February 17, 2009

Automatic Destabilizers

Writing about web page http://www.coventry.gov.uk/ccm/content/chief-executives-directorate/corporate-policy/communications-team/news-releases-2009/coventry-residents-set-for-44p-a-week-rise-in-council-tax.en

The day after Leeds City Council announced the loss of 650 local authority jobs because of "lower government grants and the economic downturn," it's Coventry's turn. According to a news release on Coventry City Council's website, our city faces a "budget gap" of £13.5 million. More than £9 million of savings have been identified. These include, in addition to "efficiency reviews of services," "a £469,000 reduction in publicity and advertising budgets, 3% cuts in grants to voluntary organisations and £530,000 through increasing charges in some social care services." It is expected that 190 posts could disappear. Councillor Kevin Foster, Deputy Leader of Coventry City Council, is quoted:

The Council, like all councils, is facing a number of challenges over the coming year. Clearly the recession is having a major impact on our finances ...

Oddly enough, this is not what is supposed to happen in a recession.

As I wrote here, faced with the current collapse of aggregate demand, "the government faces a bitter choice. It can stabilize its budget, or it can stabilize the economy, but it cannot do both." The recession is plunging the budgets of central and local government alike into deficit. Stabilizing the budget means cutting government spending and jobs as revenue falls. Stabilizing the economy, in contrast, means maintaining spending and jobs, borrowing to cover the widening budget gap. In the interests of us all, including the interests of tomorrow, the government should choose the latter course.

In theory, some stabilization of the economy should happen automatically. In our economy, taxation is progressive; this means that, when personal incomes fall, the government's tax take should fall more than proportion. As a result, personal incomes should fall by less than the country's national income, and this should to maintain spending and employment. Part of what the government spends is also progressive: as jobs and family incomes fall away, the government should automatically replace part of what is lost by meeting entitlements to unemployment benefits and other income support. These "automatic stabilizers" don't make things better. They just make things a little less bad than they would be otherwise.

Think about that word, "otherwise." It means: in the absence of the automatic stabilizers. If, say, the government always spent every penny it received, but never more, the government would continually add to the natural volatility in the economy. Every time there was a boom, the government would experience a rise in its revenues and, by rushing out to spend them, heighten the boom. Every time there was a slump, the government would respond to its lost revenues by spending less and so deepening the recession. It doesn't just sound like a bad idea: it is an absolutely terrible idea.

Yet this idea is currently being put into effect by local authorities up and down the country. As property values and business and personal incomes fall, city councils are losing revenue from council taxes and charges. At the same time, for exactly the same reason, local claims on services and benefits are growing. But our cash strapped cities not only cannot meet these rising demands; they must cut back provision.

Rather than mitigating the jobs crisis, they are adding to it and deepening it.

This is the result of a policy failure on the part of central government -- a failure of scandalous proportions. While Westminster plays the blame game -- who should be punished for the failures of our banking system? -- the real economy is sliding down into depression. The solution is well known: a strong fiscal stimulus. But, while Westminster talks, what our country is actually experiencing is the exact opposite: a powerful fiscal brake that is spread by the collapse of local government finance and adds to the burden on us all.

The failure is scandalous because the solution could be put into effect overnight. The Treasury must promise now to stabilize local government funding at its pre-recession level. Local authorities should be enabled to plan for the future without adding to the pool of the unemployed. When the economy recovers, the additional subsidy from the centre can be gradually withdrawn.

I can see two obstacles to this simple course of action.

First problem: Purists may object that our cities are subsidy junkies already; if the subsidy from central government is temporarily increased, it may be politically difficult to withdraw it later when conditions improve. I acknowledge this danger. It is an example of what, on January 20, Bank of England governor Mervyn King described as

the paradox of policy at present – almost any policy measure that is desirable now appears diametrically opposite to the direction in which we need to go in the long term. Spending now supports the economy, but in the long run we need to save more and borrow less. Public borrowing sustains spending, but in the long run needs to fall. Banks are encouraged to run down their capital to enable them to absorb losses while continuing to lend, but in the long run they will need more capital. Interest rates have fallen to unprecedented levels, but in the long run will need to rise to more normal levels.

In the same way local government in the UK must be allowed to spend its way through this crisis, yet in the long term become fiscally more self-reliant. But there are ways to achieve this; for example, local authorities could take out loans from the Treasury with repayment contingent on local incomes or employment rates returning to their pre-crisis levels. But the time for complicated solutions may be already past; this is, after all, a crisis.

Second problem: The Westminster government may positively not want to do this. Whitehall is full of spending ministers. If there is to be a stimulus package, they will want to monopolize it and claim the credit for it. Scattering central funding across many local authorities, many (like Coventry) managed by parties that are in opposition in Westminster, may not look like the best way for Labour to prepare for the next general election. I suspect this is the most important obstacle to the action that our country needs. If so, it makes the failure to act even more scandalous.

Let me repeat: allowing local authorities to keep up their spending during the current recession is not a solution to the crisis. It is just a way to neutralize a mechanism for destabilization, one that is currently making the crisis worse than it needs to be.


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I am a professor in the Department of Economics at the University of Warwick. I am also a research associate of Warwick’s Centre on Competitive Advantage in the Global Economy, and of the Centre for Russian, European, and Eurasian Studies at the University of Birmingham. My research is on Russian and international economic history; I am interested in economic aspects of bureaucracy, dictatorship, defence, and warfare. My most recent book is One Day We Will Live Without Fear: Everyday Lives Under the Soviet Police State (Hoover Institution Press, 2016).



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