Arthur Cecil Pigou

Arthur Cecil Pigou (November 18, 1877 – March 7, 1959) was an English economist, known for his work in many fields and particularly in welfare economics. He served on a number of royal commissions including the 1919 commission on income tax.

Education

Arthur Cecil Pigou went to Harrow School and graduated from King's College, Cambridge, where he studied under Alfred Marshall, whom he later succeeded as professor of political economy.

As Marshall's prize student and designated heir, Pigou personified the Cambridge Neoclassicals — the heart of the Marshallian orthodoxy in the first third of the century.

Life and work

His major work, Wealth and Welfare (1912, 1920), brought welfare economics into the scope of economic analysis. In particular, Pigou is responsible for the distinction between private and social marginal products and costs. He originated the idea that governments can, via a mixture of taxes and subsidies, correct such market failures — or "internalize the externalities." Pigovian taxes, taxes used to correct negative externalities, are named in his honor.

This approach came under attack from Lionel Robbins and Frank Knight. The New Welfare Economics that arose in the late 1930s dispensed with much of Pigou's analytical toolbox. Later, the Public Choice theorists rejected Pigou's approach for its naive "benevolent despot" assumption. Finally, Ronald Coase demonstrated that efficient outcomes could be generated without government intervention when property rights are clearly defined. Coase presents his case in the article "The Problem of Social Cost" (1960 — see Coase Theorem), however the applicability is rare outside the classroom.

In the The General Theory of Employment, Interest, and Money, John Maynard Keynes held up Pigou's Theory of Unemployment (1933) as the example of everything that was wrong with Neoclassical macroeconomics. He never quite recovered from the shock of being betrayed by his old colleague and friend. The rest of Pigou's life was spent occasionally counterattacking (e.g. with the "Pigou Effect" ("The Classical Stationary State," 1943) or submitting to the "Keynesian Revolution."

Pigou was a Professor of Political Economy at Cambridge University from 1908 to 1943.

The Pigou effect

The Pigou effect is an economics term that refers to the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation.

Wealth was defined by Arthur Cecil Pigou as the sum of the money supply and government bonds divided by the price level. He argued that Keynes's General theory was deficient in not specifying a link from "real balances" to current consumption, and that the inclusion of such a "wealth effect" would make the economy more 'self correcting' to drops in aggregate demand than Keynes predicted. Because the effect derives from changes to the "Real Balance" , this critique of Keynesianism is also called the Real Balance effect.

History

The Pigou effect was first popularized by Arthur Cecil Pigou in 1943, in The Classical Stationary State (an eight page Economic Journal article). He had proposed the link from balances to consumption earlier, and Gottfried Haberler had made a similar objection the year after the General Theory's publication ([1]).

Following the tradition of classical economics, Pigou favoured the idea of "natural rates" to which the economy would return, and saw the "Real Balance" effect as a mechanism to fuse Keynesian and classical models. (In most cases - he acknowledged that sticky prices might still prevent reversion to natural output levels after a demand shock.)

Integration with Keynesian Aggregate Demand

Keynes said that a drop in aggregate demand could lower employment and the price level (an everyday concept in the deflationary depression). In the IS-LM framework of Keynesian economics, a negative aggregate demand shock would shift the LM curve left due to rising real wages changing liquidity preference. The Pigou effect would counterbalance this by shifting the IS curve right due to rising real balances raising expenditures.

Why Pigou's hypothesis prevents the liquidity trap

An economy in a liquidity trap cannot use monetary stimulus to increase output because there is little connection between personal income and money demand, John Hicks thought that this might be another reason (along with sticky prices) for persistently high unemployment. However, the Pigou effect creates a mechanism for the economy to escape the trap:

1. As unemployment rises,
2. the price level drops,
3. which raises real balances,
4. and thus consumption rises,
5. which creates a different set of IS-curves on the IS-LM diagram, intersecting the LM curves above the low interest rate threshold of the liquidity trap.
6. Finally, the economy moves to the new equilibrium, at full employment.

Pigou concluded that an equilibrium with employment below the full employment rate (the classical natural rate) could only occur if prices and wages were 'sticky'.

The Pigou effect and Japan

If the Pigou effect always operates strongly the Bank of Japan's policy of near-zero nominal interest rates might have been expected to end the Japanese deflation sooner.

Other apparent evidence against the Pigou effect from Japan may be its long period of stagnating consumer expenditure whilst prices were falling. Pigou hypothesised that that falling prices would make consumers feel richer (and increase spending) but Japanese consumers tended to report that they preferred to delay purchases, expecting that prices would fall further. A similar, reverse Pigou effect happens throughout the world in consumer electronics because of depreciating prices (this is sometimes called the Osbourne effect).

Government debt and the Pigou effect

Robert Barro argued that the public is not fooled into thinking they are richer when the government issues bonds to them, because government bond coupons must be paid from increased taxation. Therefore, he said that:

1. At the microeconomic level, the subjective level of wealth would be lessened by a share of the debt taken on by the national government.
2. Bonds should not be considered as part of net wealth at the macroeconomic level.
3. Therefore: There is no way for the government to create a "Pigou effect" by issuing bonds, because the aggregate subjective level of wealth will not increase.

Major publications

• Robert Browning as a Religious Teacher, 1901.
• Tariffs, 1903.
• "Monopoly and Consumers' Surplus," 1904, EJ.
• Industrial Peace, 1905.
• Import Duties, 1906.
• "Review of the Fifth Edition of Marshall's Principles of Economics," 1907, EJ.
• "Producers' and Consumers' Surplus," 1910, EJ.
• Wealth and Welfare, 1912.
• Unemployment, 1914.
• "The Value of Money," 1917, QJE.
• The Economics of Welfare, 1920.
• "Empty Economic Boxes: A reply," 1922, EJ.
• The Political Economy of War, 1922.
• "Exchange Value of Legal Tender Money," 1922, in: Essays in Applied Economics.
• Essays in Applied Economics, 1923.
• Industrial Fluctuations, 1927.
• "The Law of Diminishing and Increasing Cost," 1927, EJ.
• A Study in Public Finance, 1928.
• "An Analysis of Supply," 1928, EJ.
• The Theory of Unemployment, 1933.
• The Economics of Stationary States, 1935.
• "Mr. J.M. Keynes's General Theory," 1936, Economica.
• "Real and Money Wage Rates in Relation to Unemployment," 1937, EJ.
• "Money Wages in Relation to Unemployment," 1938, EJ.
• Employment and Equilibrium, 1941.
• "The Classical Stationary State," 1943, EJ.
• Lapses from Full Employment, 1944.
• "Economic Progress in a Stable Environment," 1947, Economica.
• The Veil of Money, 1949.
• Keynes's General Theory: A retrospective view, 1951.
• Essays in Economics, 1952.

External links

• History of the effect on Economy Professor
• History of the extensions of the original Pigou effect into more generalized "Wealth effects."
• Liquidity Traps... Is Japan Really Trapped at the Zero Bound?2002 Kobe University analysis of the deflationary spiral, points out that an "insatiable liquidity preference" neutralizes the Pigou effect, and that theory would then indicate persistent deflationary stagnation (below full employment). Paul Krugman's description of a liquidity trap resistant to the Pigou effect is also mentioned. (His advocacy of long term inflationary JPY policies was partly based on dismissing the Pigou effect.)
• Link to free online copy of "The Economics of Welfare" at the Library of Economics and Liberty

Profile of Arthur Cecil Pigou at the History of Economic Thought website.

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