British policy-makers were well aware that a policy of deflation would, by contrast, have regressive social consequences. As early as January 1918 the Treasury produced a paper on ‘The Conscription of Wealth’ which anxiously foresaw the post-war conflict of interest:
So long as we have a national debt of £6,000,000,000 to £8,000,000,000 with an annual debt charge of £300,000,000 to £400,000,000 the rentier will be the subject of perpetual jealousy and perpetual attack: the owners of other forms of capital wealth whose property would, at any rate in the opinion of a large section of the public, be appropriated to meet the rentier’s claims will be in a position scarcely less vulnerable. The slower the restoration of general prosperity, the heavier will become the pressure of taxation and the greater the popular discontent.45
As in the 1820s, deflation meant a rapid increase in the real value of the debt burden and the cost of servicing it. As in the 1820s, the bondholders were a wealthy élite: in 1924 nearly three-quarters of all British government securities issued after 1914 and held in private hands were owned by individuals whose estates were valued at more than £10,000.46 And, as in the 1820s, the real returns they enjoyed on their investments were exceptional high, as Figure 17 shows: 9.5 per cent in the 1920s and only 1 per cent less in the 1930s.
On the other hand, the number of bondholders was certainly a much higher proportion of the population than in 1815, thanks to the success of wartime efforts to sell bonds to small investors and the growth in importance of savings institutions. Around 12 per cent of the internal British national debt was held by small savers by 1924. Moreover, many of the biggest holders of war bonds were institutional rather than individual investors – insurance companies, savings banks and so on – whose large wartime purchases were effectively made on behalf of small savers. For example, 5.5 per cent of the British debt in 1924 was held by insurance companies.47 The tax system after 1918 was also significantly more progressive than it had been after 1815.48 Finally, it is important to remember the benefits of lower interest rates enjoyed by all countries that returned to gold.49
Nor should we understate the risks of the inflationary course. In view of his later (caricatured) reputation as an inflation ‘dove’, it is worth remembering that few contemporaries described the perils of this policy more vividly than John Maynard Keynes. In his Economic Consequences of the Peace (1919), he was harshly critical of the effects of high inflation on the distribution of wealth:
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls … become ‘profiteers’, who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished not less than of the proletariat. As the inflation proceeds … all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless…. There is no subtler, no surer means of overturning the existing basis of society.50
Or, as he put it in the Tract: ‘Inflation … impoverish[es]… the middle class, out of which most good things have sprung … [and] destroys the psychological equilibrium which permits the perpetuance of unequal rewards.’51 There is certainly much to be said for the view that, regardless of the macroeconomic costs and benefits, the damage to the German bourgeoisie’s trust in liberal institutions was fatal to the Weimar system.52 It is significant that Keynes did not relax his hostility to inflationary finance during the Second World War, when he recommended ‘deferred pay’ in preference to ‘voluntary saving’. Reliance on the traditional system of government borrowing, he argued, would simply lead, as in the First World War, to a ‘vicious’ and ‘ridiculous’ wartime inflationary spiral.53
It is an irony then that the policies which produced the inflations of the 1970s were so often stigmatized as ‘Keynesian’. For if the euthanasia of the British rentier had been decisively rejected between the wars, after 1945 a policy of slow starvation was adopted. In every decade between 1940 and 1979 the real return on British government bonds was negative: on average, minus 4 per cent.54 American bondholders fared only slightly better. This was the period when the real value of the debts incurred during the world wars was dramatically reduced not only by growth but by inflation. In effect, to adopt a modern political phrase, bondholders paid the greatest ‘stealth tax’ in history. Perhaps the most surprising thing is how slowly they responded to these low returns. Bondholders in Weimar Germany – like the members of the Women’s Suffrage Union whose plight we encountered in Chapter 5 – could claim, not wholly implausibly, to have been the victims of a swift and unforeseeable hyperinflation. But even the nominal returns on bonds in the 1950s and 1960s were meagre; a powerful ‘money illusion’ (or institutional inertia) must have been at work to persuade investors to stick with gilts and treasuries into the inflationary 1970s.
THE NEW TAX-EATERS
The euthanasia of the rentier was not the only way in which fiscal policy in the mid-twentieth century became more egalitarian in its distributional effects. As we have seen, taxation in most industrial countries was already becoming more progressive by 1900, while public expenditure was rising on ‘social’ policies which directly or indirectly redistributed income from the rich to the poor. In the aftermath of the First World War these tendencies were accelerated. In the inter-war period welfare essentially represented a transfer from the rich (a minority of direct tax payers) to the poor (the unemployed and impoverished elderly, again a minority). However, the universalist welfare systems that emerged in Western Europe after the Second World War had the potential to adjust the incomes of nearly everyone.
In 1948 there were a million Britons on national assistance (2 per cent of the population); by the mid-1990s over five million people were on its equivalent, Income Support (close to 9 per cent). Roughly half the income of all pensioners now comes from social security.55 Of the final household income of households in the bottom quintile of the British population, a staggering 74 per cent consists of benefits in cash and kind (net of tax).56 In other words, a fifth of all households rely on the state to provide three-quarters of their income (see Table 9). Yet these are just the dependent minority. For the welfare state’s goal of universal provision means that nearly everyone is a recipient of some form of transfer payment. In 1993 the Department of Social Security estimated that the number of people receiving at least one social security benefit totalled 46 million: nearly 80 per cent of the population, or four out of every five Britons.
Table 9. Redistribution of income through taxes and benefits, United Kingdom 1992, by quintile groups of households (£ per year)
Source: Social Trends 1995, table 5.17. The figures are for 1993.
It was the nineteenth-century French liberal Frédéric Bastiat who called the state ‘the great fictitious entity by which everyone seeks to live at the expense of everyone else’.57 Hyperbole in Bastiat’s own day, this nicely describes the welfare state of the late twentieth century. For at the same time, of course, nearly everyone is a taxpayer, even if they pay only indirect taxation.
‘Who whom?’ was Lenin’s famous question. In the welfare state the question is who pays for whom? In the absence of an integrated system of taxation and social security, it is in fact far from easy for some individuals to be sure if they are net winners or losers. One estimate suggests that 46 per cent of households are net gainers, while 54 per cent are net losers; but it is doubtful that most households know into which group they themselves fall. Consider the middle fifth of households in terms of disposable income. Table 9 shows that they receive almost exactly as much in the form of benefits in cash and in kind as they pay in the form of taxes. T
o quote two critics of the British welfare system: ‘In its modern, climactic absurdity, taxation has at last fused the shearers and the shorn into one.’58 This policy of taxing the right pocket to fill the left is not merely pointless, but also costly. As the last column shows, the expense of the entire redistributive exercise leaves the average household worse off in net terms, to the tune of just under £1,000 a year. Even more perversely, the bulk of benefits under the universal welfare system – including all public subsidies to health, education and transport – flow not to the poor but to the rich. According to one estimate, the wealthiest fifth of the UK population receive 40 per cent more public spending on health than the poorest fifth; with respect to secondary education the figure is 80 per cent, to university education 500 per cent and to railway subsidies a staggering 1,000 per cent.59
Figure 18. Relative poverty rates before and after taxation and transfers, 1991
Source: Solow, ‘Welfare’, p. 21.
Note: Poverty rates are defined as percentage of families with an income less than 40 per cent of the median.
Nevertheless, mainly because of the effects of progressive taxation, the European welfare state does substantially reduce inequality. As Figure 18 shows, in the absence of taxes and transfers nearly all major industrial economies would generate a considerable amount of what has been called ‘deep [relative] poverty’. In eleven out of fifteen countries covered by the chart, more than a fifth of all families would be on incomes below 40 per cent of the median family income were it not for the welfare system. The chart shows that in all the continental European countries, taxes and transfers reduce the proportion of families in ‘deep poverty’ to 5 per cent or less. Britain and her former colonies Canada and Australia have slightly more poverty after fiscal redistribution. But the United States stands out because, even after taxes and transfers, nearly 12 per cent of families are still in deep poverty. Put another way, all but one of the fiscal systems covered in the chart reduce deep poverty by more than two-thirds; the Belgian reduces it by more than 90 per cent. The American system reduces it by just 44 per cent.
But is there a downside to equality? Do Europe’s more egalitarian welfare systems explain its relatively slower economic growth in recent years? The empirical evidence is ambiguous on this point.60 Despite the widening gap between the United States and Europe in terms of productivity growth since 1994, there is still no compelling proof that the more egalitarian system is ultimately the more sluggish.61 What is undeniable is that universal welfare systems are more likely to create perverse incentives, encouraging patterns of behaviour which in turn necessitate higher government spending. The failure of the British Conservatives to limit the duration of unemployment benefit was a costly mistake, given the empirical evidence that unlimited entitlement discourages job-seeking. Another glaring instance is the way fiscal policy in the past few decades has penalized married couples with children relative to single parents and childless couples. Taking into account all taxes and benefits, the real weekly earnings of a single mother of two in the lowest income ‘decile’ rose by 145 per cent between 1971 and 1993. The equivalent figure for a married man with a non-working wife and two children was 38 per cent.62 The strains on the housing stock and social security budget have been increased by what amount to incentives to remain single or to divorce. Between 1981 and 1995 spending on lone parents rose four and a half times.63
In a sense, then, it does not matter whether these and other skewed incentives directly retard growth. The real question is how far such systems can be sustained in fiscal terms. Given their burgeoning costs and the ways in which they are being financed (or not), there are reasons for doubt.
Between 1960 and 1992 transfers and subsidies rose from 8 per cent of the GDP of industrial countries to 21 per cent in 1992. As we have seen, a high proportion of this rising cost was financed by borrowing. But the rise of public debt reintroduces an old variable into the redistributive equation (omitted from Table 9): the traditional transfer from taxpayers to bondholders in the form of debt interest. One unforeseen consequence of the welfare state has in fact been a revival of the rentier, rumours of whose demise turn out to have been exaggerated.
The bondholder of the early twenty-first century has learnt from the past, however. Far more than in the nineteenth century, he now enjoys safety in numbers, since a very large proportion of modern national debts are held on his behalf by institutions such as pension funds. Insurance companies, pension funds and investment trusts accounted for just 29.5 per cent of total holdings of gilts in 1975. By 1999 the proportion had risen to 62.3 per cent. Individual holdings had meanwhile fallen from 18 per cent to less than 9 per cent.64 True, investments in government bonds represent a declining fraction of total private sector wealth, thanks to the spread of home-ownership and equity ownership. In Britain the value of gilts amounted to 40 per cent of wealth in 1970; twenty-five years later the proportion was just a quarter.65 Nevertheless, the growing proportion of the population that held bonds indirectly through institutions by the late 1970s may help explain, in terms of political economy, why there was a return to positive real rates of interest in the 1980s and 1990s. Real rates of return on British bonds rose above 9 per cent in the first half of the 1990s: more or less what they were in the 1820s and 1920s (Figure 17 again). A British investor who invested in gilts at the beginning of 1997 enjoyed a total return of 14.85 per cent over the year.66
Still, even today’s institutionally organized bondholders should feel a certain unease. For the expansion of public debts may yet prove to be an unsustainable process in some developed countries. The threat to the modern rentier is not posed by a politically powerful inflationary coalition of workers and entrepreneurs, however. Rather it is posed by the largest of all the disenfranchised groups left in today’s democracies: the young and unborn.
GENERATION GAMES
The ‘Ricardian’ theory of public debt is, as we have seen, that an increase in government borrowing today will be offset by an increase in private saving, because the present generation knows that, without such saving, the next generation will have to repay the government’s debt out of its own income. Even when individuals do not have an infinite planning horizon, the fact that generations are linked by bequests to heirs should suffice. Experience suggests that this is not the way the world really works.67 Whether because of ‘fiscal illusion’ or indifference to the next generation’s financial fate, present generations do not seem to behave with perfect altruism with regard to their heirs. Rather, they tend to ‘overlook future liabilities and to assume that debt-financed public services come for free’.68 In doing so, they leave unpaid bills to the next generation over and above what could be justified by ‘tax smoothing’. To put it differently, ‘the stock of debt is the cumulative amount of transfers that past taxpayers have received from future ones’.69 The extent of this phenomenon is best captured using the new technique, introduced in Chapter 4, known as generational accounting.70
Generational accounts are simply total net taxes over entire lifetimes – to be precise, the sum of all future taxes citizens born in any given year will pay over their lifetimes, given current policy, minus transfer payments they will receive. Comparing the generational accounts of current newborns with the accounts of future newborns, with due adjustments for population and economic growth, therefore provides a precise measure of generational balance or imbalance.71 If future generations face higher generational accounts than current newborns, today’s policy is generationally unbalanced and therefore unsustainable. Because of the unbreakable inter-temporal budget constraint, the government simply cannot collect the same net taxes from future generations as it would collect, under current policy, from today’s newborns.
The calculation of generational imbalance is an informative counterfactual, not a likely policy scenario, because it imposes the entire fiscal adjustment needed to satisfy the government’s inter-temporal budget constraint on those born in the future. Nevertheless, such
a calculation delivers a clear message about the need for policy adjustments. The question then becomes how to achieve generational balance without foisting all the adjustment on future generations. As an example, we can calculate the reduction in total future government purchases that would be necessary to lower the size of the generational accounts of future generations by enough to achieve generational balance. Whatever the size of that reduction in percentage terms, the policy could be implemented by an immediate and permanent cut in the annual flow of those purchases by the same percentage. Alternatively, there could be an immediate and permanent increase in annual tax revenues. This would raise the collective generational accounts of those now alive, and therefore reduce those of future generations.
When ‘generational accounts’ are constructed they clearly show that in most developed countries today fiscal policy is indeed ‘enabl[ing] members of current generations to die in a state of insolvency by leaving debts to their descendants’.72 Figure 19 is based on generational accounting results for nineteen countries. It shows two mutually exclusive ways these countries could achieve generational balance: either by increasing all taxes or by cutting all transfer payments. Each of these policies is described in terms of the immediate and permanent percentage adjustment required. The magnitudes of these alternative adjustments provide an indirect measure of countries’ generational imbalances.
The Cash Nexus: Money and Politics in Modern History, 1700-2000 Page 26
