Whitlam, the Right the Left, the Tea Party and the Greens – Economic Rationalists

What is an economic rationalist? It wasn’t that long ago that the favourite insult hurled by the left was the badge of honour worn by the right.

The arguments were hilarious. “You’re a self-serving economic rationalist,” spat the village lefty. “Correct,” the targeted right-winger would retort.

Social progressives like the Australian Greens are of the view that economic rationalism is a doctrine that improves efficiency rather than equality. On the other hand the Tea Party in the United States have formed the view economic rationalism is aligned with laissez-faire economics and small government.

Recognising that the Australian Liberal Party is to the left of the Democrats in the United States. There is little doubt that the left of Australian politics would oppose the views of the Tea Party and the Tea Party would be horrified to discover that the Term Economic Rationalist was infact the economic argument put forward by Edward Gough Whiltlam, Prime Minister of Australia and arguably the most progressive of Australian leaders.

So do the Tea Party and the Green actually believe in the same economic theories? Or do both of them get a F, for economic study.

In 1996 Tom Valentine explored the meaning of economic rationalism in his paper Economic Rationalism Vs The Entitlement Consensus.

The term economic rationalism has come into common use in recent years. There are major problems surrounding the use of this terminology. The term is rarely defined and the meaning attached to it varies considerably. Much of the discussion is emotional rather than analytical. Some disagreement over definitions is inevitable because there is a margin of vagueness in the area covered by economic rationalism. Nevertheless, the wide range of definitions adopted in recent debates is not fully explained by this margin of vagueness. Rather, it depends to a considerable extent on the objectives of the commentator in question.

This article deals with these problems in a number of ways. First, it presents an appropriate definition of eco­nomic rationalism, a definition that focuses on its role as a basis for economic policy making. Discussion of the meaning of this term also reveals some of the debate’s extensive history, and it is argued that ‘economic rational­ism’ is simply what was formerly known as ‘economic liberalism’. Secondly, economic rationalism will be clar­ified by indicating what it does not include, surveying the term’s many misuses and misunderstandings. Both the first and second sections require us to confront some widely accepted myths about economic rationalism. Thirdly, so as to illustrate its robustness and relevance, the approach will be applied to a number of questions in economic policy. These are wages and unemployment, privatisation and trade policy. Finally, economic ration­alism is compared with its major contemporary competi­tor as a basis for economic policy formulation, an ap­proach which might be designated the ‘entitlement consensus’.

What Is Economic Rationalism?

 Economic rationalism is best defined as an approach to economic policy that accepts the primacy of markets. This approach includes the adoption of market indicators as the appropriate benchmarks for any activities to be carried out by the government. It was encapsulated by the Campbell Committee in its description of the criteria it adopted in considering the regulation of the financial system:

The Committee starts from the view that the most efficient way to organise economic activity is through a competitive market system which is subject to a minimum of regulation and govern­ment intervention (Australian Financial System Inquiry 1981:1).

A freely functioning market produces price signals that accurately reflect the desires of consumers. The values of the inputs to production are derived from the value that consumers put on the products that can be produced by them. These price signals direct the organi­sation of production and determine the distribution of the income resulting from that production. The prices pro­duced by a market system reflect the costs of producing a product. That is, a market based economic system auto­matically adopts a ‘user pays’ approach to pricing. This approach ensures that resources are not used up producing goods or services unless the people who consume them are willing to pay the cost of producing them. It therefore prevents a waste of resources.

The competitiveness inherent in a market economy promotes efficiency in the use of resources. The business­es that produce at the lowest cost will be the successful ones and producers who make an inefficient use of re­sources will lose business.

Finally, a competitive system encourages innovation (the development of new products) and entrepreneurship (the initiation of new projects) because the people who undertake these activities reap a major part of the benefits that they produce.

A preference for market outcomes does not mean that they are viewed as perfect. Indeed, many problems have been noted in the outcomes produced by a market econ­omy, and government intervention may be required to improve these outcomes. These problems include:

  •  the existence of externalities, i.e. by-products of pro­duction for which consumers of the product cannot be charged. Pollution is often cited as an example of such an externality (see Musgrave and Musgrave 1984: 743-756).
  •  some goods and services might be undersupplied by the market, such as public goods, i.e. goods and services from which once created it is difficult to exclude people (Musgrave and Musgrave 1984: Chapter 3). Leading examples are defence and the legal system. These goods cannot be priced on a user pays basis.
  •  unrestricted competition sometimes leads to an in­dustry being dominated by a single producer. This outcome arises when the industry involves unlimited economies of scale so that larger firms can produce at lower unit cost than smaller firms. Industries subject to these conditions are known as ‘natural monopo­lies’. Utilities, such as telecommunication compa­nies, postal services, etc, are often characterised by such conditions. The existence of natural monopo­lies might create a need for government intervention to ensure efficiency and to protect customers (see Sharkey 1982: 151-152).
  •  competition does not always lead to the success of a superior product. Baumol (1991) shows how ‘lem­ons’ (low quality products) can drive higher quality products from the market. The lemons can be sold at a lower price than better products and the producers of the latter are likely to be forced out of business.
  •  Arrow and Lind (1970) contend that governments are often the only investors able to undertake risky projects because of their ability to distribute risk over a large number of taxpayers which allows them to discount future cash flows at a risk-free interest rate.
  •  a market economy permits ‘hit and run’ transactions, which make a large profit for some participants but which do not reflect underlying consumer desires. The machinations of the eighties’ ‘entrepreneurs’ provide examples of these transactions. The effects of `hit and run’ transactions disappear over the longer term, but they can have significant unfavourable effects in the short run. Siegfried and Round (1994) attribute the accumulation of Australia’s largest for­tunes partially to market disequilibrium and ‘hit and run’ transactions certainly fall into this category. Economists have been criticised for their failure to consider these transient states.
  •  a frequent failure to consider the costs of adjustment that are produced by a process of deregulation. When these costs are taken into consideration, a deregulation appropriate at some times might not be appropriate at others. For example, it might (but only might) be inappropriate to remove tariffs when unemployment is high because in such an environ­ment the cost of shifting resources from one activity to another will be greater.
  •  the distribution of income and wealth produced by a market economy should not necessarily be regarded as socially desirable, and the government might therefore wish to take action to alter this distribution. However, economic analysis shows that taking in­come and wealth from individuals changes their incentives so that production might be reduced. Thus, redistribution is best done in as neutral a way as possible, i.e. in a way that has a minimal impact on decisions about production and price setting. This view was a basic tenet of the Campbell Committee, which argued against the use of financial regulation as a tool of social policy (Australian Financial System Inquiry 1981: 624-632). The Committee argued that social assistance delivered by financial regula­tions (e.g. interest rate ceilings) could not be accu­rately targeted and would cause distortions in the economy.

The word ‘rational’ has many meanings and this makes it a misleading way to describe the approach to economic policy under discussion. Central planning is often described as a rational approach to economic policy, although this approach is the opposite of that favoured by economic rationalists due to the almost uniform failure of planning (Mintzberg 1994). Economic rationalists often stress the limits of rational planning in economics. In their book Chaos, Management and Economics, David Parker and Ralph Stacey (1995) provide one possible explanation for the failure of planning. They believe economies can be regarded as chaotic processes, and therefore it is not possible to predict future developments accurately. With­out such predictions, planning cannot be successful.

However, economic rationalists do favour a rational approach to policy-making so that goals are achieved at least cost. They require any expansion of government activity to be subjected to an evaluation to ensure that it is cost effective. They are aware that resources are in limited supply and that their use in one way precludes their use in others. They argue that these choices should be made on rational grounds and that adoption of a market based system is the best way to ensure that this is the case. They also note the tendency for bureaucracies to become ineffi­cient because they are not subject to competitive pressures and because they develop criteria for success unrelated to efficient performance.

In this article the focus is on the purely economic aspects of the free enterprise approach, but there are very important non-economic aspects of the question. Sup­porters of a free enterprise system often also see it as the form of economic organisation which best promotes the freedom of individuals and provides the greatest opportu­nities for their development. They are critical of bureauc­racies not only because of their economic inefficiency, but also because of the way in which they encroach on individ­ual liberties. They oppose increasing the role of trade unions in government and economic management on the same grounds.

One implication of the importance of non-economic factors is that the free enterprise system must be adapted to fit different cultural environments. Thus it took a different form in nineteenth century Britain to that which emerged in the United States in this century and in the so-called ‘Asian Tigers’ in the post-World War II era. The form taken by a free market system will be coloured by its cultural environment. Nevertheless, there are some con­ditions that must be satisfied by the environment before a free market system can exist. It must, for example, incorporate an appropriate legal system and a clear recog­nition of property rights.


 Is Economic Rationalism New?

The term ‘economic rationalism’ was apparently introduced in the Whitlam years (Langmore and Quiggin 1994: 42), but it achieved notoriety as a result of the Michael Pusey’s book Economic Rationalism in Canberra (1991). Pusey used the term to describe the ideology he attributed to senior Australian public servants, particularly those in the major economic departments of government. He identifies economic rationalism with the neoclassical economics taught in leading US graduate schools. However, the approach, and debates about alternatives to it, go back to much earlier times. Most market economists trace their theories back to Adam Smith. The most important outbreak of the debate in the present century began in the 1930s and has continued to the present. It was between Keynes (and his supporters) and more traditional economists (see Cockett 1994), often described as representatives of classical economics.

In the earlier debates, economic rationalism was called economic liberalism and this term appears to be a more appropriate one. It is an important aspect of the broader political theory known as liberalism. Kenneth Minogue (1988:186) suggests that this term can be defined, following William Letwin, as a preference for individual actions over collective action. Minogue makes it clear that this definition covers a complex range of posi­tions, concluding that ‘the one virtue impossible for a liberal is — purity.’ Economic liberalism dominated Brit­ish economic thought and policy-making through the nineteenth and earlier part of the twentieth centuries. Its dominance was only usurped by the Keynesian revolution of the nineteen thirties.

As shown by Richard Cockett  (1994) a long struggle, inspired by Friedrich Hayek, was mounted to re-establish the primacy of free enterprise economics in Britain. This campaign had considerable although far from complete success.

Pusey claimed that the neoclassical economics (see Weintraub 1993) taught in US universities has had a powerful effect on public servants in Australia. Neoclas­sical economics is consistent with economic liberalism, but it is not the only economic theory with this character­istic. The ‘Austrian School’ (see Walker 1993) is another approach based on free market assumptions. Neoclassical economics is highly formalised and it is frequently ex­pressed in highly mathematical and stylised terms. It therefore lacks the richness and ready applicability to economic policy questions possessed by other formula­tions of free enterprise economics.

The latter-day identification of economic liberalism with formal neoclassical models has allowed some critics, such as Paul Ormerod (1994) and Brian Toohey (1994) to equate it to the mathematical model of a purely com­petitive economy. This identification creates an easy tar­get as the critics rush to point out that the model’s assumptions are unrealistic and that it is difficult to prove that a unique equilibrium exists. Since the arguments for economic liberalism do not depend in any way on this model, these criticisms are no more than an attack on a straw man.

It should be noted that liberalism in the economic area does not always imply that a person is a liberal in all matters. Although conservatives often support market based policies in the economic area, they are more likely to adopt illiberal attitudes on social questions. In the eco­nomic area they are more prone to fixate on some of the misleading symbols of free enterprise economics discussed in the following section.

What Economic Rationalism Is Not

Since a major motivation for the widespread adoption of the term ‘economic rationalism’ is to use it as an epithet, it is not surprising that its users are unselective in its application. Indeed, ‘economic rationalism’ is often used to describe any economic policy that the user does not like or to explain any difficulty produced by current economic policies.


An example of the first type of misuse is the identifi­cation of any cutback or retrenchment as the application of economic rationalism. While it is true that economic liberalism sees a reduction in government intervention in the economy as desirable, and that this contraction is likely to lead to some retrenchment, it does not support a reduction in every activity. In some cases, where objec­tives are judged to be useful, their effective achievement could require a greater use of resources. This would be the case, for example, if it was decided to expand the neglected economic infrastructure of the country. Economic liber­alism seeks to detect and remove instances of the waste of resources, but it is not a theory which supports indiscrim­inate ‘slashing and burning’, particularly if it reduces the effectiveness of the organisation concerned.

Pusey (1990) is an egregious example of the tendency to attribute any economic difficulty to the alleged applica­tion of economic rationalism. Pusey makes little attempt to identify linkages and indeed, as I have pointed out elsewhere (Valentine1992), simply displays his very prim­itive knowledge of economics. Moreover, the extent to which the approach of economic rationalism has been applied is open to question. Massive government inter­vention in the economy continues to be the rule and this intervention would seem to be a more likely place to start in looking for causes of economic problems.

More needs to be said about the limited extent to which economic liberalism has been implemented in spite of a widely held view that it has been extensively tested. It was applied comprehensively to the financial sector, but in the context of an economy that was heavily regulated in other areas. Some steps have been made in the area of trade liberalisation. There has been considerable privati­sation of government enterprises, but this appears to have been motivated more by budgetary considerations than by a desire to increase the competitiveness of the Australian economy or improve its use of resources. There has been much talk of `macroeconomic reform’, but much remains to be done (Productivity Commission 1996: 7-22). Economic rationalism is often criticised for assuming that people are solely motivated by economic incentives.

This criticism is justified by noting that economists often make use of the construct of an ‘economic man’, a shallow individual who is little more than a desiccated calculating machine. This assumption is actually an analytical device that allows the economist to concentrate on one class of decisions. All that proponents of economic liberalism assume is that individuals do respond to economic incen­tives, particularly in the economic transactions that occur in their lives. It would be difficult to refute this assump­tion. The assumption certainly does not imply that indi­viduals are not moved by emotions, empathy, reactions to beauty, religion or, on occasion, sheer irrationality.

It is true that the Chicago school of economics has sought to extend the ‘economic man’ concept to the analysis of many decisions which are not generally regard­ed as economic ones, e.g. choice of marriage partner. These analyses provide some useful insights, but expo­nents of economic liberalism do not necessarily accept their conclusions and they are certainly not regarded as prescriptive.

Monetarism has sometimes been taken as representa­tive of economic liberalism. The view that monetary policy should be used to control inflation and not as an active policy tool to achieve such objectives as such as reducing unemployment, stimulating economic growth and achieving balance of payments equilibrium, has a great deal of appeal to economists who have a deep seated suspicion of government intervention. Monetarism as­signs monetary policy to the neutral task of maintaining price stability, leaving markets free to make production and allocational decisions in a stable environment.

Nevertheless, the focus on monetarism diverts atten­tion from much more important elements of economic liberalism, such as deregulation of the economy so that markets function properly. Indeed, deregulation is a necessary prior condition for the establishment of mone­tary stability and the assignment of monetary policy to the control of inflation. In particular, it is important to deregulate the labour market so that a monetary policy aimed at containing inflation does not create very high levels of unemployment.

Another issue in debates between economic liberals and others is the budget deficit. Economic liberals are naturally suspicious of budget deficits because they lead to an increasing role for the government in the economy and they remove the budgetary discipline on government expenditures. Nevertheless, economic liberalism does not dictate that the budget always be balanced. A deficit might be justified if it is used to finance capital formation. In addition, the budget needs to be in deficit on average so as to provide a continuing supply of risk-free government paper which plays a basic role in the financial system, e.g. it provides a safe liquidity reserve for financial institutions.

A discussion of some applications of economic liber­alism will illuminate its meaning, and this is provided in the following section.


Economic Liberalism at Work

Wages and unemployment

One view that characterises economic liberals is that wage flexibility is necessary to ensure low rates of unemployment and to encourage economic growth. This view clashes with one which has been well established in Australia in the post World War II era — that wages and living standards should rise steadily, year in year out. This alternative view expresses itself through a wage determination system that dates back to the Harvester Judgment of 1907. A basic assumption of that system is that wages can be determined on the basis of need without reference to the state of the economy. In recent times the emphasis on ‘entitlement’ has led to an acceptance of a government responsibility to provide regular increases in benefits and to impose restrictions on work practices to make employment more pleasant. Actual wages need not rise steadily so long as the `social wage’ increases.


 The logical underpinnings of these views are extreme­ly weak. One argument frequently advanced is that higher wages lead to higher expenditure and thus to higher employment. Expositors of this view never carry it to the logical extreme — urging ever higher wages until we reach full employment — which is a good thing because the statistical evidence is overwhelmingly against the argu­ment. Not surprisingly, when the cost of labour is in­creased, employment falls. Facing higher labour costs, employers will substitute capital for labour, particularly unskilled labour, and reduce output. Elsewhere, I provide evidence in support of this view for Australia (Valentine 1993). In his book Free to WorkWolfgang Kasper (1996) outlines the benefits obtained by New Zealand from a flexible wages system.

Looking at this question another way, if the economy is not doing well and there has been a reduction in total income (for example, in the Australian case, commodity prices fell sharply), an attempt to give a large part of the population increases in income must have disruptive ef­fects. The remainder of the population (e.g. farmers) bears a disproportionate part of the loss of income or the inflexibility of wages leads to higher unemployment. A flexible wages system allows appropriate reactions to the fall in income and this reduces the need for adjustments in employment. It would also encourage a positive response in the economy so that economic growth suffers only a modest setback.

Critics of economic liberalism often caricature its approach to reducing unemployment as ‘massive wage cuts are required to reduce unemployment’. Actually, economic liberals see strong economic growth as the best remedy for unemployment. Such economic growth can be encouraged by microeconomic reform (including a shift to a more flexible industrial relations system) which allows the economy to function more efficiently. Alterna­tive policies have been ineffective. For example, proponents of the type of labour market programs pursued in Australia under the Labor government appear to be will­ing to accept a high unemployment rate as a continuing fact of life. In addition, they rarely examine the economic effects, both long and short term, of the interventionist job creation policies they espouse.


The sale of government owned business enterprises —called privatisation — is closely identified with the Thatcher government in Britain, but it has become popular in most highly developed countries. Economic liberals support this trend because it reduces the role of the government in the economy. More concretely, it is argued that shifting commercial organisations into private ownership removes a source of the diversion of government attention from its core activities, leads to better management of the organisation in question, and removes any non-neutral competitive advantage it might enjoy as a result of its government ownership.

A government’s decision to privatise a commercial operation should be reached by comparing the price obtained to the discounted present value of the future cash flows (surpluses from the organisation) which will no longer be received by the government. A willingness on the part of potential purchasers to pay a price in excess of the present value of the cash flows to be received in the future by the government suggests that they believe that they can make better use of the assets than the govern­ment, i.e. that they can manage the organisation more efficiently.

While the privatisation trend is in line with the doc­trines of economic liberalism, it was mentioned above that the major motivation for it appears to be to reduce measured budget deficits. This reduction occurs because government budgets compound capital and current trans­actions, i.e. they record cash flows rather than changes in wealth. Thus the proceeds of asset sales and the repay­ment of debt are included as inflows. One reason why this type of accounting is misleading is that it provides an inaccurate measure of the impact of the government on domestic capital markets. Both a sale of bonds and a sale of government commercial assets represents a drain on domestic savings and increases the need for an inflow of funds from overseas capital markets.

 Trade Policy

 There is a global movement towards the liberalisation of international trade by the removal or reduction of tariff and quantitative barriers to trade. Economic liberals support these initiatives because they believe that freeing up international markets will lead to increased global income, which will ultimately be of benefit to all nations. Nevertheless, removal of trade barriers will necessitate significant readjustments to the structure of domestic industry as previously highly protected industries contract and others expand to take their place.

 Similar changes in structure can be forced by changes in the exchange rate which alter the viability of different industries. This conclusion might suggest that trade barriers are simply additions to the effect of the exchange rate but the ‘protection’ provided by the exchange rate is neutral. It encourages countries to specialise in the most suitable industries, whereas government imposed trade barriers tend to support industries for sentimental and political reasons rather than economic motives. An exam­ple of the attitudes which often motivate these controls is the frequent rejection of the jobs provided by tourism as too menial for Australians. Unfortunately, consumers bear the cost of the inefficiency created in this way. Moreover, the loss in income is probably distributed in way that disadvantages lower income earners (Garnaut 1981).


One argument frequently advanced against trade lib­eralisation is the difficulty in proving that it is beneficial if some countries do not match the deregulation of others. Brander (1994) considers the situations in which a ‘strate­gic trade policy’ might be useful. He notes that the success of such a policy depends on the policymakers having accurate information. Uninformed restrictive policies (e.g. simply keeping a tariff because other countries have retained trade restrictions) are just as likely to be harmful as favourable. Andersen and Findlay (1993) review the standard arguments against trade liberalisation and find them to be largely invalid.

Economic Liberalism Versus The Entitlement Consensus

The current alternative to economic liberalism, and certainly the one supported by critics of economic liberalism such as Toohey (1994) and Langmore and Quiggin (1994), is often described as the ‘social market’ approach, but it is perhaps better described as the ‘entitlement consensus’. There exists a consensus that all members of the community have a right to certain entitlements including, amongst other things, a free education, free medical treatment and protection of employment. The range of these entitlements is growing steadily in a way which is unrelated to any growth in output or productivity. It is not surprising that a consensus can be established about the need to meet the desires of the population without a concern for where the necessary resources are to come from. The approach, however, lacks intellectual and practical credibility as a theory of economic policy.

There is no mechanism built into the consensus to ensure that entitlements are not created in excess of the resources available to satisfy them. If this happens, there will be considerable disruption in the economy. A classic example of disruption of this type is the effect on the economy of the wages explosion in the first half of the 1970s (see Valentine 1993). Some commentators have suggested that we have already reached this situation on a wider level, with a number of undesirable effects. First, the imbalance creates dissatisfaction because it is impossi­ble for everybody to achieve their entitlements. This dissatisfaction has reached significant levels in spite of the very high living standards we enjoy, on both historical and cross-country comparisons. Secondly, the dissatisfaction and the attempt to reconcile irreconcilable objectives has led to a reduction in the rate of economic growth. A number of recent writers, such as Paul Krugman (1994) and Jeffrey Madrick (1995), attribute lower economic growth to the achievement of maturity by the advanced economies. If this is true, the entitlement consensus must come to terms with a permanently lower growth rate.

There is no economic analysis underpinning the enti­tlement consensus. No attempt has been made to estab­lish that it produces a better outcome than a free market economy. Many supporters of the consensus have assem­bled criticisms of economic rationalism, as they define it, and reject it on the basis of these criticisms. They then jump to the conclusion that the rejection of economic rationalism must lead to an acceptance of the consensus, as expressed in the status quo or in further extensions of entitlements. The vital step of establishing the feasibility and desirability of their own approach is missing.


Economic rationalism, more aptly described as economic liberalism, is an approach to economic policy making based on the presumption that the best results are achieved from the adoption of a market based economic system. Price signals provided by markets free from government interference represent the best way to organise production in an economy. There are considerable variations in the detailed views held by supporters of this general position and this allows critics to choose the most extreme position as representative of economic liberalism in order to create an easy target. Failing that, they invent straw men so that they can attack these parodies of actual views.

In view of these criticisms, it is important to recognise the actual characteristics of economic liberalism. Eco­nomic liberals do not assume that individuals have no dimensions other than that of economic calculation and they do not base their recommendations on an abstract textbook model. Nor do they reject every form of govern­ment intervention in the economy. Rather, they argue that each such intervention should be subjected to a cost-benefit analysis.

The most important argument in favour of economic liberalism is that advanced by Winston Churchill in re­spect of democracy — it is the worst economic theory except for all the others that have been tried from time to time.

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Source: http://www.cis.org.au/images/stories/policy-magazine/1996-spring/1996-12-3-tom-valentine.pdf

Professor Tom ValentineBEcon (Hons) (Syd), MA, PhD (Princeton)

Tom is a professor at Universal Business School Sydney and Chair of the UBSS Academic Board. He completed his postgraduate education at Princeton University (USA) and has held senior academic appointments at Macquarie University (Graduate School of Management), the University of Western Sydney and the Australian National University. Tom has published extensively in economic and financial policy, and has an international research reputation in these areas.