, 440, 452, 469, 472, 476–478, 488–491, 494, 497, 501, 502, 510–512, 526 Intertemporal choice, 68, 69 IS-LM model, 47, 291, 293, 375 L Liberalism, 487 Liberal Market Economies (LMEs), 115

Life-Cycle Income Hypothesis, 69 Life indulgence/restraint, 60, 93 Liquidity trap, 408, 411, 419, 424, 425, 428 Low growth trap, 414 Lucas’ Critique, 349 The Lucas Paradox, 392 M Maastricht Treaty, 509, 520, 521 Macroeconomic management, 359, 412, 501 Macroeconomic uncertainty, 154 Malthusian trap, 260 Market Revolution, 232 Masculinity/femininity, 60 Means-oriented, 207 Mesoeconomics, 41 Microeconomic uncertainty, 154 Micro-foundations, 29, 42, 110 Minsky moment, 242, 377, 401, 473 Mixed Market Economies (MMEs), 115 Model “2×2×2” (2 Countries, 2 commodities, 2 coefficients), 265 Modern Money Theory (MMT), 473–475 Modern Portfolio Theory (MPT), 334, 335 Monetarism, 23, 337, 378 Moral hazard, 112, 145, 241, 348, 353, 354, 366, 450, 503 Multi-equilibrium conditions, 246 Multilateral Investment Guarantee Agency (MIGA), 493 N Natural prices, 177, 178, 188 Natural Rate of Unemployment (NAIRU), 36, 49, 247, 248, 367, 428

INDEX

Necessity entrepreneurship, 202, 203 Neoclassical school, 174, 180 Neoclassical Synthesis, 11, 236, 238, 274, 290, 291, 339 Neo-Darwinism, 243, 393 Neuroticism, 63 New Classical theory, 11, 351 New Consensus Assignment, 243 New Keynesian theory, 351 Non-determinism, 186 Non-ergodic world, 116, 209 Non-labor Income (NLI), 371 Normative economics, 7 O OECD Better Life Index, 34 One-size-fits-all, 20, 408 Operationalism, 4, 14–16, 24 Opportunity entrepreneurship, 202, 203 Optimal Currency Areas (OCA), 333, 334, 406, 445, 506 Ordoliberalism, 450 Organizational genetics, 394 Organization for Economic Cooperation and Development (OECD), 34, 128, 134, 501 Overlapping Generation Models (OLG Models), 319, 324, 325 P Pandemic Emergency Purchase Programme (PEPP), 477 Performance orientation, 60 Permanent Income Hypothesis, 69, 94 Phillips Curve, 36, 49, 239, 279, 298, 367, 446, 447, 516 Pluralistic approach, 22, 23, 25 Policy Ineffectiveness Proposition (PIP), 349

549

Political blooms, 145 Ponzi finance, 413 Ponzi units, 376, 379 Popperian falsificationism, 22 Populism, 138, 143, 144, 147, 403, 517 Porter’s Advantage, 355 Positivism, 4, 6–9, 57, 85 Positivistic economics, 7 Post-Keynesian, 48, 242, 272, 302, 375, 376 Power distance, 59, 60, 89 Predictionism, 4, 14, 16, 24 Prospect Theory, 70, 358–362 Purchase power parity (PPP), 30, 31

Q Qualitative indexes, 155 Quantitative Easing (QE), 246, 406, 408, 411, 423, 424, 428, 434, 438, 474, 503, 527 Quantitative indexes, 154, 155 Quantitative theory of money, 235, 272, 337, 414, 519

R Ramsey–Cass–Koopmans model, 320 Rational choice, 64, 65, 67–69, 72, 82, 93, 94, 239, 341 Rational Expectations Hypothesis (REH), 182–184, 186 Real Business Cycle (RBC), 241, 242, 367–369, 372, 373, 377, 378, 383 Regional Comprehensive Economic Partnership (RCEP), 500, 512 Research and development (R&D), 217, 385, 388, 389, 394 Rhetoric, 9 Rules of thumb, 183, 184, 189

550

INDEX

S Saltwater school, 369, 378 Say’s law, 280, 291, 428 Secular stagnation, 246, 247, 416, 417, 424, 425, 427, 444, 480 Single Supervisory Mechanism (SSM), 519 The Solow Growth Model, 321 Special Drawing Rights (SDRs), 490 Spillovers, 12, 246, 374, 408, 510, 529, 530 Stagnation, 19, 167, 213, 246, 247, 257, 401, 416, 418, 419, 523 Subprime Crisis, 400, 426 SWAPS, 472

Uncertainty avoidance, 19, 59, 60, 88, 89 Unemployment, 36, 42, 49, 110, 123, 124, 127, 154, 161, 167, 168, 184, 234–236, 239, 247, 248, 278, 279, 290, 298, 304, 313, 315, 325, 335, 337, 351, 352, 366, 367, 374, 400, 402, 408, 411, 413, 414, 422, 423, 428, 438, 447, 449, 461–463, 474, 516–518, 526 Unemployment equilibrium, 291 United Nations Development Program (UNDP), 33, 35 Universal Darwinism, 71 Universal Selection Theory, 71

T Tableau Économique, 104 Taylor rule, 239, 247, 425 Technological institutions , 275 Theory of Expected Utility, 69, 360, 361 Theory of Growth, 12, 23, 38, 49, 228, 290, 319, 383, 387, 390, 393 Too-Big-To-Fail , 503 Transatlantic Trade and Investment Partnership (TTIP), 489, 497, 498 Trans-Pacific Partnership (TPP), 489, 497, 499, 500

W Walrasian paradigm, 18, 233, 272 Work-oriented, 208 World Bank (WB), 469, 478, 488, 489, 492–494, 502, 512 World Trade Organization (WTO), 461, 489, 497, 498

U Unbalanced growth, 308

Z Zero-Lower Bound (ZLB), 424

V Value-in-exchange, 257, 267 Value-in-use, 257, 267 Vernon’s Product Life Cycle, 355 VoC: Varieties of Capitalism, 115 Volatility Index (VIX), 155