The British Government’s Tax and Spending Proposals:
Testing Keynes to Destruction (Again!)
by Sean Gabb
Tomorrow afternoon, all the journalists have been primed to say, the British Government will cut taxes and increase spending. The alleged purpose of this is to prevent a deep recession. The real purpose, there can be no doubt, is to win the next general election for Labour – and, since the Conservatives remain as useless as ever, it may well work. I will, however, discuss the alleged purpose. Politics aside, it will be about as catastrophic a response to our current troubles as can be imagined.
The politicians of every party, and every journalist I have read, are agreed on the nature of these troubles. The crises of the past year in the banking sector have caused investment to fall. Consumption is now beginning to fall. To use the Keynesian jargon, aggregate demand has fallen, or is falling, below the level needed to keep national income at its full employment level. The answer is for the Government to cut taxes, thereby encouraging people to spend, and to increase its own spending.
It is also agreed by all that interest rates should be cut, thereby encouraging people to spend still more and encouraging firms at least to go back to investing as much as they were until the troubles began. It is admitted that doing all this might cause other problems. But this admission is followed by warnings about the horrors of the deflation we otherwise face.
This kind of economic reasoning is not as worthless as some of my friends believe. In countries as heavily regulated and corporatised as modern Britain and America, an increased preference to hold cash will not be balanced in the short or medium term by changes in the structure of relative prices. Firms will cut production rather than prices. Trade unions will prefer job losses to wage cuts. This can mean a very long and severe recession. There can be little doubt that, regardless of whatever would have followed, even without the Second World War, the currency debasement of 1931 moderated the effect here of the Great Depression.
However, while not entirely worthless in certain conditions, what we are now being told is entirely worthless now. There is no doubt that people are spending and investing less than they were, and that they will continue to spend and invest less for some while to come. But, before agreeing that the politicians should be allowed to do what they most enjoy – namely, spending money that is not their own and that often does not yet even exist – we need to ask why we are in such trouble. The answer will explain why the proposed response will be catastrophic.
For many years, interest rates have been held below the sort of level needed to balance the supply of savings and the demand for loans. The result has been inflation. That many consumer prices have been falling is no argument against this proposition. Inflation is best seen not as price increases but as monetary expansion. There was a time when monetary expansion led fairly soon to price rises. Where at least Britain is concerned, though, most consumer goods are imported. So long as foreigners are willing to finance a growing current account deficit without devaluation, demand for imported consumer goods can expand rapidly and for years without any increase in prices.
The new money will therefore be used partly for investments in new production that may or may not be wise in the long term – and also to bid up the prices of property and of paper assets.
These bubbles never last. There comes a point where people lose faith in a currency, and where the upward spiral of asset prices is checked. The fall in the currency will push up consumer prices. Overvalued assets will fall in at least real terms. Many other investments will be shown to have been unwise. The immediate reasons for their bursting are less important than that they always will burst. This has now happened. There is no definite rule in these matters. But it seems that the length and intensity of the boom is roughly in proportion to the scale of the recession that follows.
The financial collapse we are now witnessing, therefore, should not be seen as some autonomous fall in aggregate demand that can be offset by increasing other variables in the national income income equation. It is instead part of the unavoidable correction to past experiments in demand management. All the clever people disagree. They do believe that playing with aggregate demand can avert, or at least moderate, the coming recession. Now, these people are often very clever – most of them more so than I am. They are still wrong.
Cutting taxes is always a good idea. Not balancing them with spending cuts is not so good. If the British Government will do tomorrow what the journalists say it will, the inflation will be continued, though now without the confidence in sterling that allowed it before last year to create the illusion of prosperity. Taxes will fall. Government and other spending will rise. Interest rates will be cut. In the short term, this may be enough to win the next election for Labour. It not even before, though, the pound will collapse shortly after. Interest rates will then need to rise sharply, if the Government is to continue selling its bonds and if consumer prices are not to rise sharply and continuously.
There is no reasonable chance of deflation. For the next few months, while the collapse of sterling is only gathering momentum, firms will be able to reduce prices to keep up demand for their products. This will give the appearance of deflation. Eventually, though, their margins will not be further reducible, and the collapse of sterling will raise costs that must be handed on. This will happen even without further action. The bank rescues of last month were financed by money creation that will, sooner or later, find its way into circulation. Deflation is the last of our worries.
I have no professional expertise in finance, and so give no warranties of any kind. This being said, I think it a good idea for anyone who has a mortgage to get the best fixed rate he can between now and Easter, and otherwise to avoid saving money at any rate fixed longer than six months ahead. If he wants to buy imported consumer goods, he should do so now or, at latest, in the sales after Christmas.
Beyond this, I have no advice. Just because I do not believe in the solution that everyone else is urging on us does not mean that I have any alternative solution to offer. We should never have got ourselves into this mess. Failing that, the recession should have been allowed to hit last year. Since it was then deferred, it should be allowed to hit now. It will do nothing to moderate the inevitable recession. But there is a good case for cutting taxes and government spending now by at least a third, and then by five per cent a year every year for the next decade. And there is a case for returning to a fully convertible gold standard.
Of course, no politicians will take my advice. If any do read what I have just said, they will at best laugh with contempt. But I am right, and I feel some grim satisfaction in being able, come 2010, to send this article out again under the heading “See – I Told You So!”.
NB—Sean Gabb’s book, Cultural Revolution, Culture War: How Conservatives Lost England, and How to Get It Back, can be downloaded for free from http://tinyurl.com/34e2o3