The Crisis of Our Age – Part II: Welfare Economics

In Part I of this series I explored the idea that the British vote to leave the European Union may be understood as a rejection of the economic foundation of the post-World War II era.  The prevailing view has been that economic growth, primary reliance on markets to allocate resources efficiently, free trade, and global integration would make the lives of humans better.  The metric that showed this approach was working was rising standards of living measured by average per capita money incomes.  Politicians and pundits both were fond of saying that “…a rising tide lifts all boats.”

Underlying this global economic system were the findings of a branch of neo-classical economic theory called welfare economics.  Economists have long been interested in how we should determine that one set of economic rules is better for people than another.  The name “welfare economics” reflects the idea that some policies create more human welfare (wellbeing) than others.  It turns out that determining welfare changes for society is a non-trivial task.  The rules we should adopt for saying one outcome is better than another are not easy once your society has two or more people in it.

Basically there are three types of economic changes that might be improvements for society.

The first was identified by an Italian economist named Vilfredo Pareto.  Pareto argued that if there is a change in the economy such that one person was better off and no one else was worse off, that change should be considered an improvement in social welfare.  This assumes that a person’s welfare is independent of everyone else in society; that is, we are not envious of the one person’s gain.  With that caveat there is broad agreement that if there is at least one winner and no losers it should be called an improvement.  This outcome is termed a Pareto improvement by economists.

The problem is that a lot, if not all, economic changes create benefits for some people and impose costs on others.  Growing free trade since the adoption of NAFTA and other trade agreements had this effect in the United States.  Many people are able to spend less on consumer goods that used to be made in the U.S. but are now produced more cheaply in other countries.  (Peruse your closet and see if you can find on a map all of the countries your clothes were made in.)  At the same time, people working in U.S. manufacturing have lost jobs, painfully obvious in Maine’s textile, shoe, and paper industries.  Rarely does economic change create only winners.

So the second issue of welfare economics was that when there are both winners and losers, we need a rule to determine whether that change is an improvement in overall welfare.  The answer was yes, as long as the winners could compensate the losers for their losses and still have enough winnings left over to be ahead of where they were before the change.  Some economists call this a compensated Pareto improvement.

This is problematic, particularly in Western cultures, because we are uncomfortable with taxing some people (the winners in this case) and transferring those dollars to the losers.  We end up asking all kinds of questions that show this discomfort.  Did the losers perhaps lose because of their own personal failings?  Maybe they were just lazy.  And why should we punish the winners for being successful?  Won’t this just make them less entrepreneurial?  Aren’t the winners job creators?  Can we trust the losers to tell us really how much they lost?  So compensating losers became politically unpopular and some economists developed theory to help justify not paying compensation.

This is the third key idea in welfare economics embodied in something called the Kaldor-Hicks rule, named for the economists who developed it.  If an economic policy makes some people better off and others worse off, the argument goes, we can still call it a welfare gain.  We just need to show that the winners could have compensated the losers and still have enough left over to be ahead.  You don’t actually have to pay the compensation for it to count as an improvement in welfare.  This became known as a potential Pareto improvement.

This approach fails any reasonable concept of justice yet it is the foundation for the so-called neo-liberal economic approach of the post-World War II period.  Economic growth leads to rising average incomes.  Even if the distribution of that income becomes increasingly distorted (as we saw in the data in last week’s post), people should accept that society’s welfare has improved.  The losers could have been compensated.

It is no wonder that large swathes of society in Britain, the U.S., and around the world feel poorly served.  The very premise of our economic policy is ethically flawed.  Many ideas are now competing to replace this neo-liberal ideology of market-driven economic growth unfairly distributed.  In Part III next week we will explore one of these alternatives – Sustainable De-growth.

Mark W. Anderson

About Mark W. Anderson

I am proud to be a Mainer, born in Caribou and schooled at Brewer High School, Bowdoin College, and the University of Maine. I am grateful for a 35 year career at UMaine, the last decade in the School of Economics.