Sound money, practical policy
Ronald Burgess
This is the fifth of a number of articles under the general title, Inflation and Stabilisation, each of which suggests a prognosis and cure for the nation's immediate financial ills. The contributors rre drawn from leading economists representing the major schools of economic thought.
Observation shows us a Britain on the brink of economic disaster but as yet with the political parties still clinging to variations of a discredited prices and incomes policy. At one extreme the Liberal Party hold to a complete statutory policy; the official Conservative line takes the middle ground with stated preference for a voluntary policy without ruling out such statutory measures as they might deem necessary in particular circumstances; and on the left the Labour Party keep to their 'social contract' which is a voluntary incomes policy and a statutory prices policy. That such policies should remain dominant after years of complete failure is no mean recommendation for the expertise of the professional convincer; however, advocates of a sound money policy are making a strong challenge and have made important gains during recent months.
The monetarists have Much on their side. Firstly since a sound money policy has never really been tried it is not a proven failure; secondly there is an abundance of evidence to support the view that when the rate of increase in the money supply is significantly in excess of the rate of growth of real output then there is inflation. Unfortunately, in prevailing British circumstances the monetarists' point of view leads to a policy requiring both tax increases and reductions in public authorities' expenditure. It is admitted this policy would have the immediate effect of restricting trade and industry and of increasing unemployment whilst its expected effect on the rate of inflation may not become apparent until after a time lag of possibly MO years. Fear of unemployment has determined British economic policy for over a quarter of a century and experience suggests this fear would translate the current emphasis on gradualism in pursuit of sound money into insignificant action.
To the extent that monetary theory may be subject to empirical tests the results are consistent with the theory, but it appears the theory is only partly right. In particular monetary theory does not take into account all the relevant factors and as a consequence the so-called sound money policy is wrong. In a paper published in 1945 Colin Clark concluded, on the basis of pre-second world war observations, that when tax revenue plus deficit (borrowing requirement) exceeded a certain proportion of the national product then inflation was inevitable. Privately Keynes agreed with Clark and suggested post-war experience would confirm the existence of this critical ratio. In post-war Britain tax revenue plus borrowing requirement has persistently exceeded the critical ratio and post-war experience is consistent with the existence of Clark's empirical law of inflation.
The conclusion to be drawn from observation is: when tax revenue plus borrowing requirement exceeds a certain proportion of the national product then the rate of increase in the money supply will be significantly in excess of the rate of growth of real output. The policy requirements to be deduced from this conclu sion include a simultaneous commitment to a reduction in public authorities' expenditure, and an increase in the rate of economic growth. The important lesson to be learned from the empirical law of inflation is that it may not be necessary, irrespective of circumstances, to give absolute priority to reducing borrowing requirement. Reducing the borrowing require ment by increased taxation will not reduce the aggregate of borrowing requirement plus tax revenue; indeed, if such action restricted output, inflationary pressures would intensify.
Output depends upon profits and this is true even in an economy where the public sector is as dominant as it is in the United Kingdom today. If profit margins widen then output will rise, if profit margins are removed then output will fall. Today the aggregate post-tax trading profit, after allowing for depreciation and stock appreciation, of firms located in the United Kingdom is non-existent. In the circumstances it is not to be wondered at that output is stagnant if not declining. The easiest, quickest and most effective way to improve output is to restore profit margins, but if sound money is to be the final objective this must be done without increasing public authorities' expenditure.
An effective sound money policy demands the methods of successive Chancellors — in particular the methods of Mr Barber and Mr Healey — be abandoned. Again observation offers a possible solution. It is to be observed that when tax is increased profit margins narrow and when tax is reduced profit margins widen, therefore reduction in taxation may be expected to increase aggregate net trading profit and from this an improvement in real output will follow. However, in a situation as serious as now exists in this country it is essential to obtain the greatest possible effect from the smallest possible reduction in tax. Further, since the aggregate net trading profit is nil there must be many efficient firms making losses and it is these firms who require the greatest benefit from any possible easing of the tax burden. For example, a reduction in corporation tax will be very welcome to firms currently making profits; such a reduction is of
no more than academic interest to firs making actual losses. To be effective any tax reduction must benefit productive enterprises which now find themselves in financial difficulty through no fault of their own. A political weakness of the sound moneY policy as advocated by the monetarists is its effect on employment opportunities. The moon of the British electorate appears to be such that any government wishing to remain in power during the second half of the 'seventies is required to keep unemployment down to an acceptable level. It may be argued that the unemployment statistic is a misleading indicator as to the state. of the labour market, but even the strongest freely elected government is ultimately subject to the will of the electorate and the will of the electorate is influenced bY the monthly employment returns. Once more observation offers a possible solution with° the necessity of straying from the road leading towards the achievement of sound illone;Y'„ Over at least the past twenty years a change ' labour cost and net profit margins of employers has been followed over a year later by a chane in the demand for employees, a rise in profll margins and a fall in labour costs being associated with an increased demand fnr employees. Therefore, if labour costs maY bet reduced without increasing governmen expenditure, as profit margins may be improved, so it becomes possible to reconcile at politically acceptable level of unemployinen with a sound money objective. The two components making up employersr labour costs are the take-home paY bt employees and taxation. The tax componen may be further sub-divided into direct inconle, tax on wages and salaries and the emploYe,eteb and employers' contributions to national hen'', etcetera. Although income tax is the large', aggregate the national health contributions ar the most important since, being a poll tax, the9,et contributions bear most heavily on the loWe's paid and on firms located in the less prosper? areas. During the hundred years for wht,'cie reasonably consistent estimates are availa'-',.0 the take-home pay of employees is shown represent a constant share of the nationa product. There are, of course, small randont fluctuations, and there is some evidenniet suggesting the existence of a long-term cYele',/. follows from this evidence that, taking one Ye”, with another, any variation in employer'f labour cost must be the direct result n: variations in the tax component, an increat in tax component resulting in an increase in, labour cost and a decrease in tax componerIL resulting in a decline of labour cost. A practical view of the present econonliar situation leads to the conclusion that „ reduction in the employers' contribution to.; token amount will directly lower labour cns,l'e and improve profit margins. Such a rneastl!,, provides the opportunity for resolving the tWni problems of output and unemployment With increasing public authorities' expenditure, indeed it would provide immediate opportali ities for some reductions. With an improveMe in the rate of growth of real output and soot', reduction in public expenditure the critics' ratio of tax revenue plus borrowing requireli ment to the national product would begin to fn_ sharply. In these new conditions the iMPI% mentation of a sound money policy beconle,,' possible without restricting trade and industrY or increasing unemployment. The net loss of revenue over the first full Ye!sr of the proposed measure is about the saine the expected cost of the food subsidies whicA were introduced this year but without the a': infinitum escalation in cost. The initial net los,, of revenue could be fully recoverable savings in expenditure within eighteen moriti" Over 40 per cent of the employers' contribit tions are already paid by the government eithe,' directly as employers or by way of grants anal subsidies to public corporations and authorities. The loss from privatesec,.th'e contributions would be partly offset by L" increased yield of corporation tax, a reduction in Payments for unemployment and by a cut in LID. Since the greatest benefits would accrue tO those firms making losses and others located 'in the less prosperous areas the increases in REP and other government expenditures recently proposed by Mr Healey cease to be necessary. °bservation shows the road back from the brink rink of economic disaster to be long and hard out it also shows that it does not traverse the °rth face of the Eiger. The empirical law of inflation will not be ignored and is poised to exact just retribution but if we choose it offers a solution to our economic difficulties.
It.anold Burgess has been Director of the • conotrtic Study Association since its incorporation in 1966 and has published
into Price's and Incomes (1968), Local uovernment Finance (1970) and Fanfare to Action — Income Distribution as a Cause of inf14tion (1973) Locat government
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