If in a year’s time a Chancellor …

Wynne Godley

I have heard people say that the Budget was a bore. This may be true for those who had to listen to it or for those who are interested in minutiae. But as one interested primarily in economic strategy, I cannot remember a more intriguing situation. How can it possibly be right to propose a huge tax increase for next year, and an even larger one for the year after that, when by general consent unemployment is going to be in the region of three million and rising? I am going to argue that this Budget only makes sense on very special assumptions about the performance of the economy; and that if, a year from now, the situation is broadly unchanged – if, that is, output has not changed much, with unemployment still around three million and the balance of payments not in serious deficit – it will be every bit as wrong to raise taxes then as it would now.

I should make it clear before I begin that I am only writing here about strategic and structural questions: the ones which will determine the fate of the economy and the country over a period of several years – not ‘micro’ matters such as the effect of the Budget on the distribution of income or the well-being of pensioners. In order to understand what is happening at this level we have to look at the history of the last 14 years. The period since 1979 is best characterised by clearly distinguishing two distinct, though obviously related, categories of phenomena – structural and cyclical. So far as structural developments go, the key point is that Britain is far less able to compete successfully in world markets now than it was 14 years ago. That this is so can immediately be inferred from the fact that, although we have had, taking the period as a whole, the slowest rate of growth of the post-war period combined with a threefold increase in unemployment, our balance of payments (which should improve when there is a recession) is now 2 per cent of GDP in deficit compared with zero in 1979. If growth had been enough to keep unemployment at around one and a half million, imports would be so much higher that the balance-of-payments deficit now, ceteris paribus, would be in the £40-50 billion range and still rising fast. It ought not to be necessary to emphasise that an external deficit anywhere near as large as this would be totally unsustainable; our foreign indebtedness would be exploding and foreigners would long since have refused to let us live on tick on such a scale.

Supporters of the Government point out, correctly, that there have been big improvements in productivity in Britain during the last 14 years. Unfortunately these improvements have not been translated into any detectable improvement in the actual performance of the economy, as can be verified by looking again at the facts above. If the improvement in the growth of productivity does nothing at all to improve the growth of production, the country derives no benefit at all – the only significant result is to generate more unemployment.

It is easy to lose sight of the structural deterioration, which has been a fairly steady process, because the cyclical fluctuations in aggregate demand have been so wild: first, the Howe slump, then the Lawson boom, now slump again. On a chart covering the whole post-war period, the hysterical ups and downs of the last 14 years catch the eye and make the much reviled period of 1950-79 look like a haven of growth and stability. But the abiding legacy of the cyclical fluctuations is that the structural problems are even more severe than they would otherwise have been. A great deal of manufacturing capacity has been destroyed but also, as one of the results of financial deregulation, we end the period with households indebted to an extent far in excess of anything seen before. Both these things, the shortage of manufacturing capacity and the high level of debt, play a most important role in determining what the Government can and should now do with fiscal and monetary policy.

Of the two structural problems I have described, the first – that of inadequate manufacturing capacity – is relatively easy to explain and the policy implications are pretty clear, although it will remain extremely intractable. If the British economy is to grow fast enough to bring unemployment down, we simply must have larger and more competitive industries of the kind that sell goods and services in world markets – that is, mainly manufacturing industries. To this end we need a competitive pound and low interest rates, together with every conceivable support for manufacturing from the Government in the form of tax and other advantages. It is very unclear whether we shall succeed on this front, particularly as manufacturing capacity is at present so inadequate and depression is deepening by the hour in the rest of Europe.

The second problem – that of indebtedness – makes the fiscal problem very awkward to understand and explain. The usual way in which fiscal policy is discussed is in terms of the prospective public-sector borrowing requirement (PSBR) which is already very high and which everyone, including the Treasury, is expecting to rise a great deal further. The difficulty about trying to analyse the problem in terms of the PSBR is that, before drawing conclusions about it, the PSBR has to be divided into two components – a structural part (‘the effect of the PSBR on the economy’) and a cyclical part (‘the effect of the economy on the PSBR’). It is generally agreed that a cyclical PSBR requires no fiscal correction because it is itself the consequence of recession, whereas a structural PSBR always eventually requires fiscal correction if inflation and external deficits are to be avoided. It is always very difficult to make this distinction convincingly. How can one be sure, in the absence of any other evidence, that the deficit is not entirely cyclical? This is, after all, the most severe recession of the post-war period.

Everything becomes clear if one looks at some of the trends in key relationships between various kinds of income and expenditure. During the Lawson boom, households and firms financed their expenditure out of borrowing to an extent which left them with very seriously weakened balance sheets; it is known, for instance, that the average level of household indebtedness is about 100 per cent of the annual flow of income and that between one and two million households have debts which are in excess of the value of their houses. An important consequence of this indebtedness is that the whole private sector (households and companies combined), in the attempt to improve their balance sheets by paying off debt, are running a financial surplus – that is, an excess of income over all types of expenditure including investment – which is unprecedentedly large. And since the balance-sheet weakness is so serious, there is a general expectation among commentators, with which I fully agree, that it will be some years before debts are discharged on a scale which will allow private expenditure to rise back to its normal relationship with income. But sooner or later this is what will happen.

Charts illustrating this article

The fact that private expenditure is temporarily very low relative to disposable income is obscuring the important fact, to which attention has not, so far as I am aware, been drawn, that, because of slack fiscal policy in the past, disposable income itself is at a record level relative to GDP. As shown in Chart 1, post-tax personal income, expressed as a proportion of GDP, rose to 85 per cent in 1992, which is 5 percentage points above normal. The high level of disposable income relative to GDP explains another surprising feature of the present situation, namely that although personal consumption has fallen sharply during the last two years as borrowing fell (see Chart 2) the share of personal consumption in GDP, which rose to record levels during the Lawson boom, has actually risen to yet another record. In 1992, as shown in Chart 3, the share of consumption in GDP had risen to 66.5 per cent, which is about six and a half percentage point above normal.

Here we have the key to the present paradox. It would be wrong to increase taxes immediately because this would nip recovery in the bud and set unemployment rocketing. The problem is that one day, no one can say just when, personal saving will fall, investment will rise and the private-sector surplus of income over disposable income will revert to normal. When it does so, it will be absolutely essential to increase taxation by whatever amount is necessary to get personal disposable income itself and consumption with it back to their normal relationship to GDP. Unless this happens, there cannot, when the time comes, be enough productive capacity to supply the resources needed for investment, the balance of payments and necessary public expenditure on top of what consumers will be demanding.

While the computation of the precise size of the tax increase which will eventually be needed is a complicated and technical matter, its scale is fairly conveyed by the extent to which the share of personal consumption in GDP is at present abnormally high – that is, a sum in the region of £30-40 billion – two or three times as large as what the Chancellor is at present proposing for the year after next.

My first conclusion is that the Chancellor was absolutely right not to increase taxation this year because that would only have aggravated the recession. I also think he was right to give an earnest of his intention, at some future stage, to increase taxes by a very large amount, because that is what he will sooner or later have to do. The trouble is that no one knows when the private-sector surplus is going to fall back, so his timing may turn out to be completely wrong. As I said at the beginning, if in a year’s time we are in essentially the same position as we are now (with the recession persisting and the private surplus still high) it will be as great a mistake to put up taxes then as it would be now. If this happened, he could postpone the tax rise for a further period and this, I think, would be the right thing to do, however embarrassing it might be. The awful possibility remains that our performance in international trade will be so bad that fiscal restriction will be necessary in advance of any recovery in activity, in which case the only solution will be to raise taxes as planned and suffer the full consequences in terms of an even more severe recession. The only way out then would be to cut interest rates and further devalue the currency to whatever extent is necessary to get enough growth in investment and net exports.