by Judith Stein and Biodun Iginla, The Economist Intelligence Unit Financial News Analysts
Building up the pillars of state
History suggests that the effects will be permanent
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“THE GOVERNMENT
intervention is not a government takeover,” the American president
argued. “Its purpose is not to weaken the free market. It is to preserve
the free market.” The IMF pointed to the “unprecedented
policy actions undertaken by central banks and governments worldwide”.
The economic response to the financial meltdown of 2007-09 was big
enough. But in answer to the covid-19 pandemic policymakers are
launching even bigger, more radical interventions. Putting the economy
on a wartime footing is supposed to be temporary. A look at 500 years of
governmental power, however, suggests another outcome: the state is
likely to play a very different role in the economy—not just during the
crisis, but long after.
The
policy response has been swift and decisive. Globally central banks
have cut interest rates by more than 0.5 percentage points since January
and have launched huge new quantitative-easing schemes (creating money
to buy bonds). Politicians are throwing open the fiscal spigots to
support the economy. As The Economist went to press, America’s
Congress was set to pass a bill that boosts spending by twice as much as
President Barack Obama’s package in 2009 (see article). On top of that, Britain, France and other countries have made credit guarantees worth as much as 15% of GDP,
seeking to prevent a cascade of defaults. On the most conservative
measure, the global stimulus from government spending this year will
exceed 2% of global GDP, a much bigger push than was seen
in 2007-09 (see chart 1). Even Germany, whose fiscal rectitude is the
punchline of economists’ jokes, is spending more (see article).
The upshot is that the state is swelling. Last year overall government spending accounted for 38% of GDP across the rich world. The stimulus effort, combined with a fall in nominal GDP in the next few months, will push that ratio well above 40%, perhaps to its highest-ever level.
To
focus just on the numbers misses something crucial, though. There are
important qualitative changes under way in how policymakers manage the
economy—the responsibilities they have seized for themselves, what is
seen as a legitimate action and what is not, and the criteria used to
judge policy success or failure. On these measures, the world is in the
early stages of a revolution in economic policymaking.
Central
banks have in effect pledged to print as much money as necessary to
keep down government-borrowing costs. The European Central Bank is
promising more or less to buy everything that governments might issue;
this should reduce the gap in borrowing costs between weaker and
stronger euro-zone members, which widened in the early days of the
pandemic. On March 23rd America’s Federal Reserve promised to buy
unlimited quantities of Treasury bonds and agency mortgage-backed
securities, if necessary. The rise in borrowing caused by America’s
stimulus may be matched, at least initially, by bond purchases by the
Fed, which smells a lot like money-printing to finance deficits. The
central bank also announced new programmes to support the flow of credit
to companies and consumers. The Fed is now the direct lender of last
resort to the real economy, not just the financial system.
Politicians,
too, are ripping up the rulebook. In a standard recession firms are
allowed to go bust and people to become unemployed. Even in normal
economic times, roughly 8% of businesses in OECD
countries go under each year, while 10% or so of the workforce lose a
job. Now governments hope to stop this from happening entirely.
President Emmanuel Macron does not speak only for France when he vows
that no firm will “face the risk of bankruptcy” as a result of the
pandemic. Boris Johnson, Britain’s prime minister, contrasts his
government’s response with the one during the last financial crisis:
“everybody said we bailed out the banks and we didn’t look after the
people who really suffered”. Larry Kudlow, the director of America’s
National Economic Council, calls America’s fiscal stimulus “the single
largest Main Street assistance programme in the history of the United
States”, comparing it favourably with Wall Street bail-outs a decade
ago.
To
that end, governments across the rich world are channelling vast sums
to firms, providing them with grants and cheap loans in an attempt to
preserve jobs and prevent them from going bust. In some cases the
government is paying the wages of people who cannot work safely: the EU
in particular has embraced this policy, while the British state will
pay up to 80% of the wages of furloughed workers. The American package
includes loans to small businesses that will be forgiven if workers are
not laid off. Households across the rich world are being given temporary
relief on mortgages, other debts, rent and utility bills. In America
people will also be sent cheques worth up to $1,200.
The
vast majority of economists support these measures. Nominally they are
temporary, designed to hold the economy in an induced coma until the
pandemic passes, at which point the world is supposed to revert to the
status quo ante. But history suggests that a return to pre-covid days is
unlikely. Two lessons stand out. The first is that governmental control
over the economy takes a large step up during periods of crisis—and in
particular war. The second is that the forces encouraging governments to
retain and expand economic control are stronger than the forces
encouraging them to relinquish it, meaning that a “temporary” expansion
of state power tends to become permanent.
The sinews of power
In
recent centuries government spending across the capitalist world has
leapt. In the 1600s the outlays of the entire English state accounted
for about 5% of GDP, with practically no spending on
public health or education, nor much regulation of economic life, save
for crude contract enforcement (see chart 2). That began to change in
the 18th century, and from the end of the 19th century Britain and other
capitalist countries saw increased state intervention, with more
government resources being devoted to public goods such as welfare and
education and commensurate increases in taxes (see chart 3).
Governments have had some lean periods. In Victorian Britain state spending fell as a share of GDP—though
that was largely because economic growth was so rapid, and the measure
in chart 2 excludes spending by local governments, which became
exceptionally powerful over the period. In the 1980s Ronald Reagan
succeeded in stabilising America’s day-to-day federal spending. His
reforms, as well as those of Margaret Thatcher in Britain, reduced the
role of government in fixing prices; privatisations encouraged
profit-making firms to provide formerly state-run services such as power
and transport. Yet even during Reagan’s presidency the number of pages
of federal regulations rose by 14%.
A
back-of-the-envelope calculation finds that, of the more than 50
countries for which there are long-run fiscal data, two-thirds saw their
government-spending-to-GDP ratio increase between 1988 and 2018. America’s ratio of day-to-day public spending to GDP
is eight percentage points higher than it was in 1962, when Milton
Friedman wrote “Capitalism and Freedom”, a book which warned of the
dangers of socialism.
Historians argue
over why the public sector has a tendency to expand. In the 19th century
Adolph Wagner, a German economist, suggested that as places got richer,
demands on government grew. An increasingly complex production process
needed more regulation and contractual enforcement. Wealthier people
would also demand more public welfare provision, the theory goes,
perhaps because they worried less about their own material situation and
could thus turn their attention to others.
Wagner’s
theories also pointed to what economists call “hysteresis” in fiscal
policy. Governments may intend to boost spending only for a short while.
But then expectations change, making such expansionism hard to undo. It
is now common sense that the state should provide education to children
at no cost to parents, or support people who are out of work. American
governments have in recent decades cut the share of public spending
devoted to welfare. However, it remains politically impossible to bring
it down to anywhere near its level in the mid-1960s, before President
Lyndon Johnson’s “war on poverty” was launched. The upshot is that while
it is easy to ratchet state spending up, it is much harder to push it
down.
Perhaps the most important
lesson of 500 years of history, however, is that nothing has helped
boost state power in Europe and America more than crises. Historians
broadly agree that the growing fiscal capacity of capitalist countries
from the 1700s onwards was linked to the need to fight increasingly
sprawling and expensive wars, especially those using navies and where
the field of battle was far from home. (The Seven Years War of 1756-63
is widely considered to be the first global war because it involved a
large number of countries, often fighting in foreign theatres.)
To
win, countries required increasingly complex, well-resourced
administrations which could supply fighters with weapons that worked and
food that had not rotted. They also needed the money to pay for it,
whether by levying more taxes or by becoming a reliable borrower in
markets—which called for yet more bureaucracy. Growing state capacity,
in turn, allowed for the emergence of the capitalism we know today, with
properly regulated markets, efficient telecoms and transport, and
healthy and educated citizens.
The
winners of those wars also seized control of resources, from sugar and
spices to linens, which proved integral to industrialisation. So it is
no surprise that historians contend that wars and other crises have been
an engine of economic development. It is no coincidence that the
Netherlands, the first country to embrace capitalism, in the 17th
century, was also at the time the world’s pre-eminent naval power,
fighting and winning numerous wars over the period; or that Britain,
which came to dominate the seas in the 18th century, then became the
world’s largest economy. According to Larry Neal of the University of
Illinois at Urbana-Champaign, the Industrial Revolution “occurred
precisely during and because of the Napoleonic wars” of the late 18th
and early 19th centuries.
The responses
to crises since then have further consolidated the power of the state.
France’s top rate of income tax was zero in 1914; a year after the end
of the first world war it was 50%. Canada introduced income tax in 1917
as a “temporary” measure to finance the war. During the second world war
income tax in America turned from a “class tax” to a “mass tax”, with
the number of payers rising from 7m in 1940 to 42m in 1945 (today more
than twice as many Americans are caught in the net). The second world
war also led to calls for the introduction of cradle-to-grave welfare
systems. So did the dynamics of the cold war: governments across the
capitalist world wanted to forestall a communist rebellion. The
state-led model pursued in Europe from the 1950s to the 1970s, in which
bureaucrats controlled services from power networks to transport
systems, would have been unimaginable without wartime experience, where
the state managed practically everything and ordinary people made
tremendous sacrifices, whether on the battlefield or at home.
The new ideology
What
will be the lasting effects of the covid-19 pandemic? Start with the
size of the state. Over the next year government debt will rise sharply,
as spending jumps and tax revenues collapse. When the economy recovers,
attention will turn to paying it down. “Capital and Ideology”, a new
book by Thomas Piketty, a French economist, shows that after the first
and second world wars many governments in the West turned to heavier
taxation of the incomes and wealth of the richest to achieve that goal.
Another option is “financial repression”, where governments force
citizens to lend to them at below-market rates (see article).
Central
banks’ innovations will also have lasting consequences. Few economists
believe that the explicit co-operation between the fiscal and monetary
authorities risks creating runaway inflation, as it has done in
Venezuela and Zimbabwe, any time soon. (If anything, the bigger worry
right now is deflation, not least because of a collapse in oil prices.)
However, just as the use of quantitative easing in 2008-09 opened the
door to more of the same down the road, it will become harder to make
the argument that the “magic money tree” does not exist. Politicians in
the future may lean on central banks to peg interest rates at zero to
support government borrowing, even during times of economic growth and
low unemployment. If central banks promised to fund the government
during the coronavirus pandemic, they might ask, then why shouldn’t they
also fund it to launch an expensive war against a foreign enemy or to
invest in a Green New Deal?
The
final impact of the current interventions relates to policymakers’
tolerance for risk. No one cheers when a firm goes bust, but often the
process helps shift resources from less efficient to more efficient
uses, thus raising productivity and average living standards over time.
The novel notion that the government needs to preserve firms, jobs and
workers’ incomes at practically any cost may endure, especially if the
intervention proves successful in narrow terms. The policy will formally
end once the pandemic has passed, but political pressure for similar
support schemes—from the nationalisation of tottering firms to the
provision of a universal basic income—may well be higher the next time a
sharp downturn comes along. If politicians are able to preserve jobs
and incomes during this crisis, many people will see little reason why
they should not try again in the next one.
Calls
for a more activist fiscal-monetary government will come against a
backdrop of structurally higher demand for state spending. The public
sector tends to provide labour-intensive services in which productivity
improvements are difficult, such as health care and education. It must
match the salaries of workers in other sectors in order to retain its
own, even as they become less productive relative to the overall
economy—a phenomenon which raises the cost of provision. Long before the
coronavirus pandemic, fiscal wonks argued that government spending
would soar during the 2020s, even in the absence of a crisis. That was
not only or even primarily because an ageing population would raise
demand for health care, but because health systems would be able to
treat a wider range of illnesses more effectively, which would push up
costs.
The likely economic effects of
the pandemic reach far beyond the role of the state. Countries could
become even less welcoming to immigrants—the better, they may believe,
to reduce the likelihood of infection from foreign arrivals. On the same
logic, resistance to the development of dense urban centres could
mount, thereby limiting construction of new housing and raising costs.
More countries may seek to become self-sufficient in the production of
“strategic” commodities such as medicines, medical equipment and even
toilet roll, contributing to a further rollback of globalisation. But
the redefined role of the state could prove to be the most significant
shift. The rules of the game have been moving in one direction for
centuries. Another radical change is looming.■
Dig deeper:
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This article appeared in the Briefing section of the print edition under the headline "Building up the pillars of state"
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