The Instability of the Welfare State

Throughout economic history, the demand for money balances—what was later called liquidity preference—acted as such a stabilizer. In sharp cyclical downturns, commodity prices fell, often drastically so. The real value of money balances in the hands of consumers and merchants rose accordingly, exceeding the proportion of their wealth they would normally wish to hold in cash form. Consequently, when they no longer expected prices to fall much further, they started to spend money to reduce their cash balances. The total quantity of coin and liquid paper money being broadly given, they could not reduce its nominal amount, but its value in real terms was reduced as the higher spending has led to higher commodity prices as well as to greater income and wealth, until the real value of money balances again became equal to the real amount demanded.

The last time this old-fashioned stabilizer had any noticeable effect was exit from the Great Depression from about 1934 onwards, though of course the recovery had other causes as well. Since World War II, economists have been, quite rightly, dismissing the stabilizing potential of the price level, since they found that average prices, like average wages, can in the modern world hardly ever move downwards and that the money supply will in practice always accommodate a rising price level.

Government-the Passive Ballast

Instead of the value of money, economics, in assimilating the Keynesian schema of analysis, discovered another stabilizer, the public sector. In a downturn, sales taxes fell promptly and in proportion to the drop in sales, while income taxes fell with a lag, but more than proportionately. Government expenditure, much of it fixed well in advance by legislative or contractual commitments, was maintained. As a result, the public sector pumped a maintained stream of income into the private sector, but pumped a reduced tax charge out of it. The sharper was the downturn, the stronger was this effect, and the greater was the share of central and local government expenditure in the national income, the more resistant became the latter to cyclical fluctuations. The beauty of this effect was that all the government had to do was to remain passive as a heap of ballast at the ship’s bottom; no policy response was required from it, hence it could not get it wrong.

Then came, first slowly, but accelerating rapidly, the rise of the welfare state with successive Labour governments in Britain, with the social democracy of Giscard in France and Helmuth Schmidt in Germany, and of course L.B.J.’s Great Society in the US. Under these governments, two things happened to the public sector. It expanded in a seemingly inexorable way as a proportion of national income, and as welfare entitlements took a growing share of it and welfare entitlements moved inversely with economic activity, government spending actually rose when the economy turned down. The automatic stabilizer became, so to speak, a super-charged turbo engine.

In the last three decades, the amplitude of economic fluctuations has in fact been relatively moderate by historical standards, though of course a large public sector was only one of the likely reasons. That initially at least, it did have a smoothing-out role is hard to deny, even if we believe that its other, less easily discernible effects did greater long-term damage than the good stabilization may have brought us. In recent years, however, the public sector, and more particularly its welfare component, has very likely become a powerful factor of instability, pushing the system ever farther away from equilibrium once it has been dislodged from it.

“Merit Goods”

Goods that the political elite thinks ought to be consumed in greater quantity than they would be if left to unaided matching of supply and demand, are flatteringly called “merit goods”—they are said to merit a better sort than the market would mete out to them. “Culture” is the classic merit good, and in its name concert halls and theatres are built, museums, operas and libraries subsidized, artists kept afloat with public money. The class of merit goods can be stretched almost at will to include anything of which people might consume too little for their own good if left to themselves. Cod liver oil is a merit good, and so is saving for a rainy day and for retirement.

What the welfare state—more precisely, the version of it practised above all in Germany and France that calls itself the “European model”—has gradually done was to replace a large chunk of everyone’s wages by merit goods. Instead of earning, say, $1,300 a week in cash, they earned $800 in cash, and $500 in the form of mandatory deductions (employees’ and employers’ contributions) to pay for the foremost merit goods unemployment insurance, health care and pensions.

Paternalism, the inseparable satellite of the welfare state, firmly holds that if wage-earners had the extra $500 paid out to them, they would buy little or no unemployment insurance and would save too little for medical care and retirement. This may or may not be the case. What is certain, though, is that if they were paid the $500, they could spend it on these merit goods, but also on anything else they wished, so that having the $500 would never be worth less to them than the merit goods they received in its place, and might be worth appreciably more depending on individual preference and judgment. Cash of $800 plus merit goods provided by the welfare state at a cost of $500 would be worth less than $1,3000 to the average worker, but would cost $1,3000 to his employer.

A Machine To Grind Jobs

The real cost of labour to the employer and the real remuneration to the worker are normally equal. Welfare, given in merit goods, opens up a gap between the two: the cost of the part-cash, part-welfare package to the employer rises above the real value the workers subjectively place on the package.

Real cost to the employer and real value to the employee are two jaws of a machine that grinds and destroy jobs. Unemployment that should hover around 5-6 per cent gradually moves to double digits. It is now 11.9 per cent in Germany, 10.2 per cent in France and 9.6 per cent in Italy. These are official statistics that need some interpretation. In France, for instance, the unemployment figures do not include about 1.2 million people who do not qualify for unemployment insurance but are paid a minimum income by the state. In every country run on the “European social model”, the public sector is stuffed with make-work jobs whose sole real purpose is to keep some hopeless young people off the streets. These jobs, too, escape the unemployment statistics.

If due to some shock unemployment rises from 5 to 10 per cent, but the welfare state maintains the income of the newly unemployed, there is a temporary rise in the budget deficit. However, maintaining aggregate income eventually restores employment and re-balances the budget.

Under the new dispensation of the modern welfare state, with the big job-grinder going round and round, this does not happen. The gap between the real cost of labour and what labour really receives remains rigidly in place. A double-lock is, in fact, put on it because dismissing labour is now very expensive and may involve legal procedures lasting many months and some times years, and the employers will not hire if they won’t be able to fire. The same total income and aggregate demand consistent with 5 per cent unemployment is now consistent with 10 per cent unemployment. The budget deficit, too, becomes chronic, and steadily rises above the diminutive growth of the economy. In the short run, there is stability of a miserable situation, but in the longer run there is a seemingly inexorable decline that is cumulative, self-reinforcing.

Serious reform will not take place before the apparent short-term stability is widely enough recognized as creeping instability. Such recognition seems now to be dawning.