Category Archives: modern economics

The Draghi Report vs. New Economic Thinking (long)

1. Report narrative

The Draghi report starts with three statements.

The European Union needs economic growth to realize its ambitions on social cohesion, decarbonization and strategic autonomy.
Its economy suffers from a large and growing competitiveness gap with respect to the rival economies of the USA and China. This gap must be closed to achieve the EU’s strategic objectives.
To increase competitiveness, Europe must invest massively, way more than at any point in its history, and pursue coherent policies across multiple areas. This is true for economics policies writ large, and beyond: trade, competition, industrial, monetary, defence development cooperation. All these policies must be tightly integrated and put in service of the overarching strategic goal of being competitive.

Given these premises, the report identifies intervention areas: ten sectoral policies (energy, critical raw materials, digitalisation and advanced technologies – in turn broken down into high speed and broadband networks, computing and AI and semiconductors – clean tech, automotive, defence, space, pharma and transport) and five horizontal ones (accelerating innovation, closing the skills gap, revamping competition and strengthening governance). The bulk of the report then proposes, for each of these policies, some concrete objectives and the interventions to achieve them.

2. Competitiveness through a New Economic Thinking lens

Let’s look at the three statements from a NET perspective.

The first statement is obviously problematic. Most NET authors would outright deny that social cohesion, decarbonization and strategic need economic growth. And they would be mostly right. There is ample evidence for the opposite thesis, that the emissions of greenhouse gases such as CO2 are tightly correlated with economic growth. Neoclassical economists point out that, in theory, emissions can be decoupled from output; the former can decrease as the latter increases. This is called “absolute decoupling” and features as target 8.4 of the United Nations’ Sustainable Development Goals. Absolute decoupling is empirically possible, and has been observed in some of the wealthier countries. However, it has only ever happened at very slow rates. Even for the best-performing countries, decoupling should speed up by a factor ten in order for them to respect their commitments under the Paris Agreement. Many NET economists believe demand policies are a safer and more efficient way to keep human civilization within the planetary boundaries: for example, shifting from driving cars to transit and cycling gets you a lot more emissions reduction per Euro invested than shifting from internal combustion engine cars to electric ones. In a slogan, NET economists believe green growth to be a myth. French economist Timothée Parrique makes this point clearly and forcefully in this short video.

Similarly, many NET scholars refute the idea of a positive linkage between economic growth and social cohesion. We have known for a long time that reported satisfaction is uncorrelated to GDP per capita: this is called the happiness-income paradox and was discovered by James Easterlin in 1974. More recently, Ole Peters has shown that systems that grow on average while practically all its participants are reduced into poverty are perfectly possible : indeed, such systems arise naturally when the income of individuals grows randomly and multiplicatively over time, like most financial markets most of the time.

As for social cohesion, it has now become clear that, from a NET standpoint, there is no automatic path from economic growth to poverty reduction. This is a key concern for academic thinkers like Jason Hickel (who argues rich countries are better off with degrowth instead), Giorgos Kallis, Tim Jackson and others. Judging from the recent report of the United Nations Special Rapporteur on Extreme Poverty and Human Rights – bearing the NET-friendly title Eradicating poverty beyond growth – these ideas are getting buy-in in the global policy space.

Social cohesion is also linked to decarbonization. The debate on just transitions shows that decarbonization is much harder for the financially more vulnerable, and therefore harder to do in more unequal societies. Joel Millward-Hopkins calculated that highly unequal systems require far more energy to provide everyone with decent living standards. The implication is that inequality is a drain on productivity when you measure input in physical terms and output in human well-being.

The second statement – that the European economy is less competitive than the economies of the US and China, and that this is a bad thing – looks a priori reasonable. Seen through a NET prism, however, it raises empirical and normative questions. How do we measure competitiveness? By dividing the input into the economy by it output. How does the Draghi report measure output? I have not found a methodology section in the published report, but Figure 1 uses GDP to compute productivity. That’s a fatally flawed measure of productivity, because it misses what economies are actually supposed to be producing. That would be human well-being, and GDP is simply not fit to measure it, not even approximately. This has been known since Simon Kuznets operationalized it in 1934, so I will not embark on a critique here. Suffice it to say that, when you log primary forest, you increase GDP. When you sell a public park to a real estate developer to build luxury housing on, you increase GDP. It is a wildly inadequate measure of economic performance. It is disappointing to see it used in a document of the importance of the Draghi report. NET scholars would have tried to estimate physical productivity: for example, by comparing worked hours and material input with some measure of human welfare like the United Nations’ Human Development Index.

The Draghi report’s reliance on GDP as a proxy of welfare means that its authors accept the neoclassical theory of value based on utility theory, and believe that the fundamental theorems of welfare economics apply to the European economy, at least approximately. NET thinkers reject these beliefs, as do most people who are not professional economists. This leads the report to pursuing an economy that, at times, can feel dystopian – like when the report laments that most pension systems in Europe are public and mutualized, instead of private and finance-based like in the US. This is a bad thing, if you are an investment banker, because it leaves much less hot money sloshing around on financial markets for you to profit from. But if you are a human believing in human solidarity, unwilling to trust financial markets with providing for you in your old age, you are likely to find it rather good.

From the point of view of non-investment bankers, the Draghi report suffers from a “garbage in, garbage out” problem: the best analysis will still be useless, or worse, if it aims at optimizing the wrong indicator.

3. Policy innovation – but to do what?

The third statement – that the European Union is not investing nearly enough in its future, and suffers and a gap in policy coherence with respect to the USA and China – seems intuitively correct. Europe is polycentric in nature, so everything is a hard-achieved compromise, including investment. “Frugal” member states are notoriously suspicious of public investment, seen as a machine to produce Southern European public debt and shift it to Northern Europeans. Even when there are no ideological disagreements, polycentricity means that a certain amount of horse trading is baked into any major policy decision in Brussels. On average, this reduces policy coherence: it is hard, for example, to imagine a European version of the American Inflation Reduction Act.

I can imagine several NET authors agreeing with Draghi here. Already in the foreword, the report calls for unprecedented levels of investment.

To digitalise and decarbonise the economy and increase our defence capacity, the investment share in Europe will have to rise by around 5 percentage points of GDP to levels last seen in the 1960s and 70s. This is unprecedented: for comparison, the additional investments provided by the Marshall Plan between 1948-51 amounted to around 1-2% of GDP annually.

This can-do attitude resonates with the insistence of NET scholars that we can and should do things differently, if “differently” brings better results. Scholars like Stephanie Kelton, Mariana Mazzucato, Thomas Piketty, Kate Raworth, Randall Wray have produced substantial economic policy innovations, and are advocating, sometimes successfully, for their implementation. These and other NET thinkers believe Margaret Thatcher’s quip, “there is no alternative”, to be wrong. Apparently, so does Draghi. How to organize the economy is a political choice, not an inevitability. Policy makers are more free than the study of neoclassical economics has led us to believe.

Mario Draghi began his career as an academic economist. But he is best known as a banker and a policy maker; a practitioner, more than a theorist. So, it is no surprise that the most interesting content of the report that bears his name is its discussion of various specific policies. There is some solid advice here, built on insightful analysis. For example, Chapter 3 (“A joint decarbonisation and competitiveness plan”) starts with a discussion on the root cause of energy prices. The report argues that the price of energy – gas in particular – is made “unnecessarily high” by institutional factors. Even long-term contracts are indexed to spot energy prices, and spot energy markets are vulnerable to speculation because (1) the supply is highly concentrated, and (2) the European regulation on commodities derivatives grants exemptions to companies whose primary purpose is not trading. Energy prices can be reduced and stabilized by de-financializing the energy markets; abolishing exemptions from regulation on commodities derivatives trading is a good place to start, and indeed is part of the American playbook. In a similar vein, the report offers good advice in Chapter 6, dedicated to governance: consolidate coordination mechanism; consolidate budgetary resources; extend decision making by qualified majority voting in the European Council, and so on. These are not new ideas, but the Commission may hope that Draghi’s prestige lends them extra weight.

But not all the report’s policy advice is unambiguously good. Viewed through the lens of NET, some policy proposals suffer from the fundamental misalignment, noted above, on what a “good” economy looks like. If you – like me – are sympathetic to NET approaches, it sometimes makes for disturbing reading. Several times I found things that I believe are (good) features of the European economy described as bugs. For example, regulating the tech sector (the use of the precautionary principle, data protection laws, compliance on AI) may be “a barrier to scaling up” (Chapter 2), but it has protected European citizens, at least a little bit, from the worst data protection and privacy abuse of the tech giants. Same story in Chapter 5, where the report deplores the weakness of private equity funds on the European markets. This certainly raised my eyebrows: private equity is known for asset stripping companies and impoverishing workers to the benefit of the wealthy (“buy, strip and flip”). Cory Doctorow describes its effects in a colourful, but factually correct, way:

When PE buys up all the treatment centers for kids with behavioral problems, they hack away at staffing and oversight, turning them into nightmares where kids are routinely abused, raped and murdered (NBC News). When PE buys up nursing homes, the same thing happens, with elderly residents left to sit in their own excrement and then die (Politico).

Here is a Guardian article with many links to the documented effects on private equity on the economy. It is safe to say they are not productive at all. They only appear so if you insist measuring economic output wrong. Adopting a NET perspective would have avoided the dystopian moments in the report.

4. A deeper European integration

The report builds on technical arguments to advocate for deeper European integration. We need to increase productivity; to increase productivity, we need bold, tightly coordinated policies across the board; to have those, we need deeper integration. European institutions must work in a more coherent way with one another; member states must work in a more coherent way with the EU (in Chapter 1). Specifically:

If tighter integration means a two-tier EU (a tightly integrated core, plus a more loosely integrate outer layer), so be it.
The EU should move towards “the issuance of a common safe asset” (in Chapter 5), by which Draghi means “emitting European sovereign debt”.

Deep integration of economic policy and sovereign debt issuance would bring the European Union closer to something like a federal state. This is a large step, but it appears much more realistic after the COVID crisis, when European institutions were deployed to protect the population from another massive financial crisis on top of the epidemic. Debt was issued, overcoming the resistance of the “frugal” member states, and the worst was avoided. Achieving social cohesion while decarbonizing the economy, Draghi argues, is also a crisis, in the sense that it cannot wait. He is not wrong in that. Why not, then, use the same instruments that have served us well before?

I expect that most of the public debate on the Draghi report will focus on these two proposals. Considerations more pertinent to NET, such as those on value theory and indicators of economic performance, are likely to be the province of economics geeks like myself. Still, GDP as a reliable measure of well-being? In 2024? it seems like a missed opportunity. Draghi could have made his two main proposals for European integration equally well from a NET standpoint. That would likely elicit more public support: most Europeans are facing insecurity and are more likely to support policy mixes that zero in on their well-being rather than on self-referential constructs like “the economy”.

Photo: The Eurotower in Frankfurt am Main by Marco Verch under Creative Commons 2.0

The hidden inefficiency. Reflecting on modes of provisioning in new economic thinking

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The ever-brilliant Cory Doctorow calls our attention to the fact that, in the US of A, three companies control the market for school lunch payments, and they hit poor families with junk fees that go up to 60% of what families pay.

https://pluralistic.net/2024/07/26/taanstafl/#stay-hungry

Now, some of you might have seen newer economics papers refer to something called “mode of provisioning”. The concept is not very intuitive, but – I believe – the story of school lunch payments is great to explain it.

Some of these papers come up with dramatic – and often very encouraging – results. As a recent example, consider How much growth is required to achieve good lives for all? Insights from needs-based analysis by Jason Hickel and Dylan Sullivan

https://doi.org/10.1016/j.wdp.2024.100612

This paper comes up with a terrific punchline: you could provide everyone on the planet with “decent living standard” (I will define that in a minute) with as little as 30% of the energy and materials that we consume now. This is surprising, especially given that now we are nowhere near those levels of global welfare: Hickel and Sullivan cite an upcoming paper by Hoffman et al. that find over 95% of residents of low- and middle-income countries are deprived over at least one dimension of the decent living standard! So how is it that we could technically vastly improve our welfare with one third of the resources we are spending now? There must be a gigantic source of inefficiency lying around, but what is it?

To answer this question, I need to backtrack a little and introduce needs-based analysis. This approach grew out of the dissatisfaction with the dominant method for measuring poverty, associated with the World Bank. This consists of choosing a “poverty line”, which is a level of per capita income. People who earn less than that level are labeled as poor. The World Bank defines extreme poverty as the conditions of the people whose income is lower than 1.9 dollars a day, measured in purchasing power parity (PPP).

PPPs were invented to normalize monetary measures to the different cost of living in different countries. Intuitively, a salary that barely allows a single individual to survive in Tokyo might support comfortably a family of four in Bucharest. But PPPs come with all sorts of statistical pitfalls. The one that interests us here is this: they are calculated on the basis of a basket of goods that attempts to account for a broad range of goods and services, including those that are irrelevant to measuring poverty – like jewelry, luxury restaurants, commercial airfare. In this situation, if the prices of essential goods rise faster than the growth of PPP income, poverty might increase.

To overcome this problem, needs-based analysis takes a different approach to measuring poverty. It starts by defining poverty as the inability to procure a chosen basket of physical goods and services, not income: for example, Allen’s basic needs poverty line is defined as 2,100 calories per day, plus certain quantities of protein, fat and mineral, plus some clothing and heating, plus 3 square meters of housing. One person is poor according to this definition if their income does not permit them to purchase this basket in full. To calculate how many people live in poverty in a given country, economists can now compare household income data with the price of this basket.

https://doi.org/10.1146/annurev-economics-091819-014652

This is where the mode of provision comes in. Consider, for example, China. Extreme poverty – as measured by the share of the population which did not have access to Allen’s basic needs basket – was, in 1981, 5.6%, much lower than in countries like Brazil or Venezuela – which stood at around 30%, despite their per capita incomes being around five times that of China. China’s low rate of extreme poverty was due to socialist policies that ensured basic necessities like food and housing were widespread and affordable. The capitalist reforms of the 1990s, while contributing to developing China’s manufacturing base, coincided with a large increase rate in the rate of extreme poverty, which peaked at 68% (!) before finally returning, in the 2010s, to the level of the 1980s. The paper by Hickel and Sullivan mentions other cases in which extreme poverty increased even as PPP per capita income was growing: Brazil, Indonesia, Kyrgyzstan.

The paper then goes on to discuss the relationship between growth and poverty, when poverty is measured in PPP income. I, instead, want to reflect on the “socialist policies” mentioned by the authors in passing. What might they be? 1980s China was a planned economy. One can easily imagine meetings of the Central Committee of the Chinese Communist Party deliberating to allocate resources like construction materials and workforce to construct X buildings in province Y, or to direct their vehicle factories to build more tractors and fewer cars for private transportation so that agricultural output would increase. But it is just as easy to imagine policies that obtain similar results by deploying appropriate incentives, such as taxes and subsidies, while leaving production decisions to private businesses. For example, the Italian government decided that its post-COVID recovery stimulus would target retrofitting the housing stock for better insulation, in the interest of reducing household consumption of fossil fuels. Households could claim a tax credit of up to 110% of the money spent on insulation. This process was no shining example and had plenty of problems, but it did lead to a robust rise in overall employment, even in presence of a limited economy-wide growth. This means that the (fully capitalist) Italian economy redirected part of its capacity to retrofitting the country’s housing stock for better insulation. In the bargain, it also got more jobs (construction is labour-intensive) and less precarity.

Having established that “socialist policies” can be enacted also in non-socialist economies (as long as they have robust governance of the economy), it’s time to go back to the mode of provisioning, and to those American companies taking a 60% cut on the lunch money of poor schoolchildren.

Suppose you are the minister of education, and your problem is to make sure that all children eat healthy food at school. You already made sure that school cafeterias serve healthy menus. However, there’s a problem: some of those children come from poor families, and those families might be tempted to reduce their expenses by giving children, instead, cheap processed food containing only empty calories. You have an idea: you could give each poor child an electronic wallet, containing electronic cash financed by your ministry, which can be only spent at the school’s cafeterias. Now that you have come up with that, you need to choose a way to make this service available: a “mode of provision”.

One solution is direct provisioning. Your ministry takes it on itself to produce the simplest electronic wallet possible, ideally starting from an existing open source solution that you would then contribute to maintaining. This solution, like any other, will still need to cover its running costs by taking a cut from the transactions involved; but, given economies of scale, you can imagine these costs to be of the order of magnitude of 1% of the resources your ministry credits to these wallets.

Another solution is market provisioning. Your ministry allocates the money for school lunches, but it leaves it to fintech companies to provide wallets, and cover their own costs, plus profit, by taking a cut. At this point, neoclassical economics usually invokes the Coase theorem to conclude that, in a world of perfect information and perfect competition, the costs of making something in house are the same as those of buying it on the market. But we do not live in that world: we live in the world of Myschoolbucks, Schoolcafé, and Linq Connect. In this world, a transaction comes down at 8% for the relatively affluent parents who are paying for school lunches out of pocket, and at up to 60% for the poorer ones, for which it is your ministry, hence the taxpayer, who is footing the bill.

So, with direct provisioning, buying one euro of school lunches will cost you, say EUR 1.01. With market provisioning, it will cost you up to EUR 2.50 (coincidentally, these numbers are not so far from those reported in Hickel and Sullivan’s paper). Where does the extra EUR 1.49 go? If we imagine both solutions use the same tech, which costs the same EUR 0.01, it goes into shareholder profit, where it is, presumably, used to finance the consumption of things like luxury cars, commercial air travel and so on. That consumption implies that, with market provisioning, school lunches need a lot more energy and materials to land on children’s plates; those extra energy and materials are needed to manufacture and deliver those luxury consumption goods. Without the incentives provided by the latter, private sector companies will have no reason to provide children with electronic wallets with which to pay for school lunches.

This explains the impressive efficiency gains associated to changes in the mode of provisioning estimated in papers by New Economics authors such as Millward, Hickel, Steinberger and others. It gives me a lot of hope, because it means we can massively increase our ability to satisfy human needs while staying within planetary boundaries at the relatively modest price of curbing the luxury consumption of the 1%.

Photo credit: Sustainable Economies Law Center on flickr.com, CC-BY

Green New Deal redux: reflecting on the American Climate Corps