Blair may trip up facing the Tories' fiscal abyss

'The political revolution prevents the use of higher taxes to finance extra public spending. Yet the public demands growth in public services well in excess of GDP growth'

The next government, of whichever political complexion, faces the problem of overcoming the power of two parallel revolutions - one in economic thought, the other in political behaviour - which are tying the hands of democratic politicians throughout the world. Unless their grip can be loosened, a Blair government might prove a brief interlude between lengthy periods of right-wing rule, however determined the Conservatives may be to split over Europe.

Macro-economics changed forever when the academic consensus decided that, in the long run, unemployment and inflation are independent of each other. The beginning of the end came with the 1968 presidential address to the American Economic Association by Milton Friedman. This, perhaps the most important speech on economics in the post-war era, said that governments could only boost output and jobs at the expense of ever-accelerating - not just high - inflation. Since no society could ever accept ever-accelerating, or indeed ever-decelerating, inflation, the remorseless force of logic implied that the only level of output which could be sustained was that uniquely associated with stable inflation. This rate became known as the natural rate, though there was never much natural about it.

This may all sound arcane, but consider the consequences of this single powerful assertion. If it is true, then governments can no longer be held responsible for unemployment, at least through mistakes of macro-economic management. Their sole macro task becomes that of controlling inflation, which might as well be held at a low rate, since there is nothing to be gained from allowing prices to rise more rapidly.

The so-called trade-off between jobs and inflation, the very meat and drink of political debate in the Keynesian era, shrivelled up and died. And in consequence, economists started arguing that the control of inflation could safely be left to technocrats, independent central bankers who were one step removed from the political process. This, and many of the other mantras of post-Thatcher orthodoxy, basically stand or fall by the Friedman proposition. Monetary or inflation targets, PSBR objectives, medium-term plans - all of these were direct descendants of that speech in 1968.

For a while, though, people continued to argue that there were still choices to be made about the size of the state, and the burden of taxation. John Smith's disastrous shadow budget before the 1992 election, was based on that principle. But this approach ran into a political revolution every bit as potent as the economic revolution that preceded it.

No longer was the electorate willing to support any political party which promised to raise the overall tax burden, though it would not support serious proposals to reduce the size of the state, either. The prospect of a democratic state forever frozen in aspic, with no party ever willing to risk either higher taxes or an assault on the welfare state, loomed.

It still looms. If Tony Blair and Gordon Brown have half the political nous I think they have, Labour will kill stone dead any talk of higher general taxation well before polling day. But with no more tax and no more borrowing, what are they left with? A reallocation of spending programmes, reflecting different political priorities from the Conservatives? Certainly. New measures to encourage long-termism in industry, and greater incentives to invest, leading to higher long-term GDP growth rates? That, too. Better ways to manage the public services without spending money? Possibly. But quick results in terms of output and jobs? Nobody dares promise that in 1996. The economic revolution prevents the use of demand management to increase GDP growth. The political revolution prevents the use of higher taxes to finance extra public spending. Yet the public demands growth in public services well in excess of GDP growth. A recipe for political discontent on an epic scale.

A bit of wriggling room in this strait-jacket is essential. Clearly what is needed is more economic growth, as Gordon Brown has recognised with his legitimate focus on boosting long-term investment. But this is unlikely to produce measurable results until well into a second Labour term. In the meantime, there is the small problem of ensuring that there is one.

This means boosting economic growth during the first term to ease the fiscal dilemma, and it means doing this without raising inflation, even temporarily. But how can this be achieved?

First by recognising that the Friedman proposition, while basically right, should not be treated as totally invariant. A research paper published recently by the US economist Laurence Ball (NBER Working paper No 5520) asks a basic question: Does the experience of a variety of developed economies in the 1980s suggest that the huge rise in the natural rate of unemployment seen in that decade was caused by structural supply side factors, or by the decline in demand which was needed to bring inflation down?

According to the Friedman proposition, the whole of the rise in the natural rate should have been caused by the former, not the latter.

But that is not what Ball finds. Instead, he discovers that demand factors played a key role in the rise in trend in unemployment, with rather less explanatory power being left for structural labour market factors.

That alone is slightly encouraging, because it suggests that the same process may just work in reverse, with a prolonged period of gradually rising demand pressures possibly reversing some of the increase in the natural rate. But more interesting is Ball's discovery that one structural factor in the labour market - the duration of social security support for the unemployed in each spell of joblessness - interacts powerfully with demand factors to explain the rise in the natural rate. The implication is that a drop in demand initially creates the unemployment, but that long-lasting state support for each jobless person then translates this into a permanent increase in the natural rate. Without this state support, the jobless (as in America) would be forced to search for new jobs, even at the cost of accepting lower wages.

This no doubt sounds callous, but the present alternative of consigning the unemployed to the permanent hell of life on the welfare is no better. A programme of gradually rising demand pressures might just lead to permanently lower unemployment, provided that social security is adjusted to ensure that the jobless engage in active searches for new work. The introduction of the job-seeker's allowance in October, will go some way to reducing the duration of unemployment support, which should help.

But the next government needs to bite the bullet and go further in this direction, albeit combined with aggressive measures to retrain and increase the geographical mobility of the unemployed. If the Chancellor can force this through, then he has every right to ask for the support of the Bank of England in easing monetary policy, and encouraging the expansion of demand. With higher growth, the budgetary problem suddenly looks a lot less menacing.

More labour market reforms, easier money, less unemployment, and more public money left over for the services people really want. A long shot? Perhaps. There is certainly no evidence the Blair camp is thinking at all in this direction. But without emergency action to reduce the natural rate of unemployment, and then to boost demand through lower interest rates, the next government will soon stumble into the same fiscal abyss that is swallowing John Major.