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Updated liberalism vs. Neo-liberalism

Policy paradigms and the structural evolution of western industrial economies after WWII

1. Introduction

This essay is very unusual in scope, methodology, and contents. The scope is much broader than is considered sound within the research community, from the point of view of time, as it refers to more than half a century; space, as it refers to western industrialized countries in general; subject as it refers to the evolution of the structural features of these economies in general.

Of course, the parable that we are going to tell in this paper does not fit exactly none of the countries of the reference group but aims to be representative of a few general features common in each period to most of them. The main motivation underlying this (may be too) daring approach is the conviction that to react to the loss of meaning determined by the increasing division of labour in economic research we have to work out higher-order cognitive structures based on the methods and results of the usual (first-order) economic research but overcoming some of its limitations. The higher-order cognitive structures have the role of coordinating the new pieces of knowledge continuously produced by the advancement of first-order science, both between them and with the corpus of received knowledge, in order to extract all their semantic and pragmatic implications.

Higher-order science is not absent neither in economic nor in interdisciplinary research involving economics but in our opinion it is definitely underdeveloped. This is true in particular with the diachronic structures that coordinate the single pieces of information and knowledge according to a temporal order. This paper aims to suggest a few elementary diachronic structures that may help to interpret some crucial aspects of the recent history of economic facts and ideas. In this paper we will limit the analysis to a few simple, but controversial, historical patterns in industrialised countries after WWII concerning facts, policies and economic analysis, as well as their co-evolution.

The scope of the paper is therefore unusually broad although I am fully aware that more extension implies less detail and depth. To the best of my knowledge there is no way to avoid this trade-off altogether. Therefore the second section has to develop a preventive justification of the approach adopted in this essay spelling out the methodological reasons that urged the author to pursue this unusual research path. In the third section the main features of the process of growth of industrialised countries after WWII are briefly described. It is maintained that structural change was directed by two basic guidelines: welfarism in the rapidly growing public sector and Taylorism in the productive processes. The attention than focuses on the 1970s, a period characterized by a long economic crisis that determines a sharp turn in the direction of structural change. The reactions against the critical features of the pre-existing period of growth gradually moulds a new period of growth characterised by two new guidelines: systematic privatisation at the cost of (or in order to) dismantling the welfare state and flexibility in the productive process and in the architecture of organisations, substituting Taylorism with less rigid technological and organisational solutions. Section 4 describes how a steadier though lower rate of growth resumes in the 1980s and 1990s under the new guidelines. In particular it is argued that the new growth paradigms based on monetarism and market fundamentalism is unsustainable mainly because the underlying neo-liberal policy paradigm doesn’t take account of the limit of markets. So far the attention was focused on the effective behaviour of private and public decision makers. In section 5 it is rapidly described the change in the objective function of policy makers and its co-evolution with the parallel change in economic thought. We distinguish between two basic policy paradigms that have influenced the evolution of western industrialised economies, as well as the world economy: updated liberalism that is aware the limits to markets and therefore aims at their active regulation, and neo-liberalism that is based on market fundamentalism and aims to privatisation, deregulation and budgetary austerity. The paper discusses how updated liberalism raised after W.W.II, became hegemonic in the 1950s and 1960s and started to decline in the 1970s, while neo-liberalism gathered momentum in the 1970s and became hegemonic in the 1980s and 1990s. Concluding remarks follow in order to summarise the connections between the historical pattern observed in the history of facts and the parallel evolution observed in the history of economic thought and policy paradigms. We claim in particular that the new liberalism is inconsistent not only with the updated liberalism of Keynes and Pigou (and their followers) but also with the classical liberalism of Adam Smith and Stuart Mill, resembling rather the simplistic and over-optimistic laisser-faire policies of Say and Bastiat. In any case it is here argued that the neo liberalism is unable to cope with the real problems as it does not take account of the market failures that together with the failures of bureaucracy have originated them. There is no alternative but further updating classical liberalism.

2. Higher-Order Science and Historical Patterns

The professionalisation of economics since the end of the 19th century and the subsequent progressive rapid increase in the number of economists implied a not less rapid increase in the division of labour within the profession. Although the competitive interaction between supply of and demand for the professional services of economists is not fully assimilable to a standard competitive market, the mechanism that links the size of this peculiar market with the degree of specialisation of labour is very similar to that pointed out by Smith for a standard competitive market. We could generalise the famous Smithian assertion in the following way: the larger gets the competitive game, the more the division of labour increases.

A consequence of this process is a growing gap between new information and knowledge. Single bits of information are by themselves meaningless until they are inserted in cognitive structures. However, since the meaning of an information depends on its context, the meaning they acquire generally varies in different cognitive structures (Vercelli, 1999).

We have to distinguish two basic kinds of cognitive structures. Synchronic structures are networks of logical relationships, such as economic models or theories, that may receive an empirical interpretation. Diachronic structures are temporal patterns emerging from the iteration of synchronic structures and\or from empirical regularities. The more sophisticated and sound is the cognitive structure within which an information set is inserted the richer are its semantic and pragmatic implications.

The increasing specialisation of economists implies that the new theoretical and empirical information suggested by innovative contributions is typically inserted, if often only implicitly, within the specialised cognitive structures that act as common background for the researchers working in that subfield. Therefore, very often, the semantic and pragmatic implications that would emerge if the new contribution were inserted within the specialised structures of other subfields remain only virtual and fully unexploited. In more intuitive words, economic research is more and more fragmented and is less and less recomposed in a unitary framework. The tesserae of the general mosaic of economic knowledge are becoming smaller and smaller but they are put together only locally while almost no one cares of putting all of them together in order to see the general composition. This metaphor should be visualised in dynamic terms, as specialised research slowly changes the local design and all these changes are bound to affect the general composition while almost no one tries to revise the general design in a way consistent with the evolution of the local design. The consequence is a sort of alienation similar to that emerging from the increasing division of labour in manufacturing: every one knows, and to some extent affects, only the local evolutionary process but no one is aware of, and can control, the general evolutionary process.

Of course there are good reasons for this growing division of labour in economic research like in manufacturing as it allows more local efficiency within a competitive process (market) of increasing size. Also the global efficiency is potentially superior provided that the global coherence is assured by a general design. To do so we need higher-order research specialising on the coordination of the results originating in different subfields, analysing and making explicit the semantic and pragmatic implications of the new local knowledge. Higher-order research is not fully absent in scientific disciplines, including economics. We find a certain number of contributions of this kind particularly in subfields such as history of economic analysis, economic history, economic methodology. However also in these subfields the increasing division of labour tends to reduce the scope of higher-order research. Another constructive reaction may be found in the increasing number of surveys, the appearance of learned journals specialised in surveys (e.g. JEL, JEP, Journal of Economic Surveys), of comprehensive textbooks, and encyclopaedias. But all these countermeasures are insufficient to mitigate the growing alienation and loss of meaning that characterises economic research (as most other scientific disciplines).

Up to a point there are important complementarities between breadth and depth in economic research and we are far from fully exploiting them in most universities and in much of current research. However, after a certain threshold, there may be an inescapable trade-off between extension and intension of research. From that point on we have to consider higher-order science as a specialisation based not on the usual vertical criterion based on a narrowly circumscribed object and\or on a class of quantitative instruments, but on a certain horizontal criterion focusing on a particular layer of a hierarchy going from the particular to the general. The main role of the latter would not be prevalently the production of new empirical evidence, or quantitative methods or new models, but the coordination between them that however may involve the production of new interpretive meaning, general methods and models. This sort of contributions may be not less valuable than those originating in first-order science. In a sense rigorous higher-order science would be nowadays even more valuable because of its extreme scarcity. It is important that this is recognised as soon as possible by the editors and reviewers of the best learned journals and by appointment boards.

The existing skepticism against ‘generalist’ contribution must be contrasted by fixing specific standards of rigour for higher-order science. In particular the latter must be falsifiable, as first-order science, but requires specific canons of assessment in order to avoid trivial falsification. In this field a thorough direct control of the first-order details on which it is based could be beyond the capabilities of a single researcher; however one wrong detail does not necessarily falsify a general pattern. Therefore a criterion is needed to assess the relevance of a part for the whole. A car without a wheel cannot run but this is not true for the lack of a seat, apart perhaps that of the driver.

A thorough development of higher-order science is particularly urgent from the point of view of diachronic structures. We have to extract a few general patterns from the chaotic appearance of empirical evidence in order to understand the direction of historical processes. This is a necessary pre-requisite to adapt to them and\or to control or modify them. The importance of this was very clear to economists in the past from Adam Smith to Marshall, Hicks, Friedman, and so on. In fact in the past at least one course of lectures in economic history and economic analysis were compulsory in the curriculum of economists. However, since the early 1970s, not by chance as we will argue in section 6, these courses became optional and progressively disappeared. The typical economist who graduates today in one of the best international universities does not have a sound historical background and this greatly reduces his capabilities to interpret the meaning of the new theoretical and applied contributions of his fellow economists as well as the meaning of the new empirical evidence. In addition if someone tries to detect historical patterns in the history of facts or ideas his suggestions risk to be considered as extraneous to sound science, being often considered as insufficiently rigorous, i.e. thoroughly circumscribed, fully detailed and founded on sound economic fundamentals. Editorial boards of learned journals tend to reject contributions of this kind while appointment committees disregard publications of this kind considering them as irrelevant, if not counterproductive, testimonial of the professional qualities of the candidate.

These negative prejudices were nurtured by the disrepute in which the so-called historicism fell, particularly in Anglo-Saxon countries dominated by positivist or analytic philosophy. The main, and more convincing, criticism against historicist philosophy or science is its alleged teleological character (see in particular Popper, 1957). I wish to emphasize that the historical patterns discussed in this paper do not have any sort of teleological implications. These patterns are recognisable only ex post and are by no means deterministic. They may be modified by accident or, to some extent, by will. It is very important to promptly detect them in order to choose the most effective policy paradigm capable to modify them in the best possible way in order, e.g., to stabilise the economy and foster sustainable growth.

The present essay aims to suggest a few diachronic structures for a more pregnant interpretation of the evolution of industrial economies since the second world war in order to assess the evolution of policy paradigms in the same period and orientate the choice of the most effective policy paradigm for the current situation.

3. The Rise and Fall of Keynesian Growth (1951-1971) and the Transition to a New Economic Paradigm (1971-1981)

As is well-known most industrialised countries grew very rapidly in the 1950s and 1960s. In some cases, as in Italy, the average rate of growth was considered miraculous because it happened to be so high and steady to overcome the most sanguine expectations (Graziani, 1998). The economic paradigm underlying this extraordinary episode of growth was based on the technological side by the systematic adoption of Taylorist techniques of division of labour that greatly increased the productivity of labour and progressively reduced the price of many consumption goods. Therefore many of them (bicycle, car, radio, telephone, television, electric appliances, etc.) could enter in the basket of mass consumption. This technological approach gave the best results within big hierarchical firms that could fully reap the involved potential scale economies. Not by chance in this period the average size of firms increased in most industrial countries (Storey, 1994). The high rate of growth of aggregate supply was absorbed by a high, and relatively steady, rate of growth of aggregate demand sustained by the gradual consolidation of the welfare state that progressively increased the share of public aggregate demand from 10-15 percent of the aggregate demand (according to the country) in the 1920s, to about 40 percent in the late 1960s (see, e.g. Boltho-Toniolo, 1999, table 2). In addition the rate of growth was stabilised by countercyclical Keynesian policies while income policies assured that the technological progress translated in growing real wages. The increasing welfare of workers therefore boosted private aggregate demand absorbing the high rate of growth of the items of mass consumption made possible by Taylorism. The stabilisation of aggregate demand obtained through Keynesian countercyclical policies reduced systemic uncertainty to a very low level and encouraged investment in plants and machineries.

The gradual liberalisation of foreign trade promoted by frequent GATT (General Agreement on Tariffs and Trade) rounds increased at the same time the export of manufacturing goods from industrialised countries. In consequence of rates of growth higher than the rate of productivity the rate of unemployment diminished throughout the period so that by the early 1960s most industrialised countries reached the full employment barrier. As lucidly anticipated by Kalecky in the early 1950s, the economic paradigm based on Taylorism and welfarism proved to be unsustainable in conditions of persistent full employment within the existing institutional and political framework. He claimed that in these conditions the increasing power of labourers and trade unions, would have induced an inflationary bias in the system and a reduction in flexibility would have implied a reduction in the rate of productivity growth.

In the late 1960s the prophecy of Kalecky started to materialise. Most industrialised countries hit the barrier of full employment by the early 1960s. This increased the number of unionised workers in big hierarchical firms and decreased the deterrence of firing, being unemployment almost exclusively frictional. This encouraged wage increases and the concession of further contractual improvements that increased unit labour costs inducing bouts of cost-push inflation. The ensuing deflationary policies triggered countercyclical policies that added demand-pull inflationary tensions nurturing further rounds of wage increases, and so on. These policies of stop-and-go did not succeed neither to maintain monetary stability, nor to keep full employment as inflationary expectations progressively increased. Since these tensions hit in different measure and timing different industrial countries, the System of Bretton Woods based on fixed exchange rates underwent increasing tensions. The situation became rapidly non-manageable so that the Bretton Woods System broke down. In 1971 the President Nixon declared the inconvertibility of the dollar. This decision gave an end to the system of fixed exchange rates introduced in Bretton Woods. With the fixed exchange rates all the system of global governance of the world economy established in Bretton Woods was questioned. The philosophy underlying the agreements of Bretton Woods was clearly inspired by the conviction, originating in the economic turmoil of the period encompassing the two world wars and strongly consolidated by the Great Crisis of the 1930s, that local and global markets must be regulated. This was not only the opinion of Keynes, the intellectual ‘godfather’ of these agreements, and of the British delegation led by him, but also of White, the powerful chief of the US delegation. The final architecture of the international economic system rested on two fundamental pillars playing quite different, complementary, roles. The IMF was supposed to play a role of active macroeconomic stabilisation of the member countries, while the World Bank had to intervene on the structural problems (poverty, infrastructures, economic take-off, etc.)

The third pillar of Bretton Woods global governance was the coordinated set of policies meant to progressively liberalize trade between countries. This role was demanded to GATT. However the process of liberalization of international trade was supposed to comply with the constraints put forward by other international agreements promoted by UN and its main articulations (UNESCO, OIL, WHO, UNEP, UNPD, etc) in order to foster social, humanitarian, sanitary, and environmental goals. The decision on dollar convertibility of 1971 jeopardised the stability of the whole of the Bretton Woods architecture. It took about a decade before the international economic order could settle on a new equilibrium (see section 5).

The 1970s were difficult years characterized by bouts of inflation, increasing unemployment, and all the other typical characteristics of cyclical crises (falls in the stock exchange, sharp reduction of investment and growth, increase in bankruptcies, increase in systemic uncertainty, etc.) The crisis, however, lasted much more than the usual ones that characterise a typical business cycle as it encompassed several business cycles that were shorter but more marked than in the two preceding decades. The cause of this anomalous behaviour is often brought back simply to the two oil shocks in 1973 and 1979 interpreted as purely exogenous factors. No doubt they had a great impact on the industrialised economies but they were partly endogenous and interacted with other important endogenous factors. In particular, the inflationary tensions accumulated at the end of the preceding period had strongly reduced by the early 1970s the terms of exchange between oil (and other primary resources exported by developing countries) and the industrial goods and services imported from the industrial countries. The sudden quadruplication of the price of oil decided by OPEC in 1973 was not only a political move in reaction to the Kippur war but also an occasion to re-equilibrate the terms of exchange between industrialised countries and producers of commodities. In addition the suspension of the dollar convertibility in 1971 added the fear that the devaluation of dollar could further worsen the terms of exchange. The fall of the Bretton Woods regime in its turn originated from the increasing inflationary tensions emerged in industrialised countries in the late 1960s. Being these tensions different in timing and size in different countries the tension on the system of fixed exchange rates became increasingly difficult to manage through official revisions of the exchange rates. We could therefore ante-date the beginning of the ‘long crisis’ by a few years, more or less according to the specific country we have in mind. However the breakdown of the Bretton Woods system is a convenient conventional divide since it has the advantage of being a crucial event for all the industrialised economies convincing most decision makers that the way out from the crisis had to be actively searched non within the guidelines of the pre-existing economic paradigm as in the 1950s and 1960s but in a different direction. In particular this event that amounts to a complete deregulation of the currency exchange regime also announces a crucial characteristics of the new economic paradigm: the systematic deregulation of markets. Deregulation of markets started to be universally considered as a recipe to be applied to all sort of problems. However only in 1979 with the government of Mrs.Thatcher started a systematic strategy of deregulation at the domestic level. Her example was soon imitated in the USA by the President Reagan, appointed in 1980, and then spread progressively to the other industrialized countries.

In the meantime, in the 1970s the industrial economies had reacted to the crisis by modifying their industrial structure. In the new environment characterized by intense industrial conflict, sudden unexpected fluctuations and strong systemic uncertainty, the Taylorist organization of industry proved soon to be inadequate. This led to the demise of the traditional assembly line, the decentralization of production in more small plants and\or to the externalisation of many phases of the productive process in favour of small and medium enterprises (SMEs). In consequence of these developments the share of employment in SMEs that had declined progressively in the 1950s and 1960s inverted its direction in the 1970s and continued to grow throughout the 1980s and 1990s (see e.g. Storey, 1994).

4. The Monetarist Growth and the Rise of Market Fundamentalism (1980-2000)

Most industrialised countries reacted to the first oil shock in the traditional Keynesian way by lowering the interest rate and increasing public expenditure in order to sustain employment. However, in the new scenario characterized by supply-push inflation, this policy aggravated the problems producing more inflation and increasing the public deficit towards unbearable levels. The simplistic so-called Keynesian stance inspiring policy in those years did not take account that the economic crisis hitting industrial countries was completely different from that of the 1930s that originated Keynes’s own approach, as the macroeconomic disequilibria (monetary, budgetary, balance of payments, unemployment itself) were now brought about by excessive, rather than insufficient, aggregate demand. Therefore the most common initial reaction to the failures of the traditional Keynesian policies was explored in the direction of more ambitious versions of the traditional policies (fine tuning, huge programs of public expenditure, etc.) that completely failed to redress the situation (see Boltho-Toniolo, 1999). At last, to the second oil shock industrialised countries reacted in a completely different way by adopting strict monetarist policies. This was a crucial turn around since from then on economic policy in most industrialised countries substantially adopted and maintained a, more or less rigorous, monetarist inspiration by assuming as priority a strict control of monetary stability and the elimination of public deficit rather than the mitigation of structural unemployment. In addition most industrialised countries started to privatise systematically public economic activities and public services. After the election of Mrs. Thatcher (1979) Great Britain was the first country to frame this new policy within the radical project of a systematic dismantling of the basic tenets of the welfare state. It was soon imitated by the Reagan administration (in charge since 1980) and then from most industrialized countries, although with different timing and peculiarities. These policies contributed to recover macroeconomic stability by curbing inflation and reducing the primary public deficit. However, in consequence of these policies, in the 1980s the real rate of interest in industrialised countries became exceptionally high, increasing public debt in some of them (like Italy), while the average rate of growth remained rather moderate leading to creeping increases in unemployment.

As a consequence of the new policy, technological and organizational decentralization gradually consolidated and spread a new economic paradigm characterized by Deregulation and Flexibility (from now on DF economic paradigm). The two basic guidelines of the new paradigm were flags waived respectively against Welfarism and Taylorism, and -more in general- against the previously ruling Keynesism. However, sound Keynesism would be perfectly consistent with technological and organizational flexibility, although not with indiscriminated flexibility in labour markets. On the contrary, in the new policy approach, deregulation was taken to mean flexibility in all the markets, including labour markets. Moreover flexibility in labour markets and industrial relations implied a shift of power from employees and their trade unions to the employers, while deregulation implied a shift of power from the electorate and their political representatives to managers and entrepreneurs.

The transition towards the DF paradigm in the national economies was accompanied and favoured by a parallel transition towards neo-liberal globalisation. The three pillars of global economic governance sharply changed orientation since the early 1980s, abandoning the original Keynesian orientation in favour of monetarism and market fundamentalism. In particular the IMF stopped worrying about unemployment and over-restrictive policies of member countries identifying in inflation the main evil to be tamed. In the early 1980s also the WB aligned on the neo-liberal line. The new active macroeconomic policies were reduced to deregulation and privatisation in the simplistic conviction, based on market fundamentalism, that once property rights are well defined and attributed to private subjects, unfettered markets are able to maximise welfare and eventually to re-launch and sustain growth. This new global policy stance was christened ‘Washington consensus,’ i.e. policy approved by the Washington-based IMF, WB, and the Treasury of US. The original complementarity between IMF and WB was progressively substituted by a sort of hierarchy led by IMF in agreement with the American Treasury. After 1981 the WB de facto accepted such asymmetrical link since it agreed to subordinate the concession of its structural adjustment loans to the approval of IMF. The rationale for this dependence was apparently based on the recognition of the influence of structural policies (under the jurisdiction of WB) on macroeconomic stabilisation policies (under the jurisdiction of IMF). However in this way the feed-back of macroeconomic policies on the structural features of the economy was completely disregarded. This led to the implementation of macroeconomic and structural policies in developing countries that involved negative, often dramatic, structural consequences such as sharp increases in persistent unemployment, poverty and inequality, rapid deterioration in environmental and social conditions (Stiglitz, 2002).

The conditions imposed by IMF to macroeconomic (and indirectly structural) adjustment loans to countries in a critical financial situation were deregulation of markets, privatisation, and budgetary austerity in the adamant conviction that these measures were necessary and sufficient conditions to stabilize the single economies and the world economy. However the rapid deregulation of markets in countries lacking the necessary institutions for regulating their activity (efficient legal system, effective antitrust authority, safety nets for the unemployed and the poor, etc.) brought about more unemployment, poverty and corruption without increasing the average wealth of the country. In particular a too rapid abatement of the trade barriers in developing countries produced the destruction of the local downing industry. In addition West countries have often pushed developing countries to eliminate trade barriers but did not dismantle their own barriers (e.g. in agriculture, farming, and textiles). In addition the premature and too rapid liberalisation of capital markets greatly contributed to global instabilities triggered by the sudden vagaries of huge sums of hot money of investors and speculators exhibiting an ever more pronounced herd behaviour. This was considered the main single cause of most recent financial crises including those of Far-East countries in 1997-98 and Argentina in 2001 (see, e.g., Stiglitz, 2002).

In order to avoid these catastrophic events it is not at all sufficient to develop the strength of markets through an indiscriminated process of privatisation. Many recent examples of rushed programs of privatisation strongly supported by the IMF without preparing the necessary conditions for their success (sophisticated and efficient legal system and regulation of markets) led to economic and social disasters: ‘briberisation’, private monopolies, higher prices and lower quality of goods and services provided (Russia is a particularly impressive case in point: see Stiglitz, 2002).

Finally the budgetary austerity was often imposed on countries already suffering from insufficient aggregate demand further increasing unemployment and reducing growth. The beggar-thy-neighbour policies that greatly contributed to the birth and persistence of the Great Depression were substituted by ‘beggar-thyself’ policies that had similar catastrophic effects on the countries adopting them and to the world economy through spill-over effects.

Summing up, the mistake made in the 1930s of reacting to economic depressions caused by insufficient aggregate demand through deflationary measures was resumed under the aegis of the Washington Consensus after the brief interlude of Keynesian policies in the 1950s and 1960s. This produced new set-backs: financial crises (Mexico, Far East, Brazil, Russia, Argentina), growing unemployment (in particular in Russia and Argentina), increase in poverty (in all the above cases). These acute crises were not greater only because the G7 countries, differently than in the 1930s, did not follow the same policy. In particular the USA throughout the period reacted to the first signs of recession with extreme energy by reducing the discount rate and engineering expansionary policies (in particular the FED governor Alan Greenspan was extremely successful in this game before September 11). However it is not clear, and not explained by the neo-liberal supporters, why economic policy should adopt this double standard.

Since the early 1980s the humanitarian and economic transfers to developing countries fell down abruptly while the deregulation of international markets was pursued with increasing energy. In particular the GATT Rounds accelerated their action directed to establish free trade at the world level. This action was particularly successful with capital movements. This brought about an extraordinary increase in the size of international flows of capital with a progressively growing share motivated by speculative goals: in 1971 the 90% of international financial transactions referred to the real economy (foreign direct investment) and only the 10% was speculative (short positions in foreign securities), while at the end of the 1990s more than 95% was speculative.

The internationalisation of economic and financial markets, interrupted and to some extent reversed in the period between the two world wars, was resumed after the second world war and continued from then on reaching and, in same cases, overcoming the level reached at the turn of the 19th century. This process was favoured by a series of eight GATT Rounds that managed to reduce to some extent the tariff and non-tariff barriers to trade.

The Uruguay round, started in 1984, progressively introduced and enforced a new philosophy of deregulation of international markets fully consistent with the neo-liberalist tenets. This process culminated in 1995 with the establishment of the WTO, a new international organisation with the mission of deregulating systematically not only the traditional markets for goods and for capital, but also the new markets for services, intellectual property rights, etc. The new institution could have advantages over the preceding situation even for developing countries. In particular it could have the authority, missing in GATT agreements, of sanctioning G7 countries including the USA for barriers to trade towards developing countries. And in fact in a few cases these countries were effectively sanctioned by WTO. However on the whole the activity of the WTO was carried on in such a way to sweep away many environmental, sanitary and humanitarian constraints introduced by national countries, international organisations (such as UNEP, ILO, WHO, UNESCO, etc) and even by international agreements ratified by the same countries that participate in the WTO itself. The institutional setting of WTO and the mind-set of its bureaucrats induced to interpret the humanitarian, environmental, social, sanitary constraints to trade as unfair non-tariff barriers that could not escape severe sanctions.

This new philosophy of management of international trade further consolidated free trade and increased the rate of growth of the participating countries; but at the same time contributed a further progressive worsening of the global income inequality and of the environmental health of the planet. This raises the question whether the neo-liberal view of development may be considered sustainable in the long run. The answer must be negative because it violates the two basic conditions of sustainable development: the environmental condition of a substantial preservation of the global environment and the social condition of a sufficient fairness in the distribution of income, wealth and use of resources (see Borghesi-Vercelli, 2001). The way out may be obtained only by further updating the updated liberalism of Keynes and Pigou.

5. The Co-evolution of Economic Thought: Three Types of Liberalism

The structural evolution of industrial economies was accompanied by a parallel evolution in the cultural sphere. We are not going to discuss on this occasion to what extent one evolutionary path affected the other; however casual observation suggests that the complex process of causation went both ways. In this essay we restrict the analysis to the co-evolution of liberalism in economic thought and in practice.

Traditional liberalism, as codified by the great classical economists (mainly Smith and Ricardo) at the end of 18th century and developed by their followers (John Stuart Mill, Marshall) in the 19th century, underlined the virtues of free markets but never forgot their limits. The founding fathers of classical liberalism were fully aware of the crucial importance of analysing with extreme precision the limits of markets in order to understand where they had to be supplemented by the intervention of the state. The legal system, education, defence, the health system, are examples of services that the market was not believed to provide efficiently and reliably and that had to be provided by the state. The liberal tradition dedicated a lot of effort to the analysis of the exact definition of the limits of the markets and on the best way to mend them through public intervention.

At the beginning the main focus was on the forms of competition. It was soon clarified that only ideal markets of perfect competition possess the virtues of optimal static allocation of resources and that in an unregulated market monopolistic and oligopolistic situations tend to emerge and consolidate spontaneously. This calls for some sort of regulation of markets that prevent these degenerations to occur.

The model of general equilibrium elaborated since the 1870s by Walras and Pareto further clarified another crucial limit of the markets. An ideal perfectly competitive market is unable by definition to solve the distributional problems that therefore may be aggravated by its functioning, since the distribution of wealth and resources is given in each period described by the model. In the multiperiodal version of the model the distribution of income becomes to some extent endogenised but its actual dynamic path depends on the initial distribution of resources and wealth and there is no tendency whatsoever to assure the convergence of this path to some sort of equilibrium or acceptable level. Economic policy therefore cannot avoid to face the distributive problems and intervene on them in order to assure acceptable distributive standards. For this reason the updated liberalism introduced the so-called income policies meant to preserve a fair distribution between profits and wages. Its practical implementations were much criticised but their foundations were, and still are, absolutely sound.

In the 1920s and 1930s two crucial steps forward were made to understand the limits of competitive markets and the way to remedy them.

Pigou, in his epoch-making book The economics of welfare (1920), elaborating on ideas sketched by Marshall, his academic mentor, clarified a fundamental reason for the existence of market failures: the existence of economic externalities, i.e. costs or benefits that cannot be registered by the market. He pointed out at the same time how to remedy to them in principle (internalisation of externalities through subsidies or taxes). Pigou provided in this way the microeconomic foundations for welfare economics and for the establishment of the welfare state supported in precedence with passion but weak foundations by political figures such as Lord Beveridge and political movements such as the Fabian Society. A few years later Keynes in the General Theory (1936) provided the macroeconomic foundations of a theory of market failures and of the macroeconomic policy required to mend them. These two fundamental contributions were complementary and were later on merged in a more advanced model of updated liberalist regulation (called in this essay updated liberalism) that spread after the second world war up to the 1970s. Its success was fostered by the growing power of trade unions in the 1950s and 1960s while the growth of big firms increased the unionised base and the diminishing unemployment increased their strength.

There cannot be any doubt that these fundamental contributions of Keynes and Pigou were fully consistent with the basic tenets of classical liberalism. Not by chance both elaborated ideas already present in germinal form in the works of their common master Marshall. It is a pity that the complementarity of these two contributions was not recognized by the two protagonists and their followers in part for personal reasons (possibly a Freudian jealousy between the best pupils of the same master) and in part methodological reasons (acceptation by Pigou and rebuttal by Keynes of a general equilibrium approach) although this last contradiction was not insurmountable and was soon somehow mended by the founders of the neoclassical synthesis (Hicks, Samuelson, Modigliani, Patinkin).

Subsequent research clarified that there are further important reasons that distinguish real markets from the ideal ones and require an active regulation. In particular, a competitive market realizes the optimal allocation of resources among alternative uses only under very stringent assumptions underlying the abstract model of perfect competition, namely: completeness of markets, zero transaction costs, absence of serious uncertainty that is guaranteed only when the agents have perfect foresight or rational expectations, sufficient thickness and extension of markets that is assured in principle only when the number of traders tends to infinity, and stability of markets. The trouble is that real markets never comply with all these conditions. On the contrary very often they do not comply with most of them. This is particularly true in developing countries. However, in principle, the process of globalisation pushes the real markets closer to the abstract model of perfect competition; therefore it improves the economic and financial efficiency of markets by enhancing their extension and thickness. However the allocation of resources of unregulated global markets cannot be considered optimal for a host of reasons.

First of all the uncertainty intrinsic in the working of the markets raises serious problems because it is often endogenous and and\or inconsistent with the usual axioms of decision theory under uncertainty (as expressed, e.g., by Savage, 1956). In particular it implies that the expectations of economic agents are neither in general correct nor rational (see, e.g., Shiller, 2000, Vercelli, 2001). In addition when information is imperfect or asymmetric, competitive equilibrium is not Pareto efficient (Greenwald-Stiglitz, 1986).

In addition markets are incomplete; in particular most future markets are missing and cannot be easily established. What is worse, it can be proved that in principle markets cannot be made complete, in particular as far as future markets are concerned; in any case, the optimal intertemporal allocation of resources cannot be realized by real markets even if they are relatively competitive because most future markets are missing and the more do expectations refer to the distant future the more they are liable to be systematically incorrect.

Also Transaction costs are often quite sizeable. In particular the costs necessary to match demand and supply may involve significant material costs, such as travel costs, or immaterial costs, such as those involved by the gathering and elaboration of information about the relevant characteristics of potential demand and supply. Their existence is sufficient to jeopardize the ability of a competitive market to realize the optimal allocation of resources (see Arrow, 1999, for a recent assessment of the problem).

Externalities are particularly important because of the above problems and in particular because incomplete markets by definition cannot register all the costs and benefits of economic decisions, and because the property rights on goods and resources are not always well defined, as is typical with many environmental resources such as the global commons (water, air, biodiversity, etc.)

There are in addition a few important markets that are fairly unstable from three different points of view. Competitive markets tend to be institutionally unstable in the sense that they tend to lose their competitive nature as a consequence of the exploitation of scale and scope economies, or of discretionary power in disequilibria, or of monopolist and oligopolist practices. In addition markets may be dynamically unstable in the sense that they do not recover easily the equilibrium position whenever they are displaced from it by a shock. Finally markets may be structurally unstable in the sense that a small shock may alter the qualitative characteristics of their dynamic behaviour.

We must conclude from the preceding arguments that for sound well-known reasons global markets cannot be left unregulated. Their active regulation is necessary for maintaining and perfecting competition, improving intertemporal allocation of resources (in particular the intergenerational distribution of resources), reducing uncertainty and mitigating its effects, internalising externalities. In addition, as argued above, the distribution of resources, income, and wealth cannot be left to unregulated global markets because even perfectly competitive markets cannot assure their fairness.

Of course, if market failures require some amount of regulation, the failures of regulation are not less harmful. Both the experience and the theoretical analysis of bureaucratic and political processes have shown that the failures of regulation are systematic and may be even worse than those of the markets. In addition the failures of regulation are much more visible than the market failures that they are supposed to mend. Therefore the disillusionment on the efficiency of regulation has been so strong that an irrational faith has spread, particularly since the 70s, on the power of unregulated markets. The ensuing process of deregulation has been successful in dismantling many degenerated forms of regulation and must go on to this end, but in a few cases it has gone too far, dismantling also the necessary forms of regulation such as those that set environmental, sanitary, humanitarian and ethical standards. In addition the relationship between regulators and regulated agents proved to be a sort of evolutionary game: the regulated agents always try to elude the rules set by the regulators who must therefore continuously update these rules. Therefore a continuous process of re-regulation must accompany the process of deregulation meant to dismantle obsolete or inefficient rules in order to introduce the most efficient minimal necessary rules in the evolving context. However, the mistrust in regulation has gone so far to cloud the necessity of regulating the markets. Of course the regulation of markets must be kept to a minimum level in order to avoid as far as possible the disruptive potential of regulation failures but cannot be altogether absent.

The prophets of the neo-liberalist counter-revolution ignored the arguments on the limits of real markets accumulated not only by the updated liberalism but also by the classical liberalism that demonstrated the necessity of active regulation of markets in order to maximise their contribution to social welfare. In this essay I limit myself to briefly examine the crucial contributions of three of the most important founding-fathers of neo-liberalism.

The microfoundations of the neo-liberalist stance was originally suggested by Coase (1950). He did not deny that real markets are subject to failures but in his opinion this happens whenever the property rights are not well defined, as in the case of environmental commons. Therefore the remedy suggested was quite different from that of updated liberalism. This new explanation was not seen by the neo-liberal followers of Coase as an additional explanation of market failures, that could well be considered consistent with those pointed out by updated liberalism, but as the ultimate cause of observed market failures that in principle substitutes all the other explanations analysed by updated liberalism. To the best of my knowledge, the reason why the other causes of market failures were ignored by this stream of thought has never been spelled out with thorough scientific arguments. This extremist interpretation of the Coase approach led to a very simplistic policy rule vis-a-vis the regulation of markets: “let’s define property rights on all the goods, including public goods (such as, e.g., environmental goods, property rights, etc) the unregulated market will solve by itself all the other problems”. This was a very radical departure not only from updated liberalism but also from classical liberalism. All the areas reserved to the states by classical liberalism, including education, are now considered in principle as better manageable by unregulated markets. In addition, one particular aspect of the Coase theorem – it does not matter to whom property rights are attributed (rich or poor, polluter or polluted, etc.)- was interpreted as if distributional problems were immaterial for social wealth.

Friedman suggested the first macroeconomic foundations against updated liberalism since the 1950s by arguing that countercyclical policies are noxious for the economy, at least in the longer period, as they tend to increase the structural inflation rate and the natural rate of unemployment (see e.g. Friedman, 1969). His approach shares the dynamic methodology of Keynes and Pigou descending from the influence of Marshall, that focuses on the crucial role of disequilibrium dynamics, but it is turned against Keynes. The main argument is that the Keynesian attempts to stabilise the economy are bound to increase its instability by nurturing increasingly inflationary expectations. However all the argument is based on a strong under-valuation of the intrinsic instability of unfettered markets in a sophisticated monetary economy (see e.g. Vercelli, 2000, and the literature there cited).

Lucas provided different, and much more radical, macroeconomic foundations to the neo-liberal stance: the existence of perfectly competitive equilibrium is just assumed. Provided that the model based on this assumption mimics reality sufficiently well, all the deviations from the perfectly competitive paradigm (disequilibrium, oligopoly, monopoly, etc.) are considered as irrelevant for economic analysis (see Vercelli, 1991). Under these assumptions Lucas proved that what is generally defined as Keynesian anticyclical economic policy is impossible, or at least fully unreliable, as it is disturbed in an unpredictable way by the structural instability of a monetary economy and is due to increase structural uncertainty. Lucas argues that disequilibrium concepts, such as unemployment, and out-of-equilibrium dynamics are meaningless so that he remains without any method for detecting market failures and remedying to them. Friedman advocated a fixed monetary policy and systematic deregulation. Therefore in this view the only structural intervention considered sound was privatisation. Lucas does not rule out some scope for further structural policies that increase the efficiency of free markets, but both deny any scope for active regulation of competitive markets. Since the late 1970s the macroeconomic school of new classical economists inspired by Lucas ousts both the Keynesian school and Friedman’s monetarism as mainstream school in macroeconomics in full syntony with the contemporaneous rise of neo-liberalism.

As we have seen in the above brief analysis of the contributions of three of the most important prophets of the neo-liberalism the departure from the classical liberalism of Smith and Ricardo, not only with its updated version of Keynes and Pigou, was very radical. Active economic regulation was completely ruled out. In this view deregulation and privatisation must characterise a transition period towards the golden age of unfettered, perfectly competitive, free markets. The main role of the state remains that of defining and defending property rights. If we want to find a precedent after the revolution of classical economists we have to refer not to their genuine followers but to Say, Bastiat and the other economists that Marx, impolitely but not without reason, called ‘vulgar economists’.

6. Concluding Remarks

The basic thesis argued in this essay is that the long crisis of the 1970s produced a crucial redirection in the path of structural change in industrial economies by substituting the pre-existing economic WT paradigm with a new DF paradigm and substituting at the same time the updated liberalist regulation of markets with neo-liberal de-regulation. This interpretation is by no means the usual one, as it has to compete with at least two alternative hypotheses that have many supporters.

Many observers believe that it is artificial to detect general diachronic structures in the historical evolution and see a fundamental homogeneity in the evolutionary process apart from exogenous shocks (see, e.g., Lucas, 1981). We have mentioned in section 2 a few good reasons for rejecting this point of view.

The other point of view that we have to mention here was, and is, very popular and greatly contributed to the rise of the neo-liberal approach and contributes now to its consolidation. In this view the Keynesism that spread after the second world war up to the 1970s is seen as a deviation from sound liberal principles as it led the policy authorities to impose growing constraints on the market restricting its scope and therefore its ability to regulate the economy. Therefore, in the neo-liberal view, the counterrevolution that spread since the late 1970s is interpreted as the healthy restoration of the traditional, supposedly sound, liberalist principles. However we have seen in the former section that the market fundamentalism that characterizes the neo-liberal thought and policies has nothing to do with classical liberalism and that on the contrary the ‘Keynesian’ paradigm, based on seminal works such as The General Theory by Keynes and The economics of welfare by Pigou, was nothing but a further step in the evolution of liberalism.

Of course the actual applications of both paradigms in industrialised countries are full of inconsistencies. Anticyclical policies were abused, particularly since the late 1960, ignoring the constraints of basic monetary stability that Keynes never ignored. More in general the intervention of the state in the economy went too far, much beyond what Keynes and Pigou would have considered sound, both in size and method. A reaction to these degenerations became in any case necessary in the 1970s, and to some extent monetarism, supply economics, and systematic deregulation went for a while in an obvious direction, that even Keynes and Pigou would have approved of.

Analogously the actual applications of the neo-liberal regulation were not at all consistent. The abuse of anticyclical policies continued, although they were now openly orientated towards the interests of business rather than of workers. The corruption and conflicts of interests that accompanied the growing role of the state in the WT liberalism changed nature but did not diminish. Pensions in the WT liberalism were jeopardized by the growing debt of the state, while in the neo-liberal era they were menaced by the unstable market value of Pension Funds recently shaken by the stock exchange crisis nurtured by bankruptcies and conflicts of interests.

Of course the reconstruction of a diachronic structure requires a strong simplification of reality in order to sort out a few essential tendencies from the chaotic, and apparently contradictory, noise of raw empirical evidence. In particular we have to stress that classical liberalism, updated liberalism and neo-liberalism coexisted in both periods. In what we called the WT growth at the beginning the traditional liberal approach was still prevailing, while the neo-liberal approach (traditional laissez-faire) was not at all absent but lacked sound foundations. However the trend in this period was characterized by a progressive strengthening of the updated liberalism that conquered officially the economic policy with the Labour governments of Wilson since 1964 in the UK and with the Democratic administrations of Kennedy (1960-63) and Johnson (1963-68) in the USA. The other industrialised countries followed their lead. For example, Italy adopted officially a Keynesian policy only with the centre-left government in 1962, although the preceding governments supported by coalitions led by the Christian Democratic party pursued a socially-constrained liberal policy although under the influence of the social doctrine of the catholic church rather than under the influence of Keynes and Pigou.

Analogously in the PF growth period the updated liberalism retained much of its influence. A case in point is the genesis and development of Environmental policies. They were inaugurated only in the 1970s and were mainly inspired by the Pigouvian approach. Only with the Bush administration there was an outright rejection of the Pigouvian approach in favour of a Coasian approach more consistent with the neo-liberal drive. On the other hand left-wing government tried on many occasions to resume in part the basic idea of updated liberalism (e.g. under the Carter and Clinton administrations in the USA, under the Prodi government in Italy, the Jospin government in France, and so on). However notwithstanding these political fluctuations since the early 1980s on the whole the updated liberalism declined while neo-liberalism progressively increased its influence also with left-wing parties and governments. (A case in point is the policy of the Blair Government strongly influenced by neo-liberal ideas).This change of direction is visible by comparing the actual policies realised before and after the long crisis of 1970s. By the early 1980s deregulation, privatisation, dismantling of the welfare state, and so on, were pursued with increasing determination by most governments in industrialised countries.

It is not the purpose of this essay to discuss whether there could have been better alternative ways out from the serious problems that affected the industrialized economies at the end of the Millenium. However it is by now quite clear that market fundamentalism was unable to provide the much needed remedies to market and state failures and is likely to aggravate them because by definition it cannot face the causes of market failures as their existence is denied in principle. The neo-liberal approach was apparently successful for a while because it reacted to the abuses of updated liberalism in a direction that to some extent was compulsory (stabilization of monetary and budgetary policy and check to the excessive interference of the state on the economy). But the way in which this was done and the further steps afterwards could have been different tackling the causes rather than the symptoms of economic disease. This could be done by resuming the physiological evolution of liberalism as updated by Keynes and Pigou. Of course also their contribution should be updated in the light of the historical experience of the second part of last century.


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