Monday, July 6, 2015

Welfare economics and the Greek crisis

Suppose that you have just graduated from college and somebody presents you with two options for your future jobs and earnings.  In job A you will earn about as much as in B during the early stages of your career (see Figure 1  below); then with A, you will sharply increase your income while with B the increase will be much more moderate. You will reach the peak earnings at around the same age with both (but obviously with A giving you a higher level of earnings) and then toward the end of your career, A earnings will sharply go down ending at the same point as B. What would you choose? A single glance at the graph would, I think, suffice to make you choose A.

Perhaps, if common sense is not enough, you may wish to consult economics. Economics too would give you an unambiguous answer. Whatever rate of discount you use for your future earnings, the net present value  of earnings from A will exceed the net present value of earnings from B. You may want to consult welfare economics too. There, so long as welfare is positively related to income (that is, higher income increases your welfare however small at the margin that effect may be), your total welfare if choosing A will be greater that your total welfare if choosing B. So, it seems a no-brainer:  A dominates B.

But the graph I showed here is really coming from an entirely different source (see Figure 2). It shows GDPs capita, in international dollars, of Greece and Portugal over the period 1992-2013. Portugal and Greece both started the 1990s with about the same GDP per capita.  But from around 2000, Greece had a steep increase in income, growing by almost 4% per capita annually until the crisis struck. Portugal’s average growth rate was only 1% per capita. But then, as is all too well-known, after 2007, Greece’s economy plunged losing by 2013, a quarter of its peak-level  GDP. Meanwhile, Portugal’s economy too suffered a recession but it was much less sharp and the income loss was only 10 percent, Thus, as of 2013 the two countries ended up with the same income.
Economic and political problems of Greece are way greater than those of Portugal. Perhaps the underlying reasons for the crisis are different, but there is no doubt that one of the key reasons fueling dissatisfaction in Greece is the fact that the country has gone (and is still going) through an  equivalent of the Great Depression with sharp drops in real income.  The decline in Portugal, as we have just seen, was much smaller.

So it would seem that if you were in the beginning shown Figure 2 with the correct labeling (Greece and Portugal rather than jobs A and B), you might have chosen to be Portugal rather than Greece, But this is clearly inconsistent with your original choice, which, as we have seen, is based on common sense and fundamental economic principles.

How can we reconcile the two different choices? One possibility is to redefine our welfare function, by including in it, not only income but income changes. For example, we could argue that experiencing an income drop, regardless of what income level one has, exercises an independent negative effect on one’s welfare.  We could say that a person whose annual income goes from $2 million to $1 million will, of course have a lower welfare in the second period, but also that his welfare will be additionally decreased because he suffered an income loss. In other words, if he got to $1 million from previously having only $500,00, his welfare would have been greater than when he goes down from $2 million to $1 million.
   Although this seems at first a reasonable adjustment, and reflecting pretty well what seems to be the feeling of an average Greek (that he or she is particularly unhappy with their income now because they originally had a much higher income), we are soon facing significant problems. We have then to accept that, in welfare terms, a rich person who used to be even richer yesterday, could have a lower welfare today than a much poorer person, whose income was historically stable or increasing.

This then leads us to assess the positions taken by Latvia, Lithuania and Slovakia in the current crisis. Their hard-line position on Greek debt is motivated by the reluctance to have their own taxpayers pay for a part of the debt incurred by a richer country. They, like most economists, look at the income levels and conclude from a higher Greek GDP per capita that the Greeks must be, on average, better off  and happier than themselves, and rightly from the welfare economics  point of view, refuse to accept a regressive income transfer (transfer of income from a poorer to a richer member). But if we allow for unhappiness that a richer member might experience on the account of having lost some of its income, then such an income-regressive transfer could be argued to be actually a welfare-progressive transfers. This was implicitly what Greeks are saying: “we are really so unhappy now, and you need to transfer some of your income to us even if you are, if we look at income alone, poorer”.

But clearly this logic leads to absurd conclusion if we imagine that the same point could be made by a still very rich Wall Street banker who lost millions in the stock market, and who, on account of his unhappiness, could appeal to a high-school teacher with a more stable (and always lower)  income to transfer some of teacher’s income to him. 

The very foundation of welfare economics  and income redistribution would be entirely messed up if we were to allow that today’s welfare depends not only on today’s income but also on the previous rate of change in income. But we are still unable to account for the incontestable fact that much of Greek unhappiness stems from the difficulty of downward income adjustment. It is said that there is a curse that “may you be rich today and poor tomorrow”. This effect, it seems, does refer to something real that individuals and peoples experience. A single 1 percentage loss in real income among Americans, who still remain  by far the richest people in the world, has produced more writing than stable incomes among some of the poorest people in the world, in Congo or Afghanistan.

I do not know how these two feelings can be reconciled while still allowing us to remain on a rather strong ground where we can distinguish between progressive and regressive transfers based on the income levels of the participants. It seems that economics is missing something of importance but that trying to account for it  just throws the fundamentals of economics into disarray.