Tag Archives: uk economic policy

Still waiting.

bored pugProgress is to the UK economy as words have been to my blog. Lacking. News on economic fundamentals, and the associated policy discourse, have consistently underwhelmed. Government concern remains fixed on the same, narrow goal of fiscal consolidation, with inadequate regard of how this consolidation is achieved. 2012 bears evidence to the claim that this concern is misdirected and that the derivative economic strategy is self-defeating. December has born witness to yet another downgrade in UK growth prospects and the rise of measured government debt has only been slowed by the inclusion of projected departmental underspends and the proceeds from the 4G license sales to projections. This post is a summary piece on the the state of the UK recovery and outlines the economics behind why the policies pursued to date have been unhelpful (at best).

The economy, …. 

The underlying picture remains much as it has been for the past two years: one of persistent weakness. Fifty shades of grey minus anything remotely stimulating if you will. The economy performed less strongly in 2012 than anticipated. The OBR cut its growth forecast to predict a 0.1% fall in output this year, followed by growth of 1.2% in 2013. Output is thus at roughly the same level as 2 years ago, 4% below that in 2008. This recession by now far exceeds the “Great Depression” in length. The graph below from the NIESR illustrates the point nicely.

Screen Shot 2012-12-17 at 18.27.43

It is unclear whether below par growth this year derives from “cyclical” (temporary) or “structural” (permanent) weaknesses. Cyclical weakness sits on the “demand side” of the economy– people and businesses just aren’t buying enough stuff–, whilst structural weakness is more pernicious and difficult to tackle, the result of a “supply side” contraction — we can’t make as much stuff. The two are related as cyclical weaknesses can be locked into structural ones via a process called “hysteresis” — see this post for more. There is disagreement as to how much of our current troubles to attribute to one or the other but, regardless, the OBR now forecasts systematically weaker economic growth for the coming years than it previously predicted in March.

Screen Shot 2012-12-18 at 11.00.08

Difficulties (understatement) in the Eurozone have continued to depress net exports and confidence. However, our lacklustre performance is by no means implied by the economic woes that plague Europe and other Western countries. Growth in the US and Germany has consistently dominated that achieved on these shores, and the UK pales in comparison to a host of countries in any ranking of capital investment.

And what of the lauded deficit reduction strategy? Despite (because of?) Plan A(usterity), good news isn’t forthcoming in this domain either. The size of the of the public finance hole is of a similar magnitude to that of 2011. However, even this underwhelming achievement is sullied by the knowledge that without the inclusion of funds from the one-off 4G licensing auction and the predicted “underspends” by certain government departments, the funding shortfall facing the government would have grown this year.

… stupid. 

In his Autumn statement, Osborne upped the dosage of existing prescriptions to cure the UK economy and added a few new measures to the mix. However, don’t expect a return to health soon. Policy remains inadequate and misdirected. There continues to be insufficient concern about the ends that sustainable public finances are supposed to advance. This has contributed to a lack of attention surrounding the composition of the policy mix conjured up on order to coax fiscal sustainability back to UK shores.

Just to remind ourselves, what is a budget deficit? When people talk about the deficit they are referring to the gap between what’s coming into the government coffers through taxes/other revenue sources (call this amount “T”) and what’s being spent (amount “G”).

Budget deficit = G – T

We care about the size of the budget deficit because of the impact that unsustainable public finances have on the economic prosperity of a country and the wellbeing of its citizens. It is not of value in and of itself to pursue low government borrowing (see this post for more on the cost of a deficit). Therefore, the obsession with fiscal consolidation is misguided and has resulted in a misdirected, overly narrow economic strategy. The size of the budget deficit is not the most salient economic ill plaguing the UK at present. If financial markets were overly concerned with the sustainability of the UK fiscal position, we would see interest rates rising with market risk. We have not witnessed this, the opposite in fact, suggesting that indebtedness is not the primary concern in financial markets (see this piece by Adam Posen, former MPC member, for more evidence on why reducing the debt should not be the top priority right now).

A blinding focus simply on the extent of the debt reduction required, without much regard to the how’s and why’s, has promoted a self-defeating economic strategy. The experience of the last 12 months is testament to this. Given that what we actually care about is general prosperity and wellbeing, we should aim for a deficit reduction strategy that protects these ends as far as possible. This demands a detailed analysis of the composition of spending and taxation changes, rather than just a pure focus on levels. This is because the austerity-growth dichotomy often presented in the media and by politicians is a false one. By reallocating government resources to activities with a high “fiscal multiplier” (to be explained!), growth can be supported whilst the budget deficit is reduced.

The Fiscal Multiplier

What does it mean to reallocate spending to activities with a “high multiplier”? The fiscal multiplier gives the impact that changes in government spending have on overall demand in the economy. With a multiplier of 1, an extra pound of government spending raises total demand in the economy just by a pound. However, we generally expect the size of the multiplier to be greater than 1. Imagine government spending is increased by £1. This additional £1 then represents income for someone that can be spent. Let households spend a fraction c of their income. c is defined as the “marginal propensity to consume”. This extra c of spending then represents income for someone else…..who spends c of it….and so on. Thus, one can think of the total increase in demand leading from the £1 of government spending as

1 + c + c+ c3 + …

Therefore, there can be a more than proportionate increase in demand for an increase in government spending.

The actual size of fiscal multipliers is difficult to measure but a moment’s thought suggests they will vary across government activities. The introduction above was clearly overly simplified; there is not one fiscal multiplier but a set of them associated with different government programmes. Resources should be shifted to high multiplier activities and the burden of cuts should be disproportionately concentrated on those with low propensities to consume. To illustrate, imagine a balanced budget policy, that simply takes income from one group in society and transfers it to another. Although fiscally neutral, the policy will boost growth if spending rises by more among the recipients than it falls among the funders. This will be the case if the marginal propensity to consume is higher among the recipients. This helps to highlight that through redesigning the austerity strategy to shift resources to high multiplier groups and activities, growth can be stimulated, and output protected, without a need to increase the debt burden.

The Autumn statement flirted with this principle by earmarking funds for capital spending and investment. These are potentially “high multiplier” activities given the employment and productive projects they facilitate. However, the scale of proposed new capital spending is insufficient. £5bn over the next two years. An amount that, at best, is expected to add 0.1% to GDP. Not exactly pushing the boat out… Secondly, and more importantly, the funding source for the proposed investments has the potential to undermine their (already small) impact. Cuts to welfare and tax credits will be used to fund these measures. However, such cuts will have a significant negative impact on demand in the economy given that they fall on those at the lower end of the income distribution. Such households tend to have a high marginal propensity to consume and little way of smoothing their spending. Therefore, the policy is largely funded by those who’s incomes the government should really be trying to protect if it is to be true to a multiplier guided philosophy. (Note that this is before any equity based arguments are even considered.)

A new voice

“For last year’s words belong to last year’s language

And next year’s words await another voice.

And to make an end is to make a beginning.”

— T. S. Eliot

In the next few weeks, I will write a number of more targeted posts on specific policy proposals and Eurozone developments. However, hopefully this post will have equipped you with some background knowledge on the economy and convinced you that a significant shift in economic strategy and dialogue is required in the UK. The singular focus on austerity has been self-defeating and has contributed to the prolonging the country’s economic woes. We’re long overdue a change in vision and vocabulary. The Autumn statement highlighted some appreciation of the arguments laid out here. In 2013, the government must go further to nurse the economy back to health.

Cameron & Osborne: Pursuers of Contradictory, Superficial, Inadequate Policy

Or A Rant: “Why The Tories Make Me Mad”

This morning David Cameron gave a speech on the Tory perception of, and reaction to, the riots of last week. On Sunday, George Osborne in an interview stated his intent to remove the 50p top rate of income tax. Cameron explicitly denied a link between the riots and issues of poverty and social deprivation. Therefore, his policy proposals fall short of the mark and fail to engage with the deeper underlying issues. Osborne’s interview confirms that the Tories have not got their head around the fact that economic policy must reflect equity, as well as efficiency. Neither have recognised that their positions are inconsistent. On the one hand, Cameron pushes the importance of work to the fore, while Osborne continues to pursue policies which are sure to intensify and prolong our unemployment problem. Neither of their contradictory positions adequately engages with the real problems in UK society and judging recovery by reference to bond yields rather than the employment prospects and living conditions of normal people reveals a lack of concern for, and understanding of, the problems faced by many social groups in Britain.

Since the rioting and looting died down toward the end of last week, we have seen a flurry of explanations put forward for the chaos. I argued that it is lazy to blame the riots on The Cuts. I stand by this but don’t think I made it clear why this position is ‘lazy’. Blaming the chaos on current austerity measures deflects attention from the bigger, deeper problems which need to be dealt with.

A multiplicity of problems were ignited by opportunism and mob psychology to bring about the riots. Yet many of these problems have deprivation and lack of opportunity as a root cause. Cameron explicitly denied a link between the riots and poverty, “these riots were not about poverty”, preferring instead to put the focus on moral degradation. Although the riots may not have been intentionally bought about to express grievances about one’s material position, deprivation and lack of access to opportunity, combined with a society which places excessive value on material goods and wealth cannot be ignored as a salient contributory factor.

Cameron argues that linking the riots to poverty “insults the millions of people who, whatever the hardship, would never dream of making people suffer like this”. To say poverty, deprivation and lack of social mobility are relevant causal factors does not have to imply a one-to-one correspondence between them and looting. It also does not justify violent behaviour or have to ascribe a lack of agency to disadvantaged socioeconomic groups. Rather, it provides a context for the behaviour we have witnessed.

By failing to engage with these deeper seated problems which require us to seriously challenge the distribution of opportunity in society, Cameron’s policies will not fundamentally change Britain. They are cheap sticky plasters: inevitable to come unstuck, without even doing a good job in the first place. I quote from his speech today: “First and foremost, we need a security fight-back”. This prescription does not tackle the underlying problems. Why is there a need for such prominent policing? Why the sense of frustration and alienation? One cannot ignore the resentment created by being marginalised from real opportunity or the issues which arise when a good assessment of your life prospects is “Nil/Poor” or “Going Nowhere”. Cameron asks: “Is it any wonder that many people don’t feel they have a stake in their community?” but then goes on to explain this phenomenon by referring to Big Government and Health and Safety. Are you serious?

Cameron’s focus on welfare reform and the community provides an opportunity to link his remarks to the remarks and economic policy pursued by his Chancellor. “I want us to look at toughening up the conditions for those who are out of work and receiving benefits and speeding up our efforts to get all those who can work, back to work. Work is at the heart of a responsible society.” I agree with him that work and employment are central. But the language used to describe those on benefits is patronising and demeaning. The majority of people who are unemployed and on benefits do not want to be. Most people want to work. A major problem we have at present is that of job creation. So, surely economic policy which promotes growth and reduces unemployment should be a no-brainer for the Tories at the moment? Wait, NO?

Our economic recovery continues to be underwhelming. The Bank of England and OBR have continued to downgrade predictions of growth and unemployment remains stubbornly high. A moderation of the current austerity strategy is needed and tightening needs to involve more tax rises and gentler, more targeted spending cuts as I have argued previously. Therefore, I was open-mouthed at the news that George Osborne described the government’s debt reduction plan as “on track” and also intends to abolish the 50p tax rate amid claims that charging this higher rate of tax is not raising much in revenue and “there’s not much point in having taxes which are economically inefficient”. The recovery is on track? A tax cut….for the most advantaged in society now …NOW?

Osborne describes the recovery as on track because in his eyes the UK is currently a haven for international finance. Really? This is not clear. Only today Bloomberg commented that “Britain’s allure as a haven is crumbling as global investors desert sterling amid the lowest inflation adjusted bond yields on record and a faltering economy.” Doesn’t sound too rosy to me. Secondly, his comments illuminate a larger problem. Why is the success of policy not being judged according to its impact on unemployment? On people? Sure, interest rates and financial stability are VERY important but not as ends in themselves. We should care about them because we care about people. Our recovery should be judged according to unemployment, job creation and living conditions. If concern with these figures was at the heart of current macroeconomic policy, the government would see the urgency of a policy rethink.

Not only do we need a more gradualist approach. We also need to reduce the reliance on spending cuts and shift the pain towards those who can bear it. For economic and equity reasons. The 50p tax may not bring in a whole lot of revenue but that doesn’t mean abolishing it should top the policy agenda. Just quickly, why does a higher tax rate not necessarily lead to higher revenues? A rise in tax rates will not lead to a large rise in tax revenue if they are associated with a large substitution effect. Raising tax rates reduces our incentive to work. We get less so taking time off in favour of sweet leisure time becomes less costly. With the 50p tax rate what we’re actually worried about is people leaving the country to tax havens. If these incentives are very strong then not much extra tax revenue will be raked in because people will be working so much less.

However, I do not believe that abolishing the 50p tax rate is going to lead us to take in more revenue and the fact that this is at the top of the policy agenda sends an awful message to the majority of the UK’s population. Research suggests that the amount people work once they are actually working is not very sensitive to changing tax rates and this seems to be especially true for those affected by the 50p rate, assuming they stay in the country, considering the kind of ‘service contracts’ that characterise employment relations at the top. For those that decided to leave the country in response to the change in rates, I would be extremely surprised if they decided to come back to the UK in vast swathes in response to the policy reversal especially given the poor growth prospects that lie ahead. Furthermore, the fact that the Chancellor is even talking about this serves to further distance him and the government’s economic strategy from the UK public and those who need to be re-engaged with society. Why the lack of focus on improving job prospects and income for the many at the bottom?

So there, my rant on Why The Tories Make Me Mad. An unwillingness to address wider issues which require a more concerted effort to open up channels of opportunity and address economic inequality. Judging policy success according to the welfare of financiers. Policy inflexibility that will contribute to a more protracted recession. Mad.

Deficit Bias: Why We Need to Tie Politicians’ Hands….. Loosely

A couple of people contacted me about the problem of the (lack of) credibility of government promises to cut the debt in the future. I didn’t give this issue enough space. This post should rectify that.

There are good reasons for a government to intervene in the economy during hard times to play a stabilising role. In fact, I don’t know of a theory in which one can cut government spending and raise taxes during a recession and leave output and employment unaffected. Keynes argued that market economies find it difficult to escape deep recessions and that monetary policy could only provide limited push in helping get the economy back on track. For Keynesian economists, a fiscal stimulus in the form of either higher government spending or lower taxes is a good idea during a bad recession. Actually, they’d probably say it was more than just a good idea. In fact, until the whole ‘Greek debacle’ the US and UK governments and even the IMF at times suggested that governments should play a role in recovery.

So lets just accept for the moment that there are good reasons for the government to run a budget deficit during a recession to help smooth out the dip. Then why is it that all we’re hearing at the moment is ‘Cut Cut Cut’? Why the switch from the presumption in favour of fiscal stabilisation to ‘austerity is the ONLY way’? Especially when we hear institutions like the Office for Budget Responsibility (OBR) saying that the austerity measures in the emergency budget last year would increase the risk of a double dip recession. To understand this we need to explore the concept of deficit bias. This discussion will also illuminate the motivation for creating the Office for Budget Responsibility and why both Gordon Brown and the coalition set themselves some rules over fiscal policy.

Deficit bias is basically the idea that it is difficult and painful for the government to reduce debt levels but very easy for them to say that they will in the future. In a recession a government should want to run a budget deficit to help buffer the economy against the storm. Then when times are ‘good’, the government should act to reduce the deficit. The stabilising has been done then. However, in these good times, tax rises and spending cuts are going to remain unpopular. Politicians don’t want to turn round with a smile to their voters and say “Right now everyone, its time for those taxes rises!”. Much easier to just ignore the whole debt problem. This leads to rising debt to GDP ratios. We observe this in reality. For example, among OECD countries levels of debt relative to GDP roughly doubled in the 30 years leading up to the recession for no good reason.

From my first post, you should (hopefully!) know that very high debt levels are to be avoided. There are costs. Investors start getting hot under the collar. This is why there are calls for austerity measures now. If the government could promise to put in place measures to bring debt levels down once the economy is out of the woods then we wouldn’t see the same budget as was presented earlier this year. The government faces a commitment problem. It would be best for everyone if Os-terity Osborne committed to reducing the deficit in the future. But this commitment isn’t deemed credible. So, they say, we must reduce the deficit now. In the middle of the deepest recession since the 1930s. Brilliant. We need someway of tying the government’s hands so they do actually cut the debt in the future, thereby allowing them to help us out now.

Luckily for us there are ways to mitigate this commitment problem, allowing for less cut throat austerity measures right now. I believe that the UK government needs to slow down in its mission to reduce the deficit. I am basically calling for the government to put its hands up and say ‘look guys, I’m going to mainly cut later….only a bit now’. Setting up the OBR and putting in place the new fiscal rules helps the UK government solve its commitment problem, making a promise to get the debt under control when things get less crazy more believable.

The OBR is an independent forecasting body, giving predictions of future growth and employment, assessing the plausibility of the figures which lie behind the government’s plans and evaluating the likelihood of the government meeting its self-imposed targets. Although not under its mandate at the moment, there have been calls for the OBR to also comment on the desirability of plans for deficit reduction and the like. Setting the OBR up in itself sends quite a clear message to investors that the government is serious about fiscal discipline. I mean, its called the Office for Budget Responsibility! The government could use the fact that the OBR forecasts and figures are independently calculated to build a bit of wiggle room into policy. Austerity measures could be staggered and implemented conditional on the speed of recovery and there could be no worry that figures were cooked to let the government off the hook.

Further, the government set itself two fiscal targets when it came into power: (1) to balance the budget 5 years ahead and (2) to have net debt falling by 2015-16. As we saw with the last Labour government, the fact that rules are stated doesn’t mean that they will be followed (that credibility problem again) but the fact that the OBR independently assesses the likelihood of these targets being reached reduces that risk.

Therefore, it seems to me a little odd that we are following the ‘Only-Way-Is-Austerity’ strategy at the same time as setting up an independent body that should allow us to slow the pace of cuts.

Let me ask you now, have I missed something?!

Gallery

UK Deficit 101: Explaining the Malady and Medicine

Oh hearing those fateful words: “Wait, you’re an economist! So what’s the deal on…..”.  I shudder at the memories. This blog is in response to a couple of people who’ve recently asked me to explain the background to some of … Continue reading