Regions and Cities

Regional disparities have always been an issue in Britain, going as far back as before World War 2. For instance, before the war each industry was very much based in one part of the country. Finance was in London, textiles in Lancashire/Yorkshire and metalwork in the midlands. No government really thought in terms of regional policy, it only starts to creep into politicians minds during the interwar period because of the depressed states of some old industrial areas.

Measuring regional inequality was and had always been a tough task. Firstly, which places fall into what region? Birmingham, for example, seems to have shifted from being part of the prosperous South in the 30s-60s to now being part of the depressed North. There are many ways that the inequality could be measured: unemployment rates, labour force participation or income per head, for example. As far as unemployment goes, the further we go back the more unequal they are. In the 50s, unemployment was higher in the peripheral regions (N.England, Scotland, Wales) but the regional average was low and acceptable so nothing was done. Through the 60s, 70s and 80s unemployment everywhere rises, especially in the old industrial regions. The South and East are the only regions to avoid double figure unemployment rates in the 80s. From 1990 onwards, unemployment rates have diverged nationwide.

Labour force participation rates show a different story to the one above. They still show large regional variations with the biggest increase in working population taking place in the South. Income per head puts more attention the income in each region. It states that London and the South East have always had the highest levels, but that the South West and East Anglia have improved a lot recently. The North West fell behind after the First World War whilst the West Midlands followed suit in the 1960s.

So what is the cause of these imbalances? Part of the blame is the amount of people employed in declining sectors. As these sectors were all based in the same regions it left them lagging behind. Through the 70s and 80s the blame was increasingly placed on having the wrong mix of industry and services. Too many people were in industry when services was the growing sector. But, if we look at the statistics in a slightly different way we can get a different outlook on things. For example, if you look at female unemployment alone then the patterns diminish. Also, London looks like the best region - but it also lost a lot of manufacturing jobs from 1960-1990 leaving people unemployed. There are periods where East Anglia actually increases its employment in manufacturing.

Imbalances do exist, this is true. But why do they persist? Theory states that market forces should even things out. The first reason the imbalances continue is agglomeration effects. Firms expanding in a sector all seem to cluster together in the same area. This means, despite them perhaps clustering in high wage and rent cost, prosperous areas they benefit in the sense that they are close to skilled/specialist labour, suppliers, customers and the local infrastructure is attracting the correct type of employee. This is why more firms set up in the South - these benefits are more prevalent there. For larger firms, this effect meant that they tended to set up their corporate HQs, legal services and research and development centres in the South whilst their basic distribution and assembly tasks were focused in 'Outer Britain'. Proof of this is that over half of research and development spending in the 1980s came out of the South East of England.

The government make an attempt to rid the country of these regional imbalances from 1945 onwards. Some argue it would distort the market, others argue it was a necessity for faster national growth. The main tools they had was building and land controls and financial aid.

Financial aid could come in varying forms: loans, tax rebates to firms or grants, subsidies or infrastructure developments. Some of this aid came from the central government, some from local government and some from the EU.

1963 is when regional policy starts getting used widespread. It is used to raise growth and combat local unemployment. Before this there just wasn't the available resources to do much regionally. After 1976 this regional funding fell back because there were large constraints on public spending and the money that was available was directed towards inner city problems. More recently, from the 90s onwards perhaps, regional issues are of more importance for political reasons. Financial aid is given but much more selectively, with the focus being on new firms, regional competitiveness and aid to larger firms to attract external investment.

How effective was the policy of regional aid then? In the most assisted areas net job creation stood at around 600,000 from 1960-81. The majority of firms receiving aid said they wouldn't have been able to go ahead in their original form without the aid. But, it had its negatives. Manufacturing employment fell rapidly in assisted areas if you took the aid away - makes the suggestion that job creation was marginal. Firms receiving aid exaggerated the effects to try and get themselves more. Since the 90s, studies have suggested that aid would be useful if it was better targeted, but there haven't been available funds to do this. The problem of different tasks in the North and South persists.

Finally, we can conclude by saying that government policy affects regions differently even if they are not specifically regional policies. Plus, we cannot be sure of that actual effects of job creation because all the estimates vary massively. Make your own mind up.

1980s Economic Miracle?

If you read my previous post, the 1980s look like a rough time. But, as with most periods - look at them in a different light and the complete opposite can be argued. Thatcher had other aims whilst in power: reducing state intervention, allow market forces to do their thing and curb Trade Unions. The year she came to power was seen as a year of 'cutting spending' when in actual fact spending grew every year Thatcher was in power. Poor start.

But why does her spending stay high? Is it Thatcher's fault? In a way, no. She was stuck with an aging population and rife unemployment - this meant high social security spending. It was impossible to make big cuts in the core government services, the only cuts that could effectively be made were in minor spending programmes. She does, however, lower public sector borrowing. But with spending staying high and borrowing falling, the tax burden had to rise. Tax payments as a percentage of GDP in the 80s rise as a structural change is made in taxation. Indirect taxes become the main focus as income tax falls and indirect taxes rise. A popular move with voters.

Thatcher is obviously know for her process of privatisation as well. The industries under public control were being heavily criticised for their loss making and the benefits they provided to producers, not consumers. The investment in state programmes were adding to borrowing, so selling these industries could fund tax cuts and promote efficiency. The process started with the competitive industries being sold first: shipbuilding, for example. Utilities went after, but were still overseen by the government because they were natural monopolies.

Curbing the Trade Unions was another of Thatcher's aims in power. She didn't like the influence they had. She went about a process of tearing them down with policies such as banning closed shop, outlawing secondary picketing and strengthening internal balloting procedures.

These three policies were a political success. Trade union membership falls, income tax cuts are popular, privatisation is popular and striking falls. The manufacturing sector came out particularly strong - Britain's productivity here was growing at a faster rate than the other G7 countries. It was known as the 'manufacturing miracle'. What caused it? Hmm. The downside was, though, that absolute levels of manufacturing were below competitors and the jobless count rose sharply.  

De-industrialisation had seemingly occurred. The industrial workforce falls from 43% to 30% of total employment in a 16 year period from 1973-1989. Growth was now mainly coming from the service sector. The pessimists thought this switch to services was slowing overall productivity growth. The counter argument was that these employment trends were in line with what was happening in the other G7 countries - it seemed like a natural trend. There was no tangible output from the service sector so it was hard to measure improvements in the quality of the goods, but technological changes were definitely increasing growth in the sector.

Overall productivity in services was growing slower than in manufacturing. Across the whole economy, productivity growth wasn't that impressive - but this was a global trend at the time. Claims of an 'economic miracle' in the 1980s were overstating the reality. There were improvements, yes, but we were still behind the rest of Western Europe and these gains came at the price of higher unemployment and higher income inequality. 

Nationalisation

A nationalised industry is an industry owned by the state that produces a marketable, priced output. Over the course of 40 years from the 1940s to the 80s there was a lot of action in the field of nationalisation. Post World War 2 saw a lot of industries brought under state control: coal, gas, buses and the Bank of England to name but a few. Between the 50s and the 70s there was some backtracking and indecision from the government. Road haulage and steel were denationalised, but then steel was nationalised again in 1967. Further nationalisation took place after 1970 when shipbuilding, aerospace, Rolls Royce, British Leyland and water were all brought by the government. By 1980, 8% of the workforce were in public industries and they produced 11% of Britain's GDP.

The aim behind this process was to achieve a fairer society. This was what Labour wanted. They were also attempting to improve economic performance - for example coal was performing poorly under private sector control and the energy and transport industries had plenty of scope for coordination. The problem was that a lot of other countries in Europe had high levels of public ownership in this era also but there is no evidence to suggest that nationalisation had any positive effect on economic performance. Of course the vast range of sectors made overall performance very hard to measure, may I add.

The policy had its supporters... and its critics. Milward shows that public sector productivity growth, as a whole, is better from 1951-1985. Hannah, another historian, shows that on a global scale Britain's utilities and airline sectors had poor productivity. The consensus seemed to be that nationalisation didn't have any transformative effect on economic performance.

So, what were the problems with nationalisation? In summary, you could say the problem was that the task was too big. The initial organisational challenges were huge - some firms needed to be combined to improve efficiency which was no easy feat. To oversee the whole operation expert managers were needed, but managers that were good enough were in very short supply.

As stated earlier, the process of nationalisation had an aim of improving economic performance. Efficiency needed to be promoted - but how did public firms differ from private firms in order to create this change? A series of nationalisation White Papers were released (1961, 1967, 1978) detailing the responsibilities of public corporations. It outlined the following:

·         Investment projects had to be subjected to a series of accountancy tests that would be used in the private sector to ensure a worthwhile rate of return.

·         The firms marginal cost would be used to determine output.

·         Cross subsidisation was discouraged.

·         Firms should be aiming to break even over a planned period of time.

But, as with most things - this didn't quite work out as intended. Each point mentioned above seemed to encounter a difficulty. Forecasting the rates of return was difficult because the markets were constantly changing. With such complex outputs, measuring the corporations marginal cost was a challenge. It was virtually impossible to define conditions for loss making activities and any loss makers weren't penalised, nor firms that exceeded targets rewarded. The government was using the nationalised industries to achieve short term goals and this was undermining the White Papers.

The three main short-term goals the government was trying to achieve with these industries was technological nationalism, macroeconomic stability and social rescue. By technological nationalism we mean nationalised firms being forced to buy British products as opposed to those from abroad to try and push the firms and make them more attractive to exports. The problem with this is British products, such as planes, tended to be more costly than those from abroad, and pretty frankly they were rubbish. The macroeconomic stability was controlled by using nationalised firms investment programmes in line with the 'Stop-Go' cycle. Finally, they attempted to achieve social rescue by    keeping jobs in declining industries in unemployment black spots to stop the unemployment levels from rising and creating depressed regions, despite these declining industries essentially holding the economy back.

To conclude, nationalisation wasn't really a massive failure or a success. The thought was that bringing these firms under state control would be beneficial, but in reality they still shared the same problems they faced under the private sector. The use of these industries to meet short term goals potentially hindered the success of the program.  

Battling Against Inflation, 1970-79

The 70s were a bad decade for the British economy. 'Failure' is probably the most fitting word for the period. From 1974 to 1979 unemployment had crept up to pushing on 5%, growth had fallen to 2% but the real issue was inflation at 16%. Part of the rise in prices can be attributed to the collapse of the Bretton Woods system, this led to a global commodity price rise which saw oil rise four fold in a 2 year period. Domestically, though, the supply side issues discussed in a previous post weren't helping and a lot of errors were made in macroeconomic policy cause partly by confusion over the actual cause of inflation.

The confusion was theorists thinking they understood the tradeoffs between economic objectives, such as inflation and unemployment. Stagflation occurred in the early 70s which shocked theorists - inflation and unemployment was rife at the same time, the government were struggling to achieve any of their objectives.

The government needed to re-think. They put the priority on targeting unemployment in the early 70s. During this period the Barber Boom took place. The chancellor at the time (Barber) injected a large monetary and fiscal stimulus to raise output but not inflation because of the spare capacity in the economy. Sterling was also allowed to float freely to stop a balance of payments crisis choking the growth. Did it work? In the short term - yes. Growth peaks at 7% in 1973. But, over the longer term, the balance of payments deficit soars, inflation starts to runaway and smaller financial institutions collapsed - the three things that really weren't wanted.

Because of the soaring inflation the government makes controlling this the main priority as the 1970s progress. Unemployment falls down the pecking order. Revised Keynesian theory defined the inflation as cost-push. Wages were rising faster than productivity forcing up the prices. Pay rises needed to be checked - were income policies the solution to this? Income policies worked like so: pay rises would be limited by setting a norm that everyone should follow. Some would be voluntary, some would be forced, others would be more complex. It worked for small periods of time, but it always failed eventually as people became dissatisfied and it defied the point of trade unions.

The monetarists attacked the income policies claiming they didn't curb inflation at all they just distorted the labour market. Tighter financial policy was required. This was true, public spending was high and still increasing. It rose faster than national income from 1970-75 and reached 9% of GDP during 1975. This high spending was crowding out private sector investment by pushing up interest rates. In 1976, Labour realise the problem and agree to a deflationary package. Their new budget regime centred around cash limits. 60% of their spending would now be subject to 'cash limits'  and different programmes received a fixed cash sum year on year regardless of inflation. In real terms, this change meant public spending fell and brought inflation down to some extent.

What can we conclude from this then? Was this the end of the Keynesian era? The government were still trying their hardest to adapt Keynesian demand management policies rather than find a new, improved framework. This just resulted in what seemed like aimless policies that didn't solve any problems. Real living standards on the whole were hit, especially the middle income people, which led to a lot of resentment. 

The Crisis of the Sterling

In an international sense, the 'Golden Years' weren't quite so great. Sterling had major problems. Although as a whole the world is booming, external problems in the British  economy were starting to show. The fastest area of trade growth between major economies was in manufactured goods, yet Britain's share of manufactured trade fell from 25% in 1950 to 11% in 1970. The balance of payments was also perceived as weak because of its volatility. Visible trade was constantly in deficit and invisible trade in surplus, but the magnitude of these fluctuated a lot meaning there was never a consistent surplus. It was weakened further by the Sterling balances.

Sterling balances is the term given to debts accumulated during the Second World War. This figure stood at roughly £3.5 billion by 1950. The gold and foreign exchange reserves covered roughly 1/5th of this, although this figure was increasing. In 1957 exchange controls were removed and there was a danger than holders of the pound would sell up. The government needed to strengthen their reserves in order to stop this run on the sterling from occurring. It needed to run a persistent balance of payments surplus.

The government needed to resolve Britain's balance of payments problems. It had three routes to go down: protectionism, devaluation or deflation and 'Stop-Go'. Protection would've been opposed by the US and other members of GATT and EFTA, therefore that option was ruled out. Devaluation took place in 1949 to $2.80 as a war adjustment, but any further devaluation was difficult because of being part of the fixed exchange rate system of Bretton Woods. It would also conflict with the Sterling Area. The Sterling Area was what laid behind and held together the Commonwealth. It also supported the City of London's position as a global financial centre. Devaluation of the sterling would cause a collapse of the Sterling Area and would be unfavoured electorally. The final choice was the route taken. Bouts of deflation would be implemented to cut imports to improve the balance of payments position. However, the way the government went about it ultimately failed. They were too timid with their squeezing of the economy because they wanted to protect their full employment objectives and therefore foreign currency reserves stayed low and the sterling crisis continued.

One of the main issues Britain had was that state spending abroad was offsetting all private sector surpluses in the 1960s. The state was spending nearly £200 million a year in aid to the Commonwealth and £313 million in overseas military spending. Without this being cut any attempt to improve the balance of payments would be in vain.

Eventually, the Sterling had to be devalued. The Balance of payments crisis just prior to 1967 was the last straw and the Sterling was devalued to $2.40. Military spending was also cut back. There was some short term success from this, the balance of payments was in surplus by 1969 but it didn't last long as inflation and wage rises meant any gains were soon wiped out. The Sterling Area gradually faded away after this. It just could no longer be maintained with the decline of Sterling as a global currency. The empire was also in the process of breaking up as Commonwealth countries were beginning to gain independence and demand their own currency to complete this process. The demise of Britain was in full swing.

To conclude, we can say that during the 60s and 70s it was realised that the British economy was no longer in a position to support a global currency. The balance of payments was a persistent problem for the economy because of a wrongly held belief that Sterling was still a major currency. The problems did not end with the 1967 devaluation. 

The Challenges of the 'Golden Age'

If you read my previous post you'll see that the 'Golden Age' is a very positive time if viewed in certain lights. It wasn't all plain sailing for Britain, though, as this post will explain. If we look at the growth rate from the 1950s to mid 70s, we see it averages around 2.8% per year. Pretty good, higher than during the industrial revolution. But, compare it to the growth rate of other advanced economies and it looks feeble.  In the 1950s we expected these other economies to grow quicker with their scope for 'catch up' growth, but in the 60s many of these economies had actually caught up with and overtaken Britain and were still growing faster.

This suggests there's a fundamental problem somewhere in the British economy. Could it be a problem of investment? We said investment was one of the reasons for Britain's low unemployment in this period, but it could also be part of the reason Britain was lagging behind. Our investment rates had grown since the 1930s, but they were still a way behind other advanced economies. Some blamed this on the policy of 'Stop-Go'. The poorly planned contractions and expansions of demand were too frequent, which left a level of instability that hindered investment. In reality, during the 'Go' phase the demand was pumped into the economy too fast. Prices rise quickly and the government has to quickly backtrack with a deflationary policy that chokes off investment. In the 'Stop' phase firms just help back on their investment, waiting for the next 'Go' phase. The uncertainty of the whole system meant lower investment.

The government needed some alternative methods to raise investment whilst still maintaining their very favourable employment conditions. They didn't want to devalue the sterling and they didn't want to deflate the economy for too long. The only option left was to return to a policy of state planning. A policy of 'Indicative planning' was working well in France so the governments of the early 60s tried to mimic it.

In steps the National Plan! Launched in 1964 by the Labour government with the aim of boosting long term growth up to 4%. A lot of effort was put in to the plan, production targets were set across the board which were needed to achieve the goal. It was all placed under the control of the new 'Department of Economics'. Sound good? It wasn't. It failed. There was no method given to meeting the targets and no penalties for those that didn't make them. It was a naive hope that workers would just cooperate. Well, they didn't. It potentially could have worked, but the whole plan stemmed from a misdiagnosis of the economy's problems. It all assumed that the 'Stop-Go' cycle caused the low investment which hindered growth. What if this wasn't the cause?

Was 'Stop-Go' really the problem? In a way, no. Large fluctuations in the economy that were persistent before 1939 and also occurred after 1973 didn't occur during the 'Golden Age' and a similar policy was used in other countries that were experiencing rapid growth. So was low investment the problem? Britain's investment rates were catching other countries by the 70s, but it was investment in private housing that was holding the rate back. It seemed that Britain was very unproductive compared to its competitors with the same equipment which could have been a deterrent for investment. Investment is seen more and more as a symptom of Britain's decline, rather than a cause of it.

The suggestion from this was that Britain was suffering from other supply side weaknesses. What could these have been? Bad industrial relations, restrictive practices, poor management, poorly aimed research and development and inadequate human capital formation.

Britain's bad industrial relations came partly in the form of strikes. Compared to Germany the strike rate was poor, but compared to the USA it was much better. Productivity was the real issue. Britain's steel productivity was a 1/3 of the EEC average. We were over-manning our factories with people putting in little effort. Top managers in large industry seemed to be completely oblivious to shop floor activities.

Research and development was one of the big problems too. Britain was spending more than all other Western economies bar the USA, with half of this coming from the private sector. The direction of this spending was an issue. It was being spent on defence, civil nuclear power and civil aerospace - three unprofitable and poor commercial areas. All of the most talented scientists and technical manpower were stuck in dead end projects not adding  much to the GDP of the country. Innovation was falling too.

Another one of the supply-side issues was education. We were a comparatively uneducated economy. Only half our factor directors had degrees, the figure was closer to 90% if you looked abroad. It was even worse at middle management level. Those managers that did have degrees tended to have them in arty subjects and not managerial subjects.

So, if these really are the problems causing low growth - why did they persist? You'd assume that market forces would create change and push the inefficient parts of the economy out. The explanation for this is put down to 'Institutional sclerosis'. Key power structures had been left undisturbed for such a period of time that they had become entrenched. Vested interests were created and these resisted change. A part of this can be put down to the little damage Britain took during war. If we compare it to Germany, who took a lot of damage, we see why. Germany's war damage forced them to rethink the whole economy, they kept their strengths and replaced their weaknesses. With Britain, this didn't happen and institutions were left entrenched. The world boom then further lessens Britain's incentive to change.

The government were also very reluctant to generate the required change. They didn't want to challenge the vested interests in competition policy and preferred to follow the path of 'Stop-Go' and not detailed economic intervention. Another reason the government didn't force change is perhaps the problems weren't as bad as first implied. This was the view of some historians. There were some positives: our research and development spending was similar to France and they were growing rapidly. We looked good in industries such as pharmaceuticals and food and drink. Globally, Britain's incomes were in line with the OECD average and the economy was still successful. The only real negative was the loss of global political influence.

To conclude, the 'Golden Age' is a period that can be argued to have been good and bad for Britain. The debate about the extent and causes of the failures I've detailed above will continue for many years to come. Britain does lose ground, but is still a successful economy.

The 'Golden Years'

Once World War 2 had come to an end, the government had a changed view on the economy. There was a unanimous agreement that the economy could not be returned to the conditions of the 1930s. A prime opportunity had presented itself for economic betterment to take place. The war experience could fuel this improvement along with breakthroughs in Keynesian economic theory.

In weighing up what exactly the government could do to improve the economy from the 1930 levels, three main areas appear. Firstly, could they try a policy of nationalisation? The short answer to this was no. Many key industries were already under national control, such as steel, coal and the railways and most other important industries were so highly regulated already that nationalising them completely would have been ineffective. So, the policy of nationalisation was crossed off the list. Could they try and raise public spending? Well, in reality - not really. Public spending was already high at 37% of GDP in 1948, most of this going on social safety nets rather than boosting the economy. Any further public spending would be unsustainable. There goes public spending off the list. The option that was chosen was macroeconomic management.

The 1950s was a period of breakthrough for Keynesian theory. It saw the policy of demand management come to flourish - or better known: 'Stop-Go'. The idea behind this policy was constant tweaking of the economy to keep it heading in the right direction and to avoid overheating or recession. When unemployment began to rise, the government would loosen policy and when the economy looked like it was overheating the government would tighten policy again. Did it work? Eh... In some senses, yes, in most other senses, not really. If you place a high priority on unemployment then it could be passed as a success - unemployment reached historically low levels and fluctuated around the 1.5-2.5% mark. Living standards also rose. However, this was at the cost of frequent balance of payment crises, slower growth than the UK's major competitors and inflation (although not runaway inflation).

The policy had a famous critic in the form of the economist RCO Matthews. He had his doubts about Keynesian theory. The basic thrust of his argument was that the reason unemployment was so low wasn't to do with the policy the government had implemented - this policy only affected unemployment at the margin. He claimed that demand was higher than pre-war levels, but not because of financial policy. Tax was higher than spending, budgetary policy tended to be deflationary and interest rates were consistently higher in the 50s.

So what could the other reasons for the low unemployment be? Some have put it down to high investment rates. Investment was especially higher than in 1939 and most of it was coming from the private sector. Investment is a fickle economic variable that depends a lot on confidence. From 1950-1973 there was a world economic boom which is the reason for this high investment. In Europe and Asia, war had hit harder than in the US. This left a lot of scope for 'catch up' growth to repair the war damage using the best practice techniques. Many workers also moved into more productive sectors such as services instead of agriculture. As well as this, world trade barriers come down and the Bretton Woods system begins to function efficiently as the USA pump the system with overseas aid and defence spending. Overall, world demand increases which fuels investment and productivity growth. This growth in world trade in a way drags the British economy along with it.

Another contributory factor for the higher investment comes from Broadberry. Productivity rises were higher than wage rises which favours job creation. As well as this, wage restraints continued through the 1960s, essentially increasing firms profits allowing investment to take place. The wage restraints were supplemented by cheaper imports of food and raw materials to keep living standards rising.

We can conclude the 'Golden Age' by saying that, yes, full employment was pretty much achieved, but it wasn't all down to the wonders of government policy. They were helped a great deal by very favourable conditions around the world. With hindsight, we can also see that this is only a temporary purple patch for Britain as problems begin to crop up. 

Macro-Economic Issues

The macro-economy refers to the wider economy - it's looking at an economy as a whole as opposed to individual firms or operators within an economy that micro-economics refers to. We come across macroeconomics on a daily basis: inflation and unemployment for example. The topic gets a lot of media attention and is the main cause of a lot of the criticism that politicians receive. The importance placed on macroeconomics by politicians can never be understated - they fully understand that voters want a thriving economy and therefore they strive to achieve this.

The four major economic issues are ones we will all have heard of: Economic growth, unemployment, inflation and the Balance of Payments/Exchange rate. The government aims to keep all four of these in check as part of their policy objectives. They want economic growth to be at a high, stable level. They aim to reduce unemployment because not only is it a drain on their finances in the form of unemployment benefits but it is a waste of resources. Inflation needs to be kept low and stable to make decision making easier on individuals and firms. The balance of payments wants to be in surplus, or at least balanced, so that the exchange rate isn't pushed upwards (this can fuel inflation as import prices will rise). The problem the government faces is that these policy objectives can conflict. If there's one thing you learn from this post, make it be this: The government are in a difficult position - they will struggle to achieve all four of these objectives at the same time.

At this point I am going to direct you to a previous post I've written about the circular flow of income as this will come in handy when looking at the next part. Click here to be linked to that post.

So, the macroeconomic goals of the government have a close relationship with the circular flow of income. If the withdrawals from the flow exceed the injections into the flow then we will see a case of aggregate demand falling. This subsequently will lead to a fall in economic growth, a rise in unemployment, lower inflation and a potential improvement of the balance of payments. With injections exceeding withdrawals we expect the opposite to happen. Here is a perfect example of the difficulties the government faces. A rise in aggregate demand has the potential to push the government closer to two of its goals (economic growth and a fall in unemployment) but at the same time it also pushes them further away from the other two goals (rise in inflation and a worsening balance of payments). The dilemmas of a politician. 

Government Failure

Sometimes we see governments intervening in markets in an attempt to make them more efficient. However, it is very often the case that they aren't any better at managing resources than the free market - this is known as government failure. We'll look at example involving land conversion and biodiversity loss.

Land conversion is the main reason for biodiversity loss around the word - both grassland and forest cover is declining rapidly in some parts of the planet. We use a diagram similar to the one used in the last post which looks at the interaction between a firm's marginal net private benefit and the marginal external cost of land conversion. The definitions in this case are as follows:

• Marginal net private benefit (MNPB) = the profit associated with a one unit increase in land conversion.
•  Marginal external cost (MEC) =  External cost of a one unit rise in land conversion.

The market for this looks as follows:

Let us describe the market. We have an initial over-conversion because of the market failure. Lp is converted when the socially optimal level would be L*. This is all explained in the last post I made. The government failure, however, comes in the form of the subsidy. The government may be subsidising farmers' incomes, or something of the sort, but this is encouraging more land to be converted. The subsidy increases the marginal net private benefit of land conversion for the firm and therefore the amount of land converted has moved further away from the socially optimal level. We have to remove the government failure before we can remedy the market failure.

We've assumed a constant upwards sloping marginal external cost curve here, but it may be a good time to mention other plausible curves. We could have a curve that increases at a constant rate and once a threshold point is reached it increases faster. Or, we could even have a downwards sloping MEC curve. How? Imagine a view being ruined by a factory. The first factory has a massive effect on the view but subsequent factories have a lesser effect because the damage has already been done by the previous factories.

Government failure occurs a lot in the real world. One example would be with the Common Agricultural Policy. It aimed to provide farmers with a steady income by offering a guarantee price for their goods. This meant overproduction was rife - farmers knew that the best technique was to farm as much as they possibly could to get the most revenue. Land was farmed more intensively and more land was converted to farming to expand production. This will/has caused degradation of the land and biodiversity loss.

Another example is subsidies in developing countries. Governments there tend to impose subsidies to keep prices below the market price so that food and the like is affordable. This encourages over use of the land once again and makes the economic activity look artificially appealing, attracting more firms in. It is also a waste of financial resources that are needed elsewhere.

As we can see government failure is something that is very real. It can occur fairly easily and it needs to be stopped before any market failure can be addressed. How do we stop it, though? I'll be going into this in later posts, stay tuned. Thanks for reading.

Sam.