Fiscal constraints are mainly political

With days to go before the government unveils its Autumn Budget, the newspapers are full of the various wheezes that the Chancellor might adopt in order to keep borrowing down whilst simultaneously addressing the key areas that fiscal policy is expected to tackle. As if the economics were not daunting enough, the Chancellor is unpopular amongst large swathes of his party who view his calls for a soft Brexit as a form of heresy. Indeed, were it not for the fact that the Conservatives were decisively weakened at last June’s election, the generally accepted narrative is that Philip Hammond would have been sacked in the summer – partly for Brexit-related reasons but also because of his bungled handling of the proposed rise in national insurance contributions for the self-employed in March.

Hammond’s task is unenviable. The Conservatives are looking to him to provide a fillip to a government which is struggling to regain momentum, but if he gets it wrong his political stock will fall further. The three key areas which he is expected to address are austerity, the thorny subject of public sector pay and a lack of housebuilding. In effect, the latter two are branches of the first and go to the heart of the government’s strategy over the last seven years. Over this period, total government spending has fallen by more than 5 percentage points of GDP – there has not been a squeeze like it since the early-1990s, and even that reflected the rapid pace of nominal GDP growth.

But there is an increasing sense that public sector services are struggling to cope. Although the NHS has been ring-fenced from the worst of the cuts, outlays are not rising fast enough to cope with the changing composition of the population; concerns are mounting about the lack of funding for the police and fire brigade (something I touched on here) and education remains a major bugbear for all political parties. In addition, the squeeze on public sector pay, which was frozen for two years in 2010 and has been capped at 1% per year since 2013, has demoralised staff morale and evoked sympathy from the British public which is generally supportive of the public sector workers on which it relies. Meanwhile, there have been calls for additional borrowing to fund a public sector housebuilding programme to alleviate shortages, and reforms to a university student funding model which requires them to load up on debt now and pay it back over a period of 30 years.

All of this is taking place against a backdrop of a plan to broadly balance the budget by 2022 (although the Conservatives admitted in their election manifesto that it is unlikely to happen before the mid-2020s); the UK’s poor productivity performance – likely to be revised down by the OBR on Wednesday – which will increase the fiscal headwinds, and Brexit. Not only is Hammond’s task unenviable – it is frankly unachievable under current circumstances. Up to now, he has operated within the constraints set by previous Chancellor George Osborne, whose mantra of deficit reduction at all costs was misguided (as I never tire of pointing out). But now he has the opportunity to redefine the fiscal agenda.

First and foremost, the balanced budget agenda should be ditched for it serves no useful economic purpose. Moreover, the nonsense of talking about fiscal aggregates in monetary terms should be downgraded. The howls of tabloid outrage every time a figure in the millions – or even billions – is discussed should be set against the fact that the value of economic output is in the trillions. Furthermore, if the government is concerned about how the market perceives fiscal credibility, the focus should be on debt and not so much the fiscal balance. In simplistic terms the debt-to-GDP can fall, even in the presence of a small primary deficit, so long as the rate of nominal GDP growth is higher than the interest rate on debt. Admittedly, the government has more work to do here as it struggles to stabilise the debt ratio which, on the standard Maastricht criteria basis, is just shy of 90%. But the rate of increase has slowed and debt stabilisation is possible in the next year or so.

There is certainly no sign that the debt market is concerned about UK public finances which, let us not forget, show the deficit-to-GDP ratio just above 2% compared with almost 10% in fiscal 2009-10. Indeed, the interest rate on the benchmark 10-year gilt is currently at an unprecedented 1.3%. There is thus scope to loosen the purse strings a little. I further maintain that the plan to cut the corporate tax rate from 20% today to 17% by 2020 puts an unnecessary hole in the budget balance which could alleviate the strain on critical public services (it is estimated to cost just over £7bn in lost revenues).

A bit of fiscal largesse might go some way towards lifting the gloomy national mood which is reflected in our polarised society (rich against poor; young against old; Leavers against Remainers). Brexit will also change the calculations. Contrary to what the Leavers told us, any fiscal savings from leaving the EU will likely be more than swamped by the long-term impact on revenues resulting from slower growth. I suspect the Chancellor knows this but given the political constraints imposed by his own party, there is little he can do about it.