Wednesday, 7 October 2009

Stabilising Aggregate Demand.

Booms and recessions have followed one another for thousands of years. Certainly ancient Rome had a nasty credit crunch.

There shouldn’t be a problem with organising a constant level of demand from the public sector. Any competent government ought to be able to spend almost exactly the same amount, in real terms or money terms, year after year. Indeed any competent government ought to be able to do vastly better than this and have public spending vary at least to some extent in a counter cyclical manner.

Unfortunately during the 2007-9 recession governments have proved somewhat incompetent in this regard. That is, some governments seem to be under the illusion that just because their income from tax has declined, that therefore they need to cut their own spending. These governments need to go back and re-study basic economics. US government employees (federal, state and local) declined by 130,000 between September 08 and September 09.

In contrast to the public sector, organising a constant level of demand from the private sector is much more difficult: for example consumers have a habit of suddenly going wild with their credit cards for no obvious reason. Alternatively, (as in 2009) they suddenly do the opposite: start saving as never before. Or it’s South Sea Bubbles or tulip mania.

And then there are stock market and house price changes. When these rise, household balance sheets improve, which induces households to spend.

So how do we organise a more constant level of demand from the private sector? Well, we need a tax (or subsidy, come to that) which can be altered relatively quickly. The UK government did this in 2009 when it reduced Value Added Tax. An alternative, suggested by Winterspeak is to vary payroll taxes. (See Winterspeak's 15th and 16th Sept 09 posts.)

A problem with the two latter is that what economists call the “incidence” of the tax falls partially on employers. For example, reduce VAT, and while employers will to some extent pass on the reduction in the form of lower prices, that is not where all the reduction goes: that is, employers will to some extent pocket the reduction. And the problem with this is that employers are not the ultimate source of all demand. The ultimate source of all demand is the consumer. That is, ideally, all stimulus money needs to go directly to the consumer’s pocket.

Another problem with the above two measures is that consumers probably notice a change to their monthly income more quickly than they notice a change to the price of goods resulting from a VAT change. Thus ideally it is consumers’ income that needs to be changed.
In the UK there are three levers government could pull that would immediately change consumers’ income. 1, the state pension. 2. Pay As You Earn income tax deduction that is made from most wage earners’ wage packets. 3. Employee National Insurance contributions.

A fourth possibility is the vast array of other state benefits (e.g. for the unemployed, the temporarily sick and injured, etc). The problem here is the temporary nature of these benefits. That is, sorting out any mistakes or problems in respect of changes to someone’s state pension is probably easier than doing the same in respect of someone’s unemployment benefit. This is because a pensioner is, as it were, constantly in touch with the state via the pension system. In contrast, an unemployed individual is in contact with the relevant part of the state for a limited period. Any mistakes would involve re-contacting the individual, which could be administratively expensive for the state compared to sorting out a problem with a pensioner.

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