[A-List] Richard Musgrave

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Richard Musgrave died at age 96 on January 15, 2007 at a time when 
recognition of institutional economics is experiencing a revival over 
the fetish of market fundamentalism. Yet public finance, which includes 
Federal Reserve intervention on financial market, is standing on its 
head today, with the Fed taking the role of a clean up crew of private 
greed rather than a traffic cop for social good. Creative destruction 
has come to mean recurring financial crises that the Fed, as a private 
institution that assumes public authority, acts as a stoic undertaker of 
the undeserving destroyed for the benefit of the preferred survivors. 
Its time to re-read Musgrave.

Henry C.K. Liu

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February 15, 2004
	
David Warsh, Editor



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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his otherwise strong claim on the Nobel Prize was superseded.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.