The Seeds forthe Birth of the Logic of Economic Policy

1.4.1 Economic Policy in the Early 1930s: A Little More Than a Collection of Examples of Empirical Policy

Most classical writers and the marginalists had suggested cases where public intervention was in order, in particular in the case of taxation.

The relevance of Malthus' analysis of arguments in favour of state intervention is along similar lines. He did not expli­citly develop any specific role for public policy, but he introduced concepts that proved to be very useful for later analyses, having an immense impact on the foundations of the first pillar of economic policy as a discipline. In fact, some of these concepts were developed by Frisch, Kalecki and Keynes more than a century later. Keynes largely recog­nised his intellectual debt to Malthus, who had shifted the focus of analysis towards the short-run changes in eco­nomic activity and its monetary aspects. Inflationary and deflationary tendencies were determined by ‘effective demand', i.e. demand sustained by purchasing power.

The feeble position of the economic discipline in favour of government intervention evolved slightly with the conclu­sions of the classical school. In conjunction with a positivist turn in the orientation of analysis, Mill introduced a distinc­tion between productive and distributive actions. The former obey the laws of an objective nature, not allowing for any discretionary behaviour; the latter, instead, leave room for voluntary choices, as they depend on the opinions and senti­ments of a society.

The cases for policy intervention indicated so far were largely what Walras called ‘examples of empirical policy' rather than a broad-ranging and consistent set. They were certainly dictated on the basis of an analytical evaluation of the circumstances suggesting them but were not part of a systematic assessment of the foundations and articulation of public policy.

A systematic investigation of the foundations of govern­ment intervention only began to emerge towards the end of the nineteenth century. We can refer to it as the ‘logic of economic policy', or what was initially called ‘welfare eco­nomics' and later became a part, first, of social-choice theory and, more recently, of implementation theory.^[4]

The first attempts to develop such a theory were those of Sidgwick (1883), whose treatise had economic policy as an object in its third part. Henry Sidgwick introduced qualifica­tions to the proposition according to which Adam Smith's system of natural liberty was able to pursue the public interest only up to some point going beyond the issues arising from distribution. There are, in fact, cases - not to be relegated to imperfections, which could be omitted in a theoretical analysis - where the self-interest of people diverges from social interest. Typical is the case of production of what later will be called ‘public goods' and of goods that favour future

generations. Individuals produce a scarce quantity of the for­mer, as they cannot get sufficient revenue now.

Along a line similar to Sidgwick’s - possibly reflecting some negative consequences deriving from the triumphant industrial revolution - Marshall (1890) and Pigou (1912, 1920) also laid down essential principles for state interven­tion, partly connecting it to the preferences of citizens. These writings had not been produced only as an almost occasional and case-by-case by-product of analytical investigations (as it was for the ‘classics’ and Walras) but derived from a systematic corpus of principles that could justify a number of microeconomic policy interventions.

Pigou offers the first general and systematic account of the divergences between the marginal private and social net product, which justify public intervention due to ‘the fact that, in some occupations, a part of the product of a unit of resources consists of something, which, instead of coming in the first instance to the person who invests the unit, comes instead, in the first instance (i.e. prior to sale if sale takes place), as a positive or negative item, to other people’. These people may be (1) the owners of durable instruments of production, of which the investor is a tenant, (2) persons

⁶ The same point of view is held by Pigou - on different grounds, that of rationality (instead of impartiality) - when he speaks of the defective telescopic faculty of people. Pigou draws this principle from Jevons (1871), who claimed that the factor expressing the effect of remoteness should play no role in our decisions, allowance being made for uncer­tainty. The different positions of Sidgwick, on the one side, and Pigou and Jevons, on the other, are certainly determined by their different formula­tions, philosophical in one case and economic in the other.

In fact, in the first case, there is the tendency for the tenant to intensify the use of the instruments when the end of the tenancy is approaching. In the second case, one person may render uncompensated services or disservices to other per­sons not involved in the exchange, as in case of lighthouses, afforestation and so on. The latter case refers to industries that could produce at increasing returns due to external economies internal to the industries that they could earn as an effect of their growth but are prevented from doing so in a competitive market because expansion is not similarly profitable for each firm.

Apart from these authors and the cases of market failure they indicated, generally speaking, the principles of state intervention advocated by Pigou were condemned to dor­mancy until the 1930s, when they were criticised by Robbins (1932) and the new welfare economics. Supporting the virtue of markets was the commonly held view inspiring political parties and governments, and this view was not contradicted by the rather satisfying evolution of the econ­omy in most developed countries - also as an effect of a number of favourable economic circumstances - until the end of World War I and the postwar recovery. But a number of factual and theoretical developments were looming that sprouted in the 1930s, making a stronger case in favour of government intervention, due in particular to the insurgence of macroeconomic failures.

1.4.2 Developments of the 1930s and after World WarII

The most important factual changes in economic perfor­mance were related to the difficult adaptation to the postwar economic and social situation of some economic systems (e.g. the United Kingdom), especially if the new situation was approached with the old pro-market lens and policies; the emergence of the prolonged Great Depression; and the progressive contraction of international economic exchanges of goods and capital.

Two notable developments in the theory and a semantic novelty emerged in the 1930s7 that laid the ground for the take-off of the discipline after World War II. First was the development of the ‘new welfare economics’, which began with Robbins’ (1932) rejection of the axioms of interpersonal comparisons and equality of utility perceptions on which Pigou had based his welfare economics. This rejection was the starting point, if not the ‘manifesto’, of the new welfare economics, which really threw new light on a possible range of economic policies open when accepting the Pareto criter­ion. In particular, a large debate (continuing after the war) arose on the application of the basic principles of policy intervention in a way that enlarges the cases of government action as envisaged by this criterion. This allowed for only a partial ordering of the various possible situations and was conservative in nature, thus imposing the tyranny of the status quo (Acocella 1994). The debate discussed the com­pensation principle (Harrod 1938; Hotelling 1938; Kaldor 1939; Hicks 1939; Scitovsky 1941; Little 1949) to comple­ment the Pareto principle and enlarge its scope of applica­tion, along non-utilitarian bases. Harrod’s argument was that, without some kind of interpersonal comparison of uti­lity, economists would be condemned to suggest no indica­tion of policy action. In particular, they could not have recommended the Repeal of the Corn Laws, as Ricardo (1817) had made. The final position of Little (1949) is of

⁷ In the previous decade, there was practically no relevant contribution to the theory, with the exception of Sraffa’s contribution leading to the conclusion that it was ‘necessary... to abandon the path of free competi­tion and turn in the opposite direction, namely, towards monopoly’ (Sraffa 1926: 542).

specific interest, as it underlines the impossibility of separ­ating the distributional from the productive aspects of a change and thus evaluate it in terms of pure efficiency, excluding equity considerations.

Second was the advent of Keynesian thought, tied to a change of paradigm as well as of the historical contingen­cies (Jesperson 2015), which rather soon developed as the new orthodoxy (but see Asso 1990). This introduced a new important case of market failure - unemployment, the first of a macroeconomic type of failures - and the need for suitable government action. This innovation is already in Keynes (1930), and, more notable from a practical point of view, can be found in Frisch (1933, 1934), Kalecki (1933) and Keynes (1936).

Frisch (1933: 236) clearly expounds the paradox of thrift when he says, ‘[t]he fact that we “save” therefore means at this juncture that we destroy our productive forces'.^[5] Frisch (1934) clearly expounds the intrinsic tendencies towards contraction and expansion in an exchange system and the essence of the multiplier. Frisch called these tendencies an ‘encapsulating phenomenon', an absolutely meaningful term for the expression ‘macroeconomic market failure'. This term was first used in the 1980s by Stiglitz (1986: chap. 4), even though not only unemployment but also inflation, low (or excessive, unsustainable) growth and external imbalances were already well known causes of market failures during or after World War II.^[6] For an explanation of the reasons for use of the term ‘macroeconomic’, see Acocella (1994). Kalecki (1933) built a dynamic model containing all the ingredients of later models of Keynes due to Lange and Hicks. The contribution by Keynes (1936) is well known and does not require many details at this point.

The semantic novelty worth noting is that certainly by the mid-1930s the term ‘economic policy’ had been forged for the new discipline to appear, even if - at least in the Italian case - much of the old wine was in a new bottle. In Italy, the expression used by Fontana Russo (1935) was politico eco­nomica, although the content of his new book remained pretty much the same as before in referring mainly to trade treaties and policy (Fontana Russo 1902).

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