Sunday, November 23, 2008

Labour's Tax Bombshell Part Two: This Time It's Personal

David Cameron's new strategy of frontal opposition to Brown's economic salvage plan shows how rattled he is by 'Flash' Gordon's recovery in the opinion polls. It also neatly reflects the debate between Friedmanites and Keynesians which emerged out of the 1970s stagflation and still rumbles on today.

In the 1930s Keynes departed from the classical view of recessions by insisting that government intervention could kick-start the economy by making cash available for consumers to spend. In the 1970s, Friedman objected that this policy was essentially inflationary, and would not achieve the goal of increasing output because market actors would factor in the consequences of this inflation and behave accordingly. So consumers would not be able to consume more and output would not increase, because prices would simply go up in response to the inflationary implications of policy.

A refinement of this argument associated with Robert Lucas held that consumers had 'rational expectations' and would not be fooled by policy. Interest rate cuts would not lure mortgage-holders to spend more, since they would be better off paying down debt in anticipation of future rate hikes to combat the inflation (come to think of it...). Similarly, running a budget deficit (Keynes' automatic stabilizers) would not help either, because consumers would anticipate tax increases in the future to reduce the deficit, and would therefore save more in order to be ready for them. Policy would therefore be ineffective in stimulating demand, increasing inflation for no benefit.

One of the weaknesses of this argument is that its assumption of rational expectations - that market actors use all the available information and knowledge to make guesses about the future, and act accordingly in the present - is perhaps a little heroic. Some people don't read the Financial Times or perform econometric analyses before they go shopping. Others could, but can't be bothered, because they discount the future heavily (live for today). So demand management might work after all, if people aren't smart enough to figure out the consequences of fiscal stimulus packages or interest rate cuts.

So, back to the UK in 2008. Gordon Brown is putting together a fiscal stimulus worth perhaps 30 billion pounds of extra borrowing over the next year, in the hope that we will spend this money to keep Woolworths open and prevent shopworkers, builders, Starbucks baristas and estate agents losing their jobs (I'm particularly concerned about the estate agents). This strategy will only work if consumers go out and spend the money that the government is pumping into the economy. If instead they use the cash to pay down debts or save for a rainy day (isn't today rainy enough already?) then it will all be to no avail.

Here is where David Cameron's helpful intervention comes in. The Conservatives are reviving a campaign poster from 1992 called 'Labour's Tax Bombshell', picturing a bomb wrapped in Xmas wrapping paper. The message states 'Brown's 100 billion borrowing binge will mean higher taxes for you. Don't let him get away with it'.

This translates as 'Brown wants to convince you to go out and spend money to save us from a deep recession, but we would rather you kept the money in your pocket for now, thank you, just like that nice Mr Friedman recommended.'

Who needs rational expectations when you've got David Cameron?