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February 15, 2004
David Warsh, Proprietor

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Architect of the Public Household

In Munich, not far from Max Weber Platz, at an outpost of the University of Munich’s Center for Economic Studies, is a conference room named for Richard Musgrave.

If Weber was the most important German political economist during the first half of the 20th century (and he was), it was Musgrave who achieved that distinction in the second half. Of course, economics had changed a great deal by then. Musgrave has spent his entire working life in the United States, for many years at Harvard University.

His story is highly interesting — and not just for the manner in which his otherwise strong claim on the Nobel Prize was superseded.

Nearly sixty years after Musgrave commenced his work on public finance, with an article on “The Voluntary Exchange Theory of Public Economy” in the Quarterly Journal of Economics in 1939, he made another memorable contribution. In certain ways it was just as important. But it is much less well known.

He was born in 1910 in Koenigstein, a little town not far from Frankfurt. He obtained his degree from Heidelberg in 1933, the year of the Reichstag fire and the book burnings in the university yard. That autumn he left Germany for the University of Rochester. The next year he transferred to Harvard and, in 1937, received his Ph.D.

“There cannot have been a better time to be an economics graduate student than at Harvard in those days,” Musgrave has written. “All seemed to climax and fall into place: first, there was the rewriting of micro theory in the context of imperfect markets. Then there was the birth of macro theory in the Keynesian mode.”

But all that fancy thinking aimed at ending the Great Depression by “making the economy work” was not where Musgrave made his contribution. Instead he went back to the beginning of economics, to Adam Smith, to reexamine the underpinnings of public finance.

Smith had noted that that were certain services that, while highly useful to the individual, could not be undertaken profitably on an individual basis. In certain areas, government would have to take a hand, providing defense, justice, education and various public works such as highways and bridges.

Yet for 150 years after Smith, this focus on governments’ productive contribution was more or less completely ignored by English economists. They focused instead on analyzing the various effects that taxes would have on the “Invisible Hand” of competition. Their subject was “the market.” Government entered the picture as a means of redressing “market failure.”

Thanks to his Heidelberg education, Musgrave was familiar with the very different continental tradition in public finance — Austrian, Italian, Swedish political economy and the somewhat different German tradition known as Finanzwissenschaft, or fiscal sociology, which took the existence of communal needs as a starting point.

Financewissenschaft offered a storehouse of dubious concepts such as geistiges Kapital (spiritual capital provided by the state) and Glueckseligheit (the happiness of society as a whole). It propounded doctrines which held that the value of a good depended on its significance to the state and the state’s continuing renewal.

As he watched unfold the monstrous calamity that was Nazism, Musgrave recoiled sharply from the more literal organic conceptions of society and the state. His economics would be peopled by the same separate and independent agents as the British tradition.

But he didn’t throw the public sector out altogether. Instead he turned in his dissertation to the Swedish economist Knut Wicksell, who, along with a handful of others in the 19th century, had described a world in which the demand for public goods arose from the preferences of individual consumers.

Wicksell’s project — well known to European scholars, but completely unexplored in the United States — was to somehow apply to the public sector the same marginal utility theory that already in the late 19th century had swept the analysis of markets for private goods.

There was, however, a problem. With prices you could tell how much a consumer wanted of any particular good by his willingness to pay. But taxes presented no such easy mechanism by which preferences might be revealed.

Consumers received the benefits of public goods that were supplied free of direct charge through the budgetary process. But there was no obvious way of telling how many street lamps and much police protection they wanted – least of all by how much they voted to tax their neighbors.

How, then, to arrive in theory at a series of “tax-prices” that might indicate how many guns and how much butter, jointly and severally, they preferred? Of course citizens of the world’s democracies were doing just this in the real world, day after day. But maybe theory could discover ways to improve the process.

In a series of technical arguments too intricate to go into here, Musgrave solved the problem. He did so by adopting and combining the arguments of Wicksell and his student Erik Lindahl, and then mapping them into the English tradition, which, as noted, had almost nothing to say about the provision of public goods.

Wicksell always had wanted to go beyond simple majority rule. He envisaged various schemes of sequential voting on alternative tax-expenditure packages. He invented the idea of a “negative income tax,” an income transfer to the poor (later made famous by Milton Friedman and Richard Nixon), designed to insure that all citizens had some stake in the voting. Then, writing in 1919, Lindahl went a step further, offering what he called the “voluntary exchange solution.”

Lindahl’s idea was that citizens – either voters themselves or, much less complicatedly, the political parties representing them – should bargain over the fraction of the total cost of a particular budget appropriation each would be willing to assume, until they reached a point at which the marginal evaluations of each added up to the total cost of the project. These shares would be its various tax prices.

The implication was that with public goods, different individuals would pay very different prices for equal shares of the same thing. Private goods had the same price for different quantities, but with public goods, different prices for the same quantity would be the rule.

Today, we take it for granted that, for example, people pay very different prices for seats on the same airliner, now that computers have made it easy to strike bargains that discover willingness to pay. But these were very novel concepts when they were first broached, especially in the area of public finance.

So the budget process required, not just taxing, not just spending, but choosing as well. That in turn meant there would inevitably be politics and voting would be required to reveal preferences. This Musgrave dubbed the allocation process.

He was interrupted by the outbreak of World War II. He worked for six years for the Board of governors of the Federal Reserve System, the last couple as assistant to Marriner Eccles, the Fed’s brilliant chairman. When the war ended, he went to teach at the University of Michigan.

Musgrave’s big book, The Theory of Public Finance, appeared in 1959. The timing was ideal. He has recalled, “The 1950s were pregnant with the theory of social goods and the Keynesian vision of public finances as employment creator as well as the central role of budget policy in the emerging welfare state.

“All this had to be integrated and provided the setting for my architectural design, a three-winged cathedral (with its branches of allocation, distribution and stabilization) and a coordinating simultaneous process of budget determination in its nave….

“While much has been said over the years in criticism of this simple scheme, I still believe it to be useful, not only as a pedagogical device (a compliment made to damn with faint praise), but as a systematic approach to the structure of our science.”

By 1959, the issues surrounding Musgrave’s attempt to marry the theory and practice of good government had become clouded by the appearance of new and deeper explorations of the basic issues, from several slightly different angles.

With a little book in 1951 called Social Choice and Individual Values, for example, Kenneth Arrow had initiated the study of voting behavior known as “social choice.”

The “public choice” movement was gathering steam, based on what its founder, James Buchanan, described as “a healthy dose of Italian realism” about the motives of politicians, politics and bureaucracy.

A “social welfare function,” a highly theoretical measure of aggregate well-being that might grow or shrink with various economic policies, was introduced to mainstream analysis, by Abram Bergson and others.

But it was only after the new Nobel Prize in economics was established in 1969 that it became possible to see clearly exactly what had happened to Musgrave’s pioneering contribution in public finance. Over the next quarter century, the award proved to be an invaluable device for tracing out and illuminating the recent intellectual history of the discipline.

And when Paul Samuelson was honored in the second year of the award (the first year’s prize went to pioneers of econometric modeling, Ragnar Frisch and Jan Tinbergen.), the story that the Swedes were telling became much clearer.

It had to do with how economists were replacing a vague, more “literary” type of economics with theory rendered with mathematical stringency in such a way as to permit empirical quantification and a statistical testing of hypotheses. Among Samuelson’s achievements: his contribution to general equilibrium theory, meaning the interdependence, in principle, of all the prices and quantities in the economic system, private and public goods alike.

A case in point: a three-page paper by Samuelson that appeared in a symposium in the Review of Economics and Statistics in 1954 titled “The Pure Theory of Public Expenditure.” It began, “Except for Sax, Wicksell, Lindahl, Musgrave and Bowen, economists have rather neglected the theory of optimal public expenditure, spending most of their energy on the theory of taxation.”

Whereupon Samuelson proceeded to restate Musgrave’s argument as a mathematical model of the overall interdependence between public and private goods – with immediate and explosive results. Overnight, the language of public finance, at least cutting edge public finance, became mathematics.

“Never have three pages had so great an impact on the theory of public finance,” Musgrave wrote thirty years later. They spawned a large volume of literature, with many variations on the theme, but the basic model had been set. The conditions of Pareto optimality had been expanded to include public goods and the optimum optimorum based on a social welfare function had been restated accordingly.”

The excitement lay in the moment Samuelson chose to write his paper. It was a little like Babe Ruth pointing deliberately to the wall before his next home run. In the early 1950s, resistance to increasing formalization was widespread.

A Rand Corp. economist named David Novick had submitted an article to the Review to complain. “Whereas verbal statements of ideas and their interpretation permitted general reading and discussion,” wrote Novick, “the present trend to mathematics as a language had cut off a large part of the fraternity from an ability either to read or understand much of the new thinking.”

“An unfortunate feature of this has been that those with training in mathematics have set up a new ‘abandoned mine’ camp in which they all live by taking in one another’s washing, and the outsider who might be capable of pointing out the intellectual limitations of this existence has been cut off from them by the language barrier.”

Prominent mathematical economists stood in line to rebut the point in literary terms — Laurence Klein, James Duesenberry, John Chipman, Jan Tinbergen, Robert Solow, Robert Dorfman, Tjalling Koopmans and Samuelson himself. But the proof of the pudding was the mathematical restatement of “The Voluntary Exchange theory of Public Economy” that Samuelson concocted on short notice, based on his “dim remembrance” of a diagram in Musgrave’s paper. So obviously superior was the treatment, at least to the mathematically well-versed, that it was a devastating response to Novick’s charges.

Musgrave, for his part, was delighted – at least for the most part. He and Samuelson had been close friends for 20 years, ever since they had been graduate students together. Musgrave frequently expressed pleasure in later years at having led Samuelson to the problem that he so successfully solved. Samuelson in turn occasionally mused that perhaps he had cost Musgrave — or Abram Bergson or John Rawls or some combination – a Nobel Prize.

Then again, Musgrave did periodically permit himself a demurrer.

In Samuelson’s famous model, Musgrave would sometimes observe, rather than become bogged down in a morass of intractable game theory, he had simply set aside for some later date the problem of how an efficient solution of the public goods problem might actually be achieved in practice. For the purposes of model-building, Samuelson conveniently assumed the existence of a beneficent social planner who knew everyone’s inner-most thoughts. No need for voting mechanisms when you’ve got a friend like that!

To Musgrave, it didn’t matter. His reputation was established. He taught a few happy years at Johns Hopkins and briefly at Princeton before being called back to Harvard in 1965, with a joint appointment in the law school, from which further influence grew.

There he trained several generations of students, most notably Martin Feldstein, who in time would become the most influential public finance economist of the next thirty years. Musgrave retired from Harvard in 1981 and moved to the University of California at Santa Cruz, where his co-author wife still teaches and he holds forth in vigorous good health today.

Meanwhile, of course, as anyone who has followed the politics of the last thiry years knows full well, the pendulum swung back. The preoccupation with market failures that lay at the heart of the two great movements in operational economics in the 1930s – imperfect competition and Keynesian macroeconomics — gradually gave way to an equally avid interest in the problems of the public sector.

Civil servants became bureaucrats. The ways in which interest groups mnipulate democratic processes to serve their own ends took center stage.

Which leads directly (and finally!) to Musgrave’s second remarkable contribution to 20th century economics. In 1998, Hans-Werner Sinn, the leading economist at the University of Munich, invited Musgrave and his arch-rival in the study of political economy, James Buchanan, father of the relentlessly skeptical study of “public choice,” to a carefully organized five-day debate.

The scholars took turns stating their positions. They responded to one another. They took questions from the floor. Then they restated their views more narrowly. The results were published in 1999 as Public Finance and Public Choice: Two Contrasting Visions of the State. Their debate was a textbook example of what psychologist Daniel Kahneman recently called “adversarial collaboration.” So useful are both lenses for different purposes that it is not easy to form an opinion about who “won.”

It is, however, very likely that the lectures are the most important delivered at the University of Munich since the great Max Weber gave his farewell addresses on politics and science there in 1918. Long after the results of the next election have become old news – the next 40 years’ elections – the exchange between Musgrave and Buchanan will still be fresh.

By then, of course, the frontier of formalization in economics will have moved on. Concepts that are difficult to state concisely today will have found expression, just as Musgrave’s insights on public good provision in 1938 were given a crystal-clear formulation by Samuelson in 1954.

What are the chances that some young scholar eventually will succeed in writing down the intuition that Musgrave kept alive through a combination of literary and formal analysis all these years?

That a purely individualistic framework is insufficient for understanding the possibilities of politics? That some place in the model must be reserved for community’s claims? That interpersonal comparisons of welfare in some degree eventually must be undertaken again? That the economists’ task must be to envisage a good society and a moral state?

What are the chances? On the basis of history, pretty good, I would say.

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