Economics 4: moral hazard and fiscal policy

by George Hatjoullis

The so-called Keynesian revolution created the notion that the state had a duty to take up that portion of GDP that the owners (labour and the owners of the means of production) did not wish to utilise in any significant period. Recall that current owners of GDP might not wish to use all GDP in a given period but might wish to exchange it for claims on future GDP. However, this exchange is only possible if there is someone else on the other side of the desired exchange. There are always some that are dissaving (pensioners) and thus willing to exchange claims on GDP accumulated from past activity for currently produced GDP. There are also entrepreneurs that are willing to borrow or raise equity (and thus create the desired claims on future GDP) in order to acquire current GDP for business reasons. However, it is always conceivable that these private activities do not absorb current GDP. Accumulating inventories will elicit cutbacks in employment and output (recession) and, as Keynes noted, under certain circumstances this can lead to sustained periods of below potential GDP. The new role of the state was to take up the balance of unwanted current GDP and provide the owners with desired claims on future GDP in the form of government debt. This of course implies a period in which the state would run a budget deficit and accumulate government debt.

The process also works in reverse. During periods in which the desire for current consumption exceeds actual GDP, the state could run a budget surplus and pay down debt. Such countercyclical fiscal policy was meant to reduce the severity of business cycles. Indeed, there is an automatic stabilizer imbedded in fiscal policy. Periods of under consumption of GDP also reduce tax revenue and create a budget deficit and increase the need for the state to borrow, whilst periods of over consumption (remember the nation can import or borrow GDP from abroad) increase tax revenue and allow the state to pay down debt. There is no necessary reason why a stabilising fiscal action by the state should result in a net accumulation of government debt as a % of GDP. Hang on to this thought!

The Keynesian revolution introduced a new role for the state as underwriting the overall level of demand for GDP. Producers still ran the risk of producing the wrong goods and thus losing money but they had much less risk of suffering from a general insufficiency of demand. The state would ensure it was more or less maintained at whatever levels of GDP that was produced. Labour might also experience specific problems in specific industries but the overall demand for labour would be close to that which was consistent with potential GDP. The Keynesian revolution thus introduced the possibility moral hazard.

Moral hazard has been a big element of many Gestaltz blogs and has been explained on several occasions. It refers to the risk that by providing assistance one reduces the incentive for necessary change or adjustment. The introduction of moral hazard by the Keynesian revolution became apparent in the 1960s and arose because of an incorrect characterisation of even the modern economics notion of potential GDP. Governments were tasked with maintaining full employment which was interpreted by all and sundry to mean that all labour available to work would be able to do so. Curiously, one of J.M. Keynes‘ Cambridge colleagues warned of this effect long before the Keynesian revolution took hold. In ‘Political Aspects of Full Employment‘, (Political Quarterly, vol.14, 1943, pp. 322-31), Michael Kalecki predicted that by promising full employment, the state would introduce what we now recognise as moral hazard. No one took any notice. Perhaps it was because it was 1943 and he was a marxist. How did this materialise?

In the immediate post war period, full employment became the political mantra in many nation states, and was supported by Keynesian economists. Any evidence of unemployment elicited a demand-boosting fiscal response from the state. A budget deficit was allowed to emerge funded by borrowing. In a highly unionised world, the moral hazard soon became evident. Assured of overall adequate demand for goods and thus the labour necessary to produce, the unions embarked on a war against each other (pay relativity’s) and against the owners of the means of production (income distribution). The owners of the means of production found that, whilst overall demand was sustained, their profits were being squeezed by wage pressure and constant strike action (the main weapon of choice of the unions). This was precisely what Kalecki predicted. Structural change and productivity gains were inhibited because unions would not accept the employment consequences of change and demanded more of the productivity gains than the owners of the means of production were happy to concede. Investment declined and production moved to nation states in which the union problem was less of an issue. Inflation became the problem of the day.

By taking the ‘full employment’ responsibility literally some states were universally trying to maintain output at above potential GDP. The result was accelerating inflation. At the time the problem was seen as a spiral of wage and price increases but these resulted directly from the over-full employment fiscal policy that was being pursued. Moreover, central bank independence was rare at the time (Germany’s Bundesbank a notable exception). Central bank policy was thus invariably supportive of the over-full employment policy of the time. During the accelerating inflation, expectations of inflation were high. Individuals and corporations avoided holding money balances and preferred to hold goods. The demand for money balances was less than that supplied. Individuals collectively tried to reduce their money balances and hold goods, and this drove the inflation. The central bank should have restricted money supply until it was less than demand. However, this would have meant very high interest rates and governments were not keen as this ran counter to their over-full employment fiscal policy. Eventually, however, it did happen, as anyone that was around during Volcker’s tenure at the US Federal Reserve will recall, and, a little later, in the UK.

The Reagan/Thatcher revolution can be seen as removing the moral hazard from labour market behaviour. It did so partly by undermining unions and partly by introducing the modern notion of potential output; that level possible before inflation starts accelerating. Inflation calmed down. However, moral hazard did not go away. It just moved along to another group. The owners of the means of production were rid of difficult unions. Moreover, the state still accepted responsibility for demand management in the economy to ensure that severe recessions did not manifest. The owners of the means of production now felt free to invest in more productive plant and technology and were able keep a larger share of the productivity improvements without worrying about the labour market. Of course, none of this profitable output could be realised unless someone bought it and with labour accruing a lower share of GDP this left the state with a problem.

Productivity growth expands potential output. The same level of GDP is possible with less labour. The share of profits is growing. However, if less labour is employed who exactly is buying the output and thus enabling the owners to realise their growing profits? The more profitable is production, the greater the investment, the greater the productivity growth and the bigger the output someone has to buy.This ‘problem’ does not go away in a market economy. Globalisation helps in the short-term but this too just kicks the can down the road. The state is left buying the surplus and spending it in some form in order to stop the system from going into reverse. If owners cannot realise profits they will stop investing. However, it is now evident that the amount the state now has to buy is not cyclical and self-cancelling. It is a growing % of GDP. The more productivity grows, the less people are employed for a given output and the more the state needs to buy to keep the whole system going. State debt just accumulates and at a growing % of GDP. This is the new moral hazard. The state, by enabling owners of the means of production to realise their profits through maintaining demand in the face of a falling labour share of GDP, encourages investment and productivity growth and  makes the problem of GDP realisation worse. The recent fashion for austerity and reducing national debt levels as a % of GDP is a realisation that this process is unsustainable and the longer it goes on for the worse the problem will become. Moral hazard needs to be removed from the economic system and this means that the state no longer has a responsibility to absorb the (ever-growing) surplus GDP in exchange for claims on future GDP.

This lesson is quite difficult and has been somewhat oversimplified. It has largely ignored international trade, Balance of Payments and exchange rates. These change the mechanics but not the basic issues. It has also gone from countercyclical policy, in which government debt cancels out over time, to state demand management policies that necessitate debt growing as a % of GDP. This is not self-evident. The implicit assumption is that the share of labour in GDP is declining and that this share of output is continuously being absorbed by the state, and financed by government debt. The owners of the means of production are increasingly dependent upon demand generated via state funded action in order to realise their growing share of GDP as monetary wealth. When the state stops facilitating this, we see output drop sharply. It has done so.

So to recap:

1. The Keynesian revolution gave the state the role of maintaining demand and keeping actual GDP close to potential through countercyclical fiscal policy.

2. Countercyclical fiscal policy does not necessarily involve debt accumulation by the state.

3. An incorrect interpretation of this role introduced moral hazard via the labour market and resulted in accelerating inflation and poor investment outcomes.

4. Correction of the labour market moral hazard merely moved it into the sphere of the owners of the means of production. Guaranteed overall demand levels resulted in investment and productivity growth without regard to realisation of profits.

5. The resulting growth in government debt as a % of GDP has ushered in a period of austerity designed to remove moral hazard from the private decisions on production and investment.