John Weeks is co-convenor of Economists for Rational Economic Policies, EREP
Sound fiscal policy
For over sixty years maintaining economic stability was the basis of national fiscal systems. Governments in North America, Europe and Japan occasionally engaged in active fiscal measures to balance their economies between excessive inflationary pressures and involuntary unemployment. Common to the point of universal were “automatic stabilizers”, fiscal measures that kick-in automatically to slow expansion and dampen downturns.
The question, “can there be another Great Depression”, appeared frequently on examination papers in the United States and Britain. Then, the appropriate answer was negative. The well-prepared student would have a standard list of institutionalized mechanisms to justify the “no” answer. For the public sector the two most important were 1) payments to the unemployed that begin immediately upon loss of jobs; and 2) the progressive structure of personal taxes so that disposable income falls less than national income and income tax revenue falls more.
Equally important were automatic mechanisms in the private economy. Short run adjustment of retained corporate earnings represented the strongest of these. In those bye-gone days regulations on business in the United States and Britain made retention and investment of corporate profits advantageous. As a result, when the aggregate economy slowed or contracted, corporate retained earnings absorbed a disproportionate share of the fall in national income (see the famous 1969 NBER paper by T. Paul Schultz).
As a result of the counter-cyclical effect of these automatic stabilizers, for sixty years from 1945 through 2005 the US economy suffered no deep, extended recession, much less a depression. The same conclusion applies to the UK economy, with two episodes that are “exceptions that prove the rule”.
Following WWII a severe balance of payments constraint prompted the Labour government purposefully to constrain growth, and in her first years as prime minister Margaret Thatcher and her then chancellor Geoffrey Howe manufactured a recession with the purported goal of containing inflationary pressures (with the conscious side effect of weakening trade union bargaining power).
Destruction of automatic fiscal stabilizers
During the sixty years up to the mid-2000s built-in stabilizers cushioned the inherent instability of private investment, and, equally important, compensated for the mistakes of deficit-obsessed policymakers such as George Osborne. With stabilizers institutionalized, governments had difficulty generating a recession by accident.
It took quite an effort to force contraction of an automatically stabilized market economy, as Thatcher-Howe and US Federal Reserve Chairman Volker demonstrated at the end of the 1970s (the “Volcker recession”). First prize for policy-generated recession goes jointly to the European Commission and the Merkel government for deepening and prolonging without sign of termination the continent-wide stagnation of the euro zone. Working together with the sage counsel of ultra-austerianWolfgang Schäuble, they manufactured a period of stagnation beyond what malfunctioning financial markets could achieve.
While the private sector caused the Great Recession, it could not on its own have kept it going so long without the continuous austerity policies. The economic mess in the euro zone would quickly go from stagnation to recession (or worse) without the public and private sector stabilizers that soften the impact of the dysfunctional austerity regime.
The chart below shows clearly the operation of the UK tax stabilizer, for 56 months until the end of the Labour government in May 2010 (time period chosen to equal the duration of the Osborne chancellorship to date). The chart measures month-on-month annualized changes in revenue and GDP.
During 2005-2007 the steady expansion of GDP corresponded to a similarly steady growth of revenue. Over the two-and-one-half years changes in revenue were about 40% of change in GDP. Then, the financial crisis hit, turning growth to decline. Over the next two years and four months, 2008-2010, the ratio of changes in revenue to changes in GDP fell by half to 20%. This automatic stabilizing effect of revenue is obvious in the diagram, with tax falling much more than GDP after mid-2009, then rising slower.
Changes in GDP (black) and Public Revenue (blue), July 2005 – April 2010 (56 months, £ billions in market prices)
May 2010 ushered in the Conservative-Liberal Democrat Coalition with George Osborne as chancellor. Perhaps Mr Osborne’s most important and pernicious fiscal legacy will be his contributions to the destruction of public sector automatic stabilizers. What strikes anyone who glances at the chart above showing the Blair/Brown 56 months and the one below for Mr Osborne’s 56 is the two lines move together in the first person, but opposite to each other in the second (specially after mid-2012).
The difference in the diagnostic statistics for the two 56 month periods is as striking as the charts. In the Blair/Brown era increases in GDP were strongly associated with increases in revenue, with £100 increase in GDP matched to a £40 increase in revenue. The probability that the link is accidental (“random”) is less than one in 1000.
Comes the Osborne fiscal(mis)management and the link again is highly significant, with the probability of randomness less than one in 500. Under Mr Osborne’s “steady hand” the link reverses from positive to negative – an increase in GDP of £100 bringing a fall in revenue of £39!
Changes in GDP (black, left axis) and Public Revenue (blue, right axis), April 2011 – December 2015 (54 months), £ billions in market prices
How could this unheard of combination happen, rising income and falling revenue? First, the revenue rules and rates of the two time periods were quite different. During the Blair/Brown period the UK tax structure changed very little. Therefore, the link between revenue and GDP was stable.
In contrast, in the Osborne era revenue generation underwent radical restructuring. First, Mr Osborne cut rates on personal income for the rich, reducing both tax as a portion of GDP, thus the automatic stabilizing effect of progressive taxation. Second, Mr Osborne’s now notorious tax deals work to cut the link between corporate earnings and corporate tax (“outsourced to Google” as Jeremy Smith puts it). Third, until very recently UK employment growth has occurred at pay rates below or barely above the tax liability borderline (which is £10,600). And, fourth, the de facto shift from income taxes to VAT in itself reduces the revenue response to GDP.
These and other recent measures imply that in the short term, notably the last three years, public revenue falls as GDP rises – because the tax rules and composition of employment have changed. Once these changes end, revenue and GDP will again be linked, but in a much weaker and less stabilizing manner.
Perfect Crash next time
Much has been written anticipating another global financial crisis (for a bit of sense among nonsense see article by Ann Pettifor). When the financial shock hits, discretionary fiscal policy and automatic stabilizers will determine the impact on household incomes and employment.
By comparison to the 1930s when output in the United States fell by over 25%, the automatic stabilizers appear to have substantially softened the income and employment response to the massive financial breakdown in 2008-2010 when US GDP fell by 4%.
By comparison the contraction of the UK economy was almost twice as large, over 7%. The most likely explanations for the greater UK contract are the more effective Obama fiscal stimulus in 2009, and despite the important of Wall Street, the greater diversification of the US economy.
The UK economy suffered a severe contraction during 2008-2009. Should another finance crash come before 2020, plan on a considerably worse outcome. The public sector automatic stabilizers will be far weaker when the next crash comes, and the private sector ones disappeared long ago with the legal changes that encouraged UK corporations to distribute rather than retain profits.
In the New Testament we read that the end of the earth will come when “the elements shall melt with fervent heat” (2 Peter 3:10, 12). Not a bad metaphor to describe a financial crisis in an economy mismanaged by a deficit hawk without automatic stabilizers.