WELFARE STATE

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CHAPTER 10: THE ERA OF

POLITICAL

ECONOMY: FROM THE MINIMAL STATE TO THE WELFARE STATE

IN THE 20

^TH

CENTURY

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ECONOMY AND POLITICS AT THE CLOSE OF THE 19

^TH

CENTURY

• An era of the minimal state, economy ‘self equilibrating’

• Government expenditure as share of GDP around 10%

– Mostly military, law and order, civil administration – Public education, health, poor relief less than half

• The state set the ‘rules of the game’: laws and regulation for industry

– Legislation about maximum hours, safety standards

• Poor relief stagnated at around 1% of GDP

• Macroeconomic policy unheard of

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IMPACT OF THE FIRST WORLD WAR

• Established trade routes disrupted

• Gold standard suspended (and difficult to reintroduce)

• Full parliamentary democracy introduced (with exceptions)

• Social-democrat parties gained wide electoral base

• Trade unions strengthened

• Desire for change, but strong inertia among economists and economic policymakers

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ECONOMIC ORTHODOXY AND THE GREAT DEPRESSION

• Liberal conviction that a rapid return to the gold standard at the pre-war parities was desirable

• Some countries devalued, and this helped them when the Great Depression arrived in 1929

• New political forces made deflationary policies very difficult: trade unions, powerful firms

• Circumstance rather than conviction forced UK off gold

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INCOMPLETE ECONOMIC RE- ORIENTATION

• Intense debate between economists which would eventually lead to modern macroeconomics

• But had little impact on policy

• Many governments pursued pro-cyclical economic policy during Great Depression

– Raised taxes to balance budgets, austerity measures – Grudging and delayed abandonment of gold

• Impact: economic and political crises

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ECONOMIC ORTHODOXY IN GERMANY

• Why didn’t German policymakers change course?

• Many have argued that had no options given war reparations and gold standard

• But Germany introduced capital controls in 1931

– Against the ‘rules of the game’ but would have allowed use of monetary policy

• Reparation repayments suspended in 1932

• If Germany had abandoned economic orthodoxy, we might have been spared Hitler!

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UNEMPLOYMENT PAVES THE WAY FOR

ADOLF HITLER

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ECONOMIC POLICY AFTER THE SECOND WORLD WAR

• ‘Keynesian’ theories and macroeconomics invented in the 1930s

• Multiplier theory suggested that government expenditure could have a ‘larger than spending’ effect

• Fiscal policy was not used consistently

– Politically easier to stimulate economy during downturns than cool off economy with spending cuts

• Some experimentations with state intervention and planning

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FULL EMPLOYMENT

• Full employment became the main aim of macroeconomic management, but:

– Insufficient macroeconomic data

– Open economies influenced by international shocks – Once a year budgetary processes

• Some countries failed to raise productivity  expansionary policies gave balance of payments problems

• After 1970s unemployment took off

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THE PHILLIPS CURVE AND TRADE UNIONS

• Phillips curve: idea that there was a stable trade-off between inflation and unemployment. Not so!

• Trade unions knew that wage increases leading to

unemployment would be met by government spending

 inflationary pressures

• Fine tuning mostly worked in countries with centralized trade unions: showed restraint and were forward looking

• Golden Age’s relative success of demand management due to: elastic supplies of raw materials, labour

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ECONOMIC GROWTH DURING THE GOLDEN AGE, 1950-73

• OECD Heller report of 1968 claimed Keynesian demand management helped dampen economic fluctuations

• But seems mostly due to:

– High profits and investments, technology transfer, openness to trade, high TFP

• Gradual build-up of Welfare State and unemployment benefits gave automatic stabilizers

–  government does not need to get the timing right

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SLOWDOWN OF GROWTH IN 1970S

• Wage restraint offered by trade unions in return for secure jobs and investments broke down

• Exogenous oil price shocks

• ‘Free lunches’ of technology transfer not so easily available

• Costs of financing Welfare State increasingly fell on low to middle-income earners

• New pattern of increasing unemployment and inflation

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REACTION TO ECONOMIC SLOWDOWN

• External imbalances met by devaluations under Bretton Woods

• How to battle inflation? Many pegged to the German mark; Sweden and UK adopted floating exchange rates from the 1990s

• Other countries formed the core of the euro area

• Full employment goal subordinated to price stability

– Independent and inflation-targeting central banks

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THE INITIAL REACTION TO THE 2007/8 FINANCIAL CRISIS

• Initial reaction to the 2007/8 financial crisis contrasted with the inaction during the Great Depression

• Aggressive measures to prevent banking collapse

• Debt-financed increases in government spending

• But austerity measures launched before the recovery was underway

• Had huge impact especially on southern European countries, but Germany recovered

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WORLD INDUSTRIAL OUTPUT: GREAT

DEPRESSION VS. GREAT RECESSION

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THE BUILD UP TO THE EUROZONE CRISIS

• Asymmetry in the workings of the Eurozone: Germany had large current account surplus, supplied other nations with easy credit  real estate bubbles

• Only Greece had unsustainable public debt before the crisis

• Fiscal consolidation after crisis stopped recovery in France and southern Europe

• Output is likely to remain well under pre-crisis trend for decades

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THE ECONOMICS OF AUSTERITY

• Keynesian argument: increase government spending

• Also: ‘normal’ unemployment since the 1970s seems to have increased permanently after long recessions

• ‘Rational expectations’ argument: fiscal consolidation would only have transitory effect. Falling government borrowing would

– Squeeze interest rates  increase investment

– Stimulate consumption, since households would realize there would be fewer future tax claims to service debt

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HAVE AUSTERITY POLICIES WORKED IN RECENT HISTORY?

• Few would argue that austerity policies during the Great Depression had beneficial effects

• Lesson from e.g. Nordic countries in the 1990s seems to be that open economies with large export sectors can

combine mild fiscal consolidation with subsequent

growth if they can devalue in a world of healthy growth

• Eurozone members cannot devalue, and the alternative of letting price and wage level fall is difficult and painful

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THE ASYMMETRY OF THE EUROZONE

• Price and wage adjustment should be symmetric

• Germany has resisted calls to inflate its economy and reduce its large current account surplus

•  Entire burden of adjustment on economies which had real estate bubbles and high government debt after bail out of banks

• Germany recovered its pre-crisis level of GDP in 2010, southern Europe is still waiting!

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SOCIALISM IN EUROPE

• Marx and Engels’ Communist Manifesto (1848) inspired social-democratic movement in Europe, later communist parties

– Marx’s theory: social systems thrive and expand only if they develop technologies and increase welfare

• Socialist countries: an almost total dominance of politics over the economy, a maximum state

• Social democracy: balance markets and politics, the

‘mixed economy’

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THE SOVIET UNION

• Marx: communism would emerge after capitalism had lifted economies to unprecedented material welfare

– He would be surprised to hear that the first socialist country was Russia, an economic backwater

• Marx did not describe central planning, but USSR introduced planned economy:

– Abolition of private ownership of resources and means of production, very high investment ratios, strong bias towards capital goods investment, neglect of consumer goods

investment

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EXPANSION INTO EASTERN EUROPE

• Soviet industry expanded, war machine drove Nazis out of Russia and Eastern Europe

• After Great Depression, many intellectuals looked to planning experiment in Russia with admiration

• Soviet-style political and economic system imposed after WW2 in Eastern Europe

– Differed in treatment of private property, agricultural collectivization

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THE FAILURE OF THE SOCIALIST EXPERIMENT

• Large agricultural sectors, but most investment in

industry  implies gains to structural relocation of the labour force

• Soviet / Eastern European growth much lower than Western Europe, lower than Spain and Portugal under authoritarian rule, despite higher rates of investment

• Why were investments so inefficient? Difficulties of central planning and distortion of information

• After collapse, most E. European countries caught up

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GDP / CAPITA IN USA, RUSSIA, AND

E. EUROPE RELATIVE TO W. EUROPE

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THE WELFARE STATE

• In first decade of 20^th century government spending rarely above 10% of GDP

• Expansion after WW1 and extension of the franchise, especially after WW2

• Modern Welfare State: healthcare, education, housing, childcare, old-age pensions

• Since 1970s welfare spending 25-30% of GDP in most European nations

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THE USES OF LOCAL AND CENTRAL

GOVERNMENT SPENDING IN EUROPE

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THE WELFARE STATE AS

CONSUMPTION SMOOTHING

• Is less about redistribution and more above inter- temporal transfer of resources over the life cycle

• Progressive income taxes contribute to redistribution

• But most taxes are regressive: consumption taxes

• The Welfare State provides transfers and services to smooth consumption over the life cycle:

– Unpredictable: Unemployment, health shocks

– Predictable: Daycare, schooling, pensions and care in old age

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NET WELFARE BALANCE OF A TYPICAL

HOUSEHOLD OVER ITS LIFECYCLE

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A MARKET FAILURE THEORY OF THE WELFARE STATE

• Life-cycle transfer is an implicit contract between generations: contributors become receivers and vice versa

• Why not market alternatives?

– Tend to have distributional effects

– Externalities and coordination problems – Capital market imperfections

– Time inconsistent preferences

• Would not ensure universal access

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SUMMARY

• 20^th century saw unprecedented level of growth despite two world wars, and a level of taxation that economists would have believed incompatible with growth

• Neat balance between political and economic spheres achieved

• Market failures now considered legitimate grounds for public action

• Socialist experiment failed because it could not produce the goods or the liberties of the West

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SUGGESTIONS FOR FURTHER READING

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SUGGESTIONS FOR FURTHER READING

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