For the Euthanasia of Kaldor-Hicks/Cost-Benefit Pseudo-Science

J. R. Hicks "The Foundations of Welfare Economics" 1939:

"Positive economics can be, and ought to be, the same for all men; one's welfare economics will inevitably be different according as one is a liberal or a socialist, a nationalist or an internationalist, a christian or a pagan. 

"It cannot be denied that this latter view is in fact widely accepted. If it is intellectually valid, then of course it ought to be accepted; and I must admit that I should have subscribed to it myself not so long ago. But it is rather a dreadful thing to have to accept. No one will question the activity of some of our 'positivists' in the criticism of current institutions; but it can hardly be denied that their authority to advance such criticism qua economists is diminished by their abnegation, so that in other hands economic positivism might easily become an excuse for the shirking of live issues, very conducive to the euthanasia of our science. 

"Fortunately there is no need for us to accept it. The way is open for a theory of economic policy which is immune from the objections brought against previously existing theories..."

Just a small sample of the objections Kaldor-Hicks has been immune to over the years:

"...judged in relation to its basic objective of enabling economists to make welfare prescriptions without having to make value judgments and, in particular, interpersonal comparisons of utility, the New Welfare Economics must be considered a failure." 

"Pareto is sometimes credited with an early formulation of the ill-fated Hicks or Kaldor principles of hypothetical compensation." 

"The ethical appeal of this [compensation criterion] argument, however, is weak."  

"It turns out then that Mr. Kaldor's criterion in its most general sense has not eliminated the problem of interpersonal comparison of utility. It has only subjected utility to the measuring rod of money, a measuring rod which bends, stretches, and ultimately falls to pieces in our hands."

"...implicit assumptions about the numéraire good in the Kaldor–Hicks efficiency–equity analysis involve a 'same-yardstick' fallacy..."

"For sustainability science, the Kaldor–Hicks rule runs counter to both intra- and inter-generational concerns."

"Only later would it be realized that one did not know -- indeed, one could not know -- the value of production independent of the distribution of income and the associated price vector that provided the weights to the various physical quantities being produced."

"...in all of this prodigious elegance, rarely is there recognition that the Pareto test remains what it has always been -- an analytical construct (inconsistent and incoherent at that) with no special claim to legitimacy beyond the tautological domain out of which it
arose." 

"When the unweighted sum of net benefits from a project are used as a criterion of project evaluation, cost-benefit analysis may be sensitive to the choice of  numéraire . This is one reason, among others, why this criterion should not be used."

And yet:

"The Kaldor-Hicks criterion — a test of whether total social benefits exceed total social costs — is the theoretical foundation for the use of the analytical device known as benefit-cost (or net present value) analysis."

Not bad for an inconsistent, incoherent, ethically-weak, ill-fated tautological failure of a fallacy that should not be used!

Hicks was right. The Kaldor-Hicks theory is indeed "immune from objections."

#NUM!éraire, Shmoo-méraire: Nature doesn't truck and barter

The commodity in terms of which the prices of all the others are expressed is the numéraire. -- Leon Walras, Elements of Pure Economics.

But the numéraire is a purely technical device, introduced simply for the purpose of making exchange values explicit. In no way does the introduction of a standard of value alter the fundamental nature of the economy in question. It remains a barter economy, since goods are exchanged solely for other goods. André Orléan, The Empire of Value.

In a previous post, Public Works, Economic Stabilization and Cost-Benefit Sophistry, the Sandwichman introduced David Ellerman's argument that the supposed efficiency/equity distinction underlying the Kaldor-Hicks compensation criterion is a "same-yardstick" illusion created by the tautological use of a numéraire (or "standard commodity") to evaluate its own value. One oyster is worth exactly one oyster in oysters. Ellerman demonstrated that simply switching the numeraire could have the effect of reversing which outcome is held to be efficient.

This discrepancy is not some curious foible of arcane economic theory. The Kaldor-Hicks compensation criterion is "the theoretical foundation for the use of the analytical device known as benefit-cost (or net present value) analysis" (emphasis added, Stavins 2007)

Ellerman documented the numéraire illusion (or fallacy) in a working paper dated ten years ago. Since then, he has presented several versions of his refutation of Kaldor-Hicks. According to Google Scholar, there has been one non-self citation -- in a 2014 Masters thesis -- of the five versions listed in Google Scholar.

There is a long and futile history of pointing out flaws in Kaldor-Hicks. In their 1978 review of the Kaldor-Hicks inspired "New Welfare Economics," Chipman and Moore declared it a failure, "...judged in relation to its basic objective of enabling economists to make welfare prescriptions without having to make value judgments and, in particular, interpersonal comparisons of utility." They concluded their review with the following assessment:

After 35 years of technical discussions, we are forced to come back to Robbins' 1932 position. We cannot make policy recommendations except on the basis of value judgments, and these value judgments should be made explicit... When all is said and done, the New Welfare Economics has succeeded in replacing the utilitarian smoke-screen [of technical jargon] by a still thicker and more terrifying smoke-screen of its own.

Thirty-six years on, that thicker, more terrifying smoke-screen prevails.

In a paper published in 1997. Kjell Arne Brekke presented an analysis that highlighted a different aspect of the importance to the outcome of cost-benefit analysis of the choice of numéraire. Brekke showed that, when public goods are involved, the sign (plus or minus) of the sum of net benefits is not independent of the choice of numéraire.

Brekke's discussion is marred by the peculiar conclusion that "[t]he choice of money as numéraire is systematically favourable to those who value money the least, relative to alternative numéraire." "Why do money and not environmental units as numéraire favour the environmentalist?" Brekke asked. His answer confuses the result of incoherent calculations with actual outcomes:

The net benefits of the project is positive for the environmentalist. If this net benefit is expressed in money terms, then it becomes a large number because money is of low value to the environmentalist. However, if the net benefit is expressed in environmental quality units, then the net benefit would be a small number, since environmental quality is important to the environmentalist.

Contrary to what Brekke argued, the choice of numéraire makes no difference to the net benefits from a project -- it only changes how those benefits are represented. In fact, by (mis)representing an environmentally-harmful project as unduly financially-beneficial, such "positive" results would support a decision that is less favourable to the environmentalist. Brekke also crucially misstated the Kaldor-Hicks compensation criterion as "the winners should compensate the losers."

In a commentary on Brekke's article, Jean Drèze acknowledged that "Brekke’s interpretation of his own result is indeed somewhat misleading" but argued none-the-less that these lapses shouldn't detract from the important insight that, "[w]hen the unweighted sum of net benefits from a project are used as a criterion of project evaluation, cost-benefit analysis may be sensitive to the choice of numéraire." With regard to the ethical status of the [Kaldor-Hicks] compensation criterion, Drèze observed that "[i]f compensation is only hypothetical, it is irrelevant. If it is actual, it should be counted as part of the project, which becomes a Pareto-improving project so that its desirability is not an issue." In a passage, Drèze speculated on the reasons for the persistence of the ethically vacuous, analytically incoherent "aggregate benefit criterion" (ABC) touted by the compensation criterion:

In short, Brekke’s analysis does highlight a major problem with the ABC criterion, which adds to its other theoretical flaws. In the light of these flaws, it may be asked why the ABC criterion is so widely used in practice. Several possible reasons come to mind. First, the practitioners may not appreciate these flaws. Second, they may be aware of them, but use the ABC criterion for convenience. Third, they may be reluctant to contemplate the value judgments involved in choosing distributional weights. Fourth, they may hold the normative view that marginal social utilities are equal in terms of their chosen numéraire. Fifth, they may simply be siding with the rich.

Drèze missed a sixth possible reason: acknowledging these iatrogenic flaws in the aggregate benefit criterion may have profound implications for the theoretical foundations of neoclassical economics that can't be papered over with distributional weights, as Drèze seems to think, or by reversion to an "actual" Pareto-improving standard instead of a hypothetical one. To put it bluntly, all the stuff and nonsense about numéraires proceeds from the a priori assumption of a barter economy -- that "goods are exchanged solely for other goods."

As Orléan puts it, Leon Walras's numéraire "is a purely technical device..." What "counts" is not money but some presumably intrinsic value that is held to inhere in the goods themselves -- "behind the veil of money," so to speak. "Real money," Orlean continues, "money that 'not only supplies a unit of account but also actually circulates and in addition functions as ‘a store of value'—does not exist." The incoherence of the aggregate benefit criterion and its corollary of hypothetical compensation is a symptom of the fundamental incoherence of the barter metaphor. "The most serious challenge that the existence of money poses to the theorist," according to Hahn (1982), "is this":

...the best developed model of the economy cannot find room for it. The best developed model is, of course, the Arrow-Debreu version of Walrasian general equilibrium. A world in which all conceivable contingent future contracts are possible neither needs nor wants intrinsically worthless money.

One has to wonder, though, just what is "best developed" about a model of the economy that can't find room for the existence of money. In his review of Hahn, Minsky referred to that model more bluntly as "rubbish that prevents the flowering of new theory."

Of Sealing Wax and Cell Phones...

Arguing against perfect foresight is as embarrassing as it is futile. To borrow Robert Solow's image, it's like debating cavalry tactics at the Battle of Austerlitz with a lunatic who thinks he's Napoleon Bonaparte. But the hypothetical prescience of the numéraire is both fundamental and lethal to the Kaldor-Hicks compensation criterion. The mix of commodities available in the future will be radically different than the commodities available today, just as today's commodities are radically different from those of fifty or a hundred years ago. 

Without perfect foresight (and without money -- real money) prices in a barter economy existing sometime in the future would be incommensurable with prices in a barter economy today. There could be no "standard commodity," no numéraire. The question of the choice of numéraire would be moot because there are no candidates to choose from. 

With perfect foresight, however, market actors would know whether or not compensation is/was/will be paid to the losers in a "potential" Pareto improvement. In other words, the addition of the word "potential" makes the phrase an oxymoron that violates the model's specifications.

No doubt Cost-Benefit Analysis gets around this dilemma by smuggling in a "common-sense" notion that money is nevertheless performing its magic in spite of the value theoretical "rigor" that has banished that supposedly illusory veil. With such a hybrid of theoretical abstraction and absent-minded distraction, neoclassical value theory gets to barter off its cake and eat it too.

Try not to think of an elephant. Money is essential to a market economy. "Market economies based on barter are inconceivable..." André Orléan argues in "Money: Instrument of Exchange or Social Institution of Value?" That "inconceivable" must be taken literally. The attempt to conceive of a market economy based on barter flounders on the shoals of cognitive dissonance. "Don't think of money," the theory commands. But you think of money. As Hyman Minsky wrote 30 years ago, "the Emperor of today's theory, the Arrow-Debreu version of Walrasian general equilibrium, has no clothes." 

The Kaldor-Hicks compensation criterion proclaims that we can all get richer by laundering the Emperor's invisible new clothes.

*****

In 1952 the Bureau of the Budget, in a Budget Circular [A-47] that neither required nor invited formal review and approval by the Congress, nailed this emphasis into national policy, adopting it as the standard by which the Bureau would review agency projects to determine their standing in the President's program. And soon thereafter agency planning manuals were revised, where necessary, to reflect this Budget Circular. In this way benefits to all became virtually restricted to benefits that increase national product. The federal bureaucrats, it should be noted, were not acting in a vacuum; they were reflecting the doctrines of the new welfare economics which has focused entirely on economic efficiency.

***** 

When all is said and done, the New Welfare Economics has succeeded in replacing the utilitarian smoke-screen by a still thicker and more terrifying smoke-screen of its own.

LA MONNAIE RÉALITÉ SOCIALE

Why is there no English translation of this important work by François Simiand?

Wrath of the Yurt

I like a lot of what John Quiggin has to say. That's why I find it disturbing when he lapses into an unprovoked ad hominem swipe at people living in yurts. Not only is it disturbing but distinctly peculiar.

Of course we're all supposed to understand that Quiggin isn't really talking about yurt dwellers when he refers to yurt dwellers. It's code. The label of yurt dweller is supposed to allude to some undefined fringe of political-economic non-conformists.

I have a problem with that. It is holding people up to ridicule, not for what they believe but for a mocking image of their (presumably) idiosyncratic personal attributes that is arbitrarily substituted for their opinions. This is what we used to refer to as stereotyping.

Exactly who is being ridiculed is left ambiguous. By a process of elimination, it is not the climate-change deniers on the right nor is it the "sensible" ecological modernizers in the center who Quiggin is mocking. That leaves the tree-hugging enviros on the left metaphorically dwelling in those patchouli-infested yurts. Like Naomi Klein. Or Herman Daly. Or Tim Jackson. Or Duncan Foley.

The trouble with the yurt dweller label is that it is infinitely expandable. To Senator Inhofe, people who accept the scientific consensus on climate change are yurt dwellers. Nicholas Stern, John Quiggin, William Nordhaus, Al Gore, the IPCC. Yurt dwellers all.

Rules and Standards

Peter's discussion of policy rules reminds me of the tale of the highway design standard reputedly based on the height of dead dog in the middle of the road. University of Toronto Civil Engineering Professor, Ezra Hauer tells this story:

Recall that one of the parameters in the design procedure [for highway crest curves] is the height of the obstacle to be seen by the driver in time. Originally (already in 1940) American engineering standards set the obstacle height at 4". Those who wrote this standard did not have any particular obstacle in mind (although, rumour has it that some refer to it as the ‘dead dog’ criterion). …the 4" was selected not because lower obstacles are not a threat to safety but because the selection of a higher obstacle would not save much in construction cost. Since, at that time, nobody knew how many crashes are due to obstacles on the road, what kinds of obstacles these are, and what fraction of crashes would not have occurred had the crest been flatter, the standards committee did what was sensible. They made a decision on the basis of what was known, namely the cost of construction. 

For two decades everybody was designing roads using exacting calculations to make 4"-high obstacles visible in time to stop. Then, around 1961, it became apparent that in the newer model cars the average driver's eye was much lower than a decade or two earlier. Thus, drivers of newer cars could not really see 4" objects at the prescribed stopping sight distance... The solution to the predicament was not difficult. Since the 4" obstacle neither was some real object nor has it been selected on the basis of some factual relationship to safety, the Committee on Planning and Design Policies had no compunction noting that "the loss in sight distance resulting from lower eye height could be offset . . . by assuming an object higher than four inches . . . ” Indeed in the 1965 AASHO Blue Book, 6" obstacles became the standard of design. 

At the time the standard for the design of crest curves came into being, little was known about safety. Today we know that only 0.07 percent of reported crashes involve objects less than 6" high. We also know that, till today, no link has been found between the risk of collisions with small fixed objects on crest curves and the available sight distance. On the contrary, “Crash rates on rural two-lane highways with limited stopping sight distance (at crest curves) are similar to the crash rates on all rural highways.” Thus, the assumption invoked at the dawn of highway design history which allowed the formulation of a design procedure based on the avoidance of dead dogs in the middle of the road seems to have little to do with real road safety. Still, till today, the same standard stands, the same exacting but illusory constructs are used in the design of crest curves. Only the size of the dog and of other parameters is changing.

Planning, the Theory of Growth and the Myth of Decoupling

Guardian: Rich countries subsidising oil, gas and coal companies by $88bn a year

Put in perspective, eighty-eight billion dollars probably isn't all that much compared to Gross World Product of roughly 1000 times that amount. It's the principle of the thing. And as Kin Hubbard has taught us, "When a fellow says, 'It ain't the money but the principle of the thing,' it's the money."

It IS the money. Subsidizing expanded fossil fuel extraction is consistent with economic growth theory. The subsidies are rational, given the priorities of the rich countries' governments (say what you will about $20 bottles of Two Buck Chuck and the tribal moralism of preaching against big cars).

Faced with the dilemma of building socialism in a backward, peasant society, Soviet economists in the late 1920's hit on the idea of accelerating investment in the means of production, Marx's Department I. "But it would be absurd to say that economic growth is a new subject," Evsey Domar confessed long ago:

In economic literature, growth models, interpreted broadly, have appeared a number of times, at least as far back as Marx. Of the several schools of economics the Marxists have, I think, come closest to developing a substantial theory of economic growth, and they might have succeeded had they given less time and effort to defending their master's virtue. Some highly elaborate and interesting growth models did, however, appear in Soviet literature.

"These Soviet models are more fully developed than similar attempts made in the West..." Domar continued in a footnote, "See, for instance, G. A. Feldman [Fel'dman], "K Teorii Tempov Narodnogo Dokhoda," Planovoe Khoziaistvo, November, 1928, pp. 146-170, and December, 1928, pp. 151-178... They were evidently written in response to immediate practical problems of planning."

The present interest [May, 1952] in growth is not accidental; it comes on the one side from a belated awareness that in our economy full employment without growth is impossible and, on the other, from the present international conflict which makes growth a condition of survival.

... 

Our problem can now be formulated as follows: assuming that output and capacity are in balance at the outset, under what conditions will this balance be preserved over time, or in other words, at what rate should they grow to avoid both inflation and unemployment.

Sounds like a plan! Now Sandwichman is not hostile to the idea of planning. After all, where would the Panama Canal be without a plan? Sandwichman just thinks that when you have a plan, you call it "The Plan," not "Growth." as if it is some spontaneous organic process that happens all by itself.

The problem with economics as a "positive science" is that it is no less prescriptive for all its disavowal. Economists lie. They wrap their ethical judgements in a patriotic flag of euphemism. Full employment is GOOD, right? Growth is GOOD, right? Therefore full employment is IMPOSSIBLE without growth! Growth is impossible without investment. Investment is impossible without profit. And profit is impossible without tax breaks to encourage fossil fuel discovery and development. What's normative about that? It is just the way it is.

In some Cloud Cuckoo Land it would be possible to decouple economic growth from greenhouse gas emissions. But in the planned economy we occupy, where full employment depends on growth, which depends on fossil fuel consumption, "decoupling" is a euphemism for "we have a secret plan to end the war."

Plug and Play: The "New" Welfare Economics

Lionel Robbins (1929) "The economic effects of variations of hours of labour":

"The days are gone when it was necessary to combat the naïve assumption that the connection between hours and output is one of direct variation, that it is necessarily true that a lengthening of the working day increases output and a curtailment diminishes it."

Enrico Barone (1908)"The ministry of production in the collectivist state":

"It is convenient to suppose – it is a simple book-keeping artifice, so to speak – that each individual sells the services of all his capital and re-purchases afterwards the part he consumes directly. For example, A, for eight hours of work of a particular kind which he supplies, receives a certain remuneration at an hourly rate. It is a matter of indifference whether we enter A's receipts as the proceeds of eight hours' labour, or as the proceeds of twenty-four hours' labour less expenditure of sixteen hours consumed by leisure."

So much for combating naïve assumptions. Apparently all one had to do back in 1938 to avoid combat was "suppose" conveniently what in days gone by had been assumed naïvely and that was enough to ground the "New" Welfare Economics in mathematical tractability. None of which would have worked if the connection between hours and output was not one of direct variation. A simple book-keeping artifice, indeed!

Did it matter whether or not the theoretical ball bearings upon which Budget Circular A-47 rolled were round? Of course not. No one ever read Barone. They just plugged his handy-dandy formula into theirs. But, hey, no interpersonal comparisons of utility were made. Sometimes you have to take a big leap of faith for Science.