Tuesday, 7 July 2015

In economics it is not better to have loved and lost

Branko Milanovic has a thoughtful post asking why Greece, whose GDP rose then fell, should be bailed out by Portugal whose GDP has been constantly low:



Surely welfare in Greece is worse, but he wonders how to reconcile that with standard economics, and asks whether we need to make individuals' utility respond to changes in income.

I am sure that some suffering in Greece is caused simply by the psychology of having money and then losing it. But behavioural economics is not really necessary here. It is simpler just to think about the disruption caused by sudden crashes.

Even at individual level, and without invoking e.g. loss aversion, it is possible to suffer much more from a rise then a fall in income than from constant low income. For example, imagine that while riding high, you take out a mortgage which you can't sustain, so in the downturn you become homeless.

At social level the disruptions are much more severe. Hospitals can no longer afford the drugs they have been ordering. Businesses have cash flow crises and go bust.

Much of this would enter any reasonable model of welfare, but is not captured by raw GDP statistics. Other simple statistics can help. Here's the unemployment rate for the two countries: Greece is suffering a lot more than Portugal.