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The Welfare State and the Social Safety Net
The social safety net is the main channel by which the
welfare state cushions shocks. The tax system also plays
an important role in stabilising disposable incomes. Both
of these mechanisms are important at the individual level,
but they are also of signifi cance at the aggregate level in
the form of automatic stabilisers.
The term automatic stabiliser is a summary concept for
the automatic response of public sector revenues and
expenditures to a change in the business cycle situation.
These responses arise because revenues and expendi-
tures are contingent on, e.g. income, unemployment, etc.
A recession will therefore be associated with a deteriorat-
ing public budget position as the consequences are ab-
sorbed in the public budget. Thus, for automatic stabilis-
ers to work, it is crucial that public fi nances are in a posi-
tion where they can absorb these changes.
There are fi ve important facts about automatic stabilisers
worth noting:
I. The size/strength of automatic stabilisers is closely
related to the extent of welfare arrangements (see Fig-
ure 1); i.e. countries with more extended tax-fi nanced
welfare states tend to have larger automatic stabilis-
ers. II. Automatic stabilisers cushion individual disposable
income and therefore serve an insurance function
which has a direct positive welfare effect for risk-
averse agents. Private alternatives for this type of in-
surance are highly imperfect and incomplete.3
III. Automatic stabilisers contribute to stabilisation of the
aggregate economy via their stabilising effect on dis-
posable income and hence on private consumption
and aggregate demand.4
IV. Automatic stabilisers mute the consequences of eco-
nomic crises on income inequality.5
V. Automatic stabilisers are rule-based, inducing an au-
tomatic response to a change in the business cycle
situation. Hence, they do not require up-to-date infor-
mation on the state of the economy, and they do not
require any discretionary policy to work.
Automatic stabilisers have thus played an important role
during the fi nancial crisis. They have the advantage that
they work automatically and thus react swiftly to changes
in the economic situation. This also implies that they are
often overlooked in the public debate, where more at-
tention is devoted to discretionary policy changes. But
it is more diffi cult to time and dose such discretionary
changes correctly. Furthermore, the stronger the auto-
matic stabilisers, the less the need for such discretionary
changes.
The attractive properties of automatic stabilisers at both
the level of individuals (insurance) and of society (aggre-
gate stability, distribution) are a source of renewed in-
terest. In the wake of the Great Recession, it has been
widely argued that automatic stabilisers are too weak and
that they need to be strengthened. However, the size of
automatic stabilisers is not a direct result of macro design
but rather a by-product of policy choices in relation to tax,
social and labour market policies. The automatic stabilis-
ers are the net outcome of the extent of welfare arrange-
ments in terms of entitlements and fi nancing. Moreover,
since policy reforms in recent years have had a strong
focus on incentive effects without much concern for the
implications for insurance, it may be a consequence that automatic stabilisers have been weakened.6
Somewhat
paradoxically, automatic stabilisers have been praised
at the aggregate level but disregarded at the micro level
in relation to structural reforms. Accordingly, it is an im-
portant policy question how automatic stabilisers can be
maintained and possibly strengthened without jeopard-
ising economic performance. Is this at all possible or is
there an inevitable confl ict?
Policy Errors
A precondition for well-functioning automatic stabilisers
is a prudent fi scal policy ensuring consolidation in good
times to create absorption capacity in bad times. This is
a necessary condition for the public sector to provide a
buffer function, muting the consequences of business cy-
cle fl uctuations for private actors. This condition has not
been fulfi lled for most OECD countries.
For the OECD as a whole there has been an upward trend
in gross government debt (see Figure 2). In the 1970s and
1980s public debt increased, and in the two decades be-
fore the fi nancial crisis, the debt level remained fairly con-
stant at a level around 75% of GDP. It is particularly note-
worthy that public debt levels were not reduced over this
period in spite of rather favourable economic develop-
automatic stabilisers have been weakened.6
Somewhat
paradoxically, automatic stabilisers have been praised
at the aggregate level but disregarded at the micro level
in relation to structural reforms. Accordingly, it is an im-
portant policy question how automatic stabilisers can be
maintained and possibly strengthened without jeopard-
ising economic performance. Is this at all possible or is
there an inevitable confl ict?
Policy Errors
A precondition for well-functioning automatic stabilisers
is a prudent fi scal policy ensuring consolidation in good
times to create absorption capacity in bad times. This is
a necessary condition for the public sector to provide a
buffer function, muting the consequences of business cy-
cle fl uctuations for private actors. This condition has not
been fulfi lled for most OECD countries.
For the OECD as a whole there has been an upward trend
in gross government debt (see Figure 2). In the 1970s and
1980s public debt increased, and in the two decades be-
fore the fi nancial crisis, the debt level remained fairly con-
stant at a level around 75% of GDP. It is particularly note-
worthy that public debt levels were not reduced over this
period in spite of rather favourable economic develop. ment in a number of countries. Due to increased budget
defi cits and falling GDP levels, the fi nancial crisis has led
to further increases in the debt ratio.
The upward trend in public debt refl ects an asymmetry
in public fi nances. Budget defi cits and increasing debts
have been allowed in bad times, but in good times similar
budget surpluses have not consolidated public fi nances.
Public fi nances thus display a tendency to defi cit bias;
that is, defi cits are more frequent than surpluses. This re-
veals a political bias in the management of public fi nanc-
es which contributed to create a very vulnerable situation
prior to the fi nancial crisis.
This point is underscored by considering debt levels be-
fore the crisis (2007) and subsequent developments for
separate OECD countries (see Figure 3). The debt level
was already high before the crisis for a number of rea-
sons, and the crisis has increased it, in some cases to
critically high levels. There are two notable exceptions
to this, namely Ireland and Iceland, where the debt lev-
els were relatively low before the onset of the crisis. For
these two countries, a large part of the debt increase is
explained by direct support to the fi nancial sector (for Ire-
land this corresponds to an increase in the debt level by
42 percentage points and for Iceland by 13 percentage
points). For most countries the major reason for the in-
crease in the debt ratio is the fall in economic activity.
Somewhat
paradoxically, automatic stabilisers have been praised
at the aggregate level but disregarded at the micro level
in relation to structural reforms. Accordingly, it is an im-
portant policy question how automatic stabilisers can be
maintained and possibly strengthened without jeopard-
ising economic performance. Is this at all possible or is
there an inevitable confl ict?
Policy Errors
A precondition for well-functioning automatic stabilisers
is a prudent fi scal policy ensuring consolidation in good
times to create absorption capacity in bad times. This is
a necessary condition for the public sector to provide a
buffer function, muting the consequences of business cy-
cle fl uctuations for private actors. This condition has not
been fulfi lled for most OECD countries.
For the OECD as a whole there has been an upward trend
in gross government debt (see Figure 2). In the 1970s and
1980s public debt increased, and in the two decades be-
fore the fi nancial crisis, the debt level remained fairly con-
stant at a level around 75% of GDP. It is particularly note-
worthy that public debt levels were not reduced over this
period in spite of rather favourable economic develop. ment in a number of countries. Due to increased budget
defi cits and falling GDP levels, the fi nancial crisis has led
to further increases in the debt ratio.
The upward trend in public debt refl ects an asymmetry
in public fi nances. Budget defi cits and increasing debts
have been allowed in bad times, but in good times similar
budget surpluses have not consolidated public fi nances.
Public fi nances thus display a tendency to defi cit bias;
that is, defi cits are more frequent than surpluses. This re-
veals a political bias in the management of public fi nanc-
es which contributed to create a very vulnerable situation
prior to the fi nancial crisis.
This point is underscored by considering debt levels be-
fore the crisis (2007) and subsequent developments for
separate OECD countries (see Figure 3). The debt level
was already high before the crisis for a number of rea-
sons, and the crisis has increased it, in some cases to
critically high levels. There are two notable exceptions
to this, namely Ireland and Iceland, where the debt lev-
els were relatively low before the onset of the crisis. For
these two countries, a large part of the debt increase is
explained by direct support to the fi nancial sector (for Ire-
land this corresponds to an increase in the debt level by
42 percentage points and for Iceland by 13 percentage
points). For most countries the major reason for the in-
crease in the debt ratio is the fall in economic activity.
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