The Lost Wealth of Nations[1]
by Partha Dasgupta [2] The phrase �sustainable development� is commonplace, but economic commentators offer no guidance on how we are to judge whether a nation�s economic development is, indeed, sustainable. The famous Brundtland Commission Report of 1987 defined sustainable development as �... development that meets the needs of the present without compromising the ability of future generations to meet their own needs.� Sustainable development therefore requires that, relative to their populations, each generation should bequeath to its successor at least as large a productive base as it inherited. But how is a generation to judge whether it is leaving behind an adequate productive base? Economists argue that the correct measure of an economy�s productive base is wealth, which includes not only the value of manufactured assets (buildings, machinery, roads), but also �human� capital (knowledge, skills, and health), natural capital (ecosystems, minerals, and fossil fuels), and institutions (government, civil society, the rule of law). Development is sustainable so long as an economy�s wealth relative to its population is maintained over time. In other words, economic growth should be viewed as growth in wealth, not growth in GNP. There is a big difference between the two. There are many circumstances in which a nation�s GNP (per capita) increases even while its wealth (per capita) declines. In broad terms, these circumstances involve growing markets in certain classes of goods and services (natural-resource intensive products), concomitant with absent markets and collective policies for natural capital (ecosystem services). As global environmental problems frequently create additional stresses on the local resource bases of the world�s poorest people, GNP growth in rich countries can fuel downward pressure on the wealth of the poor. Of course, a situation where GNP increases while wealth declines can�t last forever. When an economy eats into its productive base in order to raise current production, eventually GNP will decline, too, unless policies were to so change that wealth begins to accumulate. For example, using World Bank data on the depreciation of a number of natural resources at the national level, economists estimate that, although GNP per capita has increased in the Indian sub-continent over the past three decades, wealth per capita has declined somewhat. The decline has occurred because, relative to population growth, fixed-capital investment, knowledge and skills, and improvements in institutions have not compensated for the degradation of natural capital. In sub-Saharan Africa, both GNP per capita and wealth per capita have declined. Economists have also found that in the world�s poorest regions (Africa and the Indian sub-continent), areas that have experienced higher population growth have also lost wealth per capita at a faster rate. The economies of China and the OECD countries, by contrast, have grown both in terms of GNP per capita and wealth per capita. The latter regions have more than substituted for the decline in natural capital by accumulating other capital assets. In other words, during the past three decades the rich world seems to have enjoyed �sustainable development,� while development in the poor world (barring China) has been unsustainable. These are early days in the quantitative study of sustainable development. Even so, one can argue that current estimates of wealth are biased. As for natural capital, the World Bank has so far limited itself to the atmosphere as a sink for carbon dioxide, oil, and natural gas, and forests as sources of timber. Many types of natural capital, however, have not been included: fresh water, soil, forests as providers of ecosystem services, and the atmosphere as a sink for such pollution as particulates and nitrogen and sulphur oxides. If these missing items were included, the poor world�s economic performance over the past three decades, including China�s, would look far worse. But the estimates of wealth accumulation in recent years in the rich world are biased upward too. Empirical studies by earth scientists have revealed all too often that the capacity of natural systems to absorb disturbances is not unlimited. When their absorptive capacities are reached, natural systems are liable to collapse into unproductive states. Recovery is then costly, in terms of both time and material resources. On the other hand, if, say, the Atlantic current that keeps northern Europe warm were to shift direction or to slow down on account of global warming, the change would be essentially irreversible. In short, we know that up to some unknown set of limits, knowledge, institutions, and manufactured capital can substitute for natural resources, so that even if an economy loses some of its natural capital, in quantity or quality, its wealth would increase if it invested sufficiently in other assets. The remarkable increase in agricultural productivity over the past two centuries demonstrates this clearly. But there are limits to substitutability: the costs of substitution (including human ingenuity) often increase in previously unknown ways as key resources are degraded. Global warming is a case in point. When the downside risks associated with such limits and thresholds are brought into estimates of sustainable development, the growth in wealth among the world�s wealthy nations will probably turn out to have been less than we now think. =========================================================================== Evidence-Based Economics [3] by Edmund S. Phelps [4] There is a movement in medicine to require that applications for licenses to sell a new drug be �evidence-based.� By contrast, trained economists view their discipline as having already achieved this scientific standard. After all, they express their ideas with mathematics and arrive at quantitative estimates of implied relationships from empirical data. But economics is not evidence-based in selecting its theoretical paradigms. Economic policy initiatives are often taken without all the empirical pre-testing that could have been done. A notorious example is postwar macroeconomic policymaking under the radical Keynesians. The radicals relied on Keynes�s untested theory that unemployment depended on �effective demand� in relation to the �money wage,� but their policy ignored the part about wages and sought to stabilize demand at a high enough level to ensure �full� employment. Cecil Pigou and Franco Modigliani objected that if demand were successfully increased, the money wage level would rise, catch up to demand, and thus push employment back down to its previous level. Employment cannot be sustained above its equilibrium path by inflating effective demand. Nevertheless, the radicals prevailed through what the economist Harry Johnson called �scorn and derision.� Postwar macroeconomic policies were dedicated to �full� employment, without any evidence that money wages would not get in the way. In the late 1950�s, neo-Keynesians finally conceded the point raised by Pigou and Modigliani. Will Phillips�s work on wages gave them no choice. But they still insisted that steady increases of demand at a fast enough rate would keep demand one step ahead of the money wage level, so that employment could be kept as high as desired, albeit at the cost of steady inflation. In different ways, Milton Friedman and I objected, arguing that such a policy would require an ever-rising inflation rate. Money wages will lag behind demand, I argued, only as long as the representative firm is deterred from raising wages by the misperception that wages at other firms are already lower than its own � a disequilibrium that cannot last. Like the radicals, the neo-Keynesians did not engage their challengers with empirical testing. The efficacy of high demand was a matter of faith. Yet events in the 1970�s put that faith to a cruel test. When supply shocks hit the US economy, the neo-Keynesians� response was to pour on more demand, believing it would revive employment. There was little recovery � only faster inflation. The current era offers a parallel. Although policy has since shifted to reflect supply-side economics and real business-cycle theory, the new reigning paradigm�s builders and promoters display the same antipathy to checking data for serious error. An earlier classroom lesson was well-founded: temporarily below-normal tax rates on labor this year, when merged with the prospect of reversion to normal rates next year, will encourage households to squeeze more work into this year and to work less in future years. This proposition was recently tested anew on Icelandic data and performed well. But the supply-siders jumped to the daring conclusion that a permanent cut in tax rates on labor would encourage more work permanently � with no diminution of effectiveness. Larry Summers and I both doubted that this could be generally true. If every increase in the after-tax wage rate gave a permanent boost to the amount of labor supplied, we reasoned, steeply rising after-tax wages since the mid-nineteenth century would have brought an extraordinary increase in the length of the workweek and in retirement ages. But both have fallen, and in continental Europe unemployment is higher. In my view, this core tenet of supply-side economics rests on a simple blunder. What matters for the amount of labor supplied is the after-tax wage rate relative to income from wealth. While after-tax wage rates soared for more than a century, wealth and the income it brought grew just as fast. To be sure, if tax rates were decreased permanently this year, there would initially be a strongly positive effect on labor supplied. But there would also be a positive effect on saving and thus on wealth next year and beyond. In the long run, wealth could tend to increase in the same proportion as after-tax wages. The effect on work would vanish. We must proceed cautiously, however. In standard analyses, the tax cut brings a reduction in government purchases of goods and services, like defense. But a tax cut could instead contract the welfare state � social assistance and social insurance, which constitute social wealth. In that case, the tax cut, while gradually increasing private wealth, would decrease social wealth. The issue is an empirical one. Research I did with Gylfi Zoega a decade ago confirmed that cuts in taxes on labor boost employment in the short run. But what about the long run? Do large long-run effects of tax rates show up in international differences in employment? In 1998 we examined OECD data for a correlation between national unemployment rates in the mid-1990�s and current tax rates on labor. We found none. In 2004, we looked at labor-force participation rates and again at unemployment. Still no correlation. High-unemployment countries include high-tax Germany, France, and Italy, but also low-tax Japan and Spain. Low-unemployment nations include low-tax Britain and the US, but also very high-tax Denmark and Sweden. Neoliberals are now telling continental Europe that tax cuts on labor can dissolve high unemployment. But the effectiveness of such tax cuts would be largely, if not wholly, transitory � especially if the welfare state was spared. In two decades� time, high unemployment would creep back. The false hopes raised by cutting taxes would have diverted policy makers away from fundamental reforms that are necessary if the Continent is to achieve the dynamism on which high rates of innovation, abundant job creation, and world-class productivity depend. --------------------------------- [1] Copyright: Project Syndicate 2005. http://www.project-syndicate.org/commentaries/commentary_text.php4?id=1874&lang=1&m=series [2] Sir Partha Dasgupta is Professor of Economics at the University of Cambridge and Fellow of St. John�s College, Cambridge. His most recent book is Human Well-Being and the Natural Environment. His E-mail address is [EMAIL PROTECTED] [3] Copyright: Project Syndicate 2005. http://www.project-syndicate.org/commentaries/commentary_text.php4?id=1875&lang=1&m=series [4] Edmund S. Phelps is Professor of Political Economy and Director of the Center on Capitalism and Society at Columbia University. --------------------------------- Do you Yahoo!? Yahoo! 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