Principles for good economic policy

nbr-15112013-792Published in The National Business Review (Auckland), 15 November 2013 (PDF)

A couple of weeks ago, my colleague Dr Bryce Wilkinson posed some tough questions on Treasury’s Living Standards Framework in this column. As I am told, this has triggered a lively exchange between the author and many correspondents.

Indeed, the Treasury’s deputy secretary, Dr Girol Karacaoglu, has written a response (P14), to Dr Wilkinson’s article for today’s National Business Review, a most welcome move.

It is good to have a debate on what framework policymakers and government bureaucrats should use to evaluate their actions. There are many approaches one could resort to. Cost-benefit analysis as a tool from applied welfare economics is probably the one used most often. It is a tried and tested model.

Cost-benefit analysis flowed straight from the discovery of marginal utility and the determination of an economic surplus in the late 19th century, pioneered by economists such as Jules Dupuit (1804-66) and Alfred Marshall (1842-1924). Any proposed alternative to the established cost-benefit model needs to demonstrate its value against this established benchmark.

However, it is not sufficient to just have a yardstick for policy-making, whether it is based on cost-benefit analysis or indeed a new Living Standards Framework. What is equally needed, if not more so, are some guiding principles for economic policy. In German economics, such a philosophical approach has a long tradition. German economists have often taken a different approach from their colleagues in other countries, especially English-speaking ones. Not all of these deviations from mainstream economics have been of value. However, the philosophical and historical reasoning of mainstream German economists has also produced remarkable insights which can help lay a framework for good policy making. Some of these ideas have later influenced the public choice school and new institutional economics.

When studying economics in Germany, it is impossible not to come across the name of Walter Eucken (1891-1950) and his Principles of Economic Policy, published posthumously in 1952. Eucken, the son of literature Nobel laureate Rudolph Eucken, was strongly influenced by Christian thinking. He was also a member of the resistance against the Hitler regime.

Eucken co-founded the ordo-liberal school of economics, which sought to establish a free market order through a clear economic policy framework. This philosophy became popularised as the “Social Market Economy” and formed the foundation of West Germany’s post-war economic miracle.

In Eucken’s philosophy, there are seven core principles for an economic order that should be taken into account when making policy. According to Eucken, good policy should never be in conflict with these constituting principles: a functioning price system; the primacy of monetary stability; open markets; private property; freedom of contract; liability; and the steadiness of economic policy.

The main difference between Eucken’s conception of a market economy and the prevailing Anglo-Saxon view of economics at the time was that he believed the state had an important role to play in establishing and guaranteeing a free market order. A free market would not come about by itself. It needed enforceable rules to be workable.

The starting point in Eucken’s system is the recognition that the price system is essential for any market. Where government directly intervenes through setting of prices, or where it allows manipulations of prices by restrictive trade practices, it prevents the equilibrating function of competition. For the same reason, Eucken stressed the importance of sound money. Without monetary stability, the price system cannot fulfil its role.

Open markets, private property and freedom of contract are also essential elements for the functioning of market transactions. They enable individuals and companies to interact with one another, and it is the role of the state to ensure that property rights are secure and contracts enforceable through the legal system.

Finally, Eucken’s call for the steadiness of economic policy means that policymakers should not shock markets with surprise announcements and sudden deviations from long established practices.

It is not hard to agree on Eucken’s principles – in principle. However, even though the value of each of these principles is obvious, it is clear that policymakers violate them on an almost daily basis.

For a start, Eucken would be startled to see how central banks around the world are pursuing the goals of economic growth, stabilising the exchange rate, rescuing financial institutions or increasing employment instead of focusing on their most important task: monetary stability.

He would also notice how freedom of contract and private property rights are being systematically violated by, say, town planning and environmental regulation. Eucken would surely object to the massive bailouts we have witnessed in past years for the US car industry, struggling banks and indeed entire eurozone countries, as all of these policies have nothing to do with enforcing liability.

When we are talking about a framework to measure the success of any government policy, we should also have a framework for what constitutes good policy. For this we need some normative principles. Walter Eucken’s list, despite originating in another place and another era, may be a good starting point for such an exercise.