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Cures worse than the complaints Samuel Brittan: Financial Times 18/07/02 The world needs an increase in taxes or in savings like it does a hole in the head The most interesting feature of this week's UK Spending Review has not been the public expenditure projections, which were foreshadowed in the spring Budget, but in the arrangements for monitoring performance. The myriad of objectives and performance targets and all the new quangos to inspect delivery add to the risks of the new spending being wasted or distorted. They are a product of fashionable managerialism and have nothing to do with social democracy, let alone a liberal market economy. But this is not the time to argue the detail, as the whole package has come at a time of exceptional fragility in the world economy and during a widely proclaimed pensions and savings crisis. What all these events have in common is the proliferation of so-called cures which are worse than the diseases at which they are aimed. Any inclination of mine to start a philosophical dialogue with Gordon Brown about public spending was stilled by listening to the follow-up comments and questions, which really pointed to economic follies worse than any with which they charged the Chancellor. The widespread assumption was that if growth undershoots the Treasury's projections then taxes would have to go up much further than by the projected increases in National Insurance contributions due to take place next year. Have these commentators learned nothing and forgotten everything about 20th century economic history? They are suggesting that raising taxes would be the right response to a budget deficit induced by an economic slowdown. This was just the kind of action all over the world which helped to turn the 1931 recession into a full scale international slump. You do not have to be an extreme discipline of Lord Keynes to say this. Milton Friedman, the world's leading monetarist, has always favoured a budget balanced over a whole economic cycle. Indeed, in the immediate post-war years he published a programme for stability under which the budget would not only automatically go into deficit during a slump, but the deficit would be financed by printing money. He later modified -- whether wisely or not -- the last part of this proposal but never went back on allowing the automatic stabilisers to unbalance the budget in both slump and boom. Indeed when budget deficits loomed in the US he normally argued for tax cuts rather than increases. This was both to give a supply side boost to the economy and impose a revenue squeeze on governments' spending plans. If we go back further to the Austrian economists, such as Schumpeter and Hayek, they did indeed believe that recessions were a necessary price for ill-conceived investment during the proceeding boom. But they came, if belatedly, to advocate stimulative action to prevent an investment downturn from being magnified by what they called a secondary fall in consumption. Gordon Brown has understandably fought shy of getting involved in economic ideology and has simply pointed to the margin of safety in his plans, which suggests that his fiscal targets would be met even if the economy were one per cent below the Treasury's present view of its trend. This safety margin would be adequate in the face of normal forecasting errors but would not be nearly enough in the face of a serious double dip world recession. The possibility of such a recession was highlighted by Professor Wynne Godley in a letter to the Financial Times on Tuesday when he remarked that if US household net savings were to revert to their long-term norm, personal expenditure would fall relative to income by about six per cent, thus triggering a self-reinforcing implosion of asset prices and demand. Godley and others have been warning about this danger for some years. What seems to have staved it off so far is that world real estate values, as shown in the chart, have remained stable or even buoyant, despite a 40 per cent drop in equity indices. Even in the US, real estate is a more important part of personal wealth than directly held equities. In the UK moreover, there has been a real estate bubble, which becomes more dangerous every day it continues. It is difficult to believe that the equity and real estate markets can for ever be insulated. Once households really start worrying about the effect of falling equities on their pension and insurance prospects, then the residential cushion may no longer suffice to hold up personal spending. I am not predicting a world slump - as an American sage once remarked, forecasting is very difficult especially when it comes to the future. But governments and monetary authorities have no excuse for being unprepared. The weakness of equities interacts with the pensions crisis. In the UK it is claimed that there is a gap of £27bn between actual savings and what would be required to fulfil peoples pensions expectations. But the pensions problem is general among industrial economies. There are only a few things people worried about their pensions can do. They can consume less and save more. They can reduce their expectations of retirement income. Or they can postpone retirement. It is the last which makes most sense. The worldwide problem of the welfare state is mainly due to retirement ages not being raised in line with increased longevity. From this point of view we should hardly bemoan the demise of defined benefit pensions, which tend to be based on earnings in the last few years of employment, and which encourage people to retire early before their earnings capacity begins to drop. The conventional remedy for pensions is an increase in personal savings together with a move from pay-as-you-go government schemes to the funded variety. Both ideas need heavy qualification. Pensions can only be paid out from future national income; and increased savings will only help if they increase that income. A worldwide savings increase at the wrong time would - like a general tax increase - merely aggravate any economic downturn; and, so far from financing an investment increase could reduce the incentive to instal more business capital. This was known in the 1930s as the paradox of thrift; and like many such dilemmas did not vanish but has been temporarily in abeyance. But suppose, against the odds, that this increased savings did lead to more physical investment, we then come up against the hard fact of diminishing returns to capital as more of it is put in place. The indigestion caused by recent overinvestment in the technology and communications sector is surely sufficient warning. Experience of the last few decades has given an altogether inflated view of the gains to be expected from equity holding. In the long run profits cannot rise faster than the growth of nominal national incomes. The cult of the equity was based on a prolonged, but once for all, adjustment to earlier depressed profit margins. The equity slump may have to go further to correct overoptimistic valuations; and we will probably never see a return to the rates of capital appreciation deemed normal in the 1980s and 90s.
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