As the UK general campaign gets underway politicians have
been falling over themselves to demonstrate their willingness to spend what
sound like huge amounts of money in order to revamp the economic infrastructure.
From my standpoint, as one who has been severely critical of the government’s
fiscal stance over the past nine years, an opening of the fiscal taps is welcome.
But numerous people have asked me how a Conservative government that has made
such a big deal of economic austerity, can suddenly switch from fiscal famine
to feast. It’s a fair question and the answer is quite simply because the Tories
realise that it is a popular idea whose time has come.
Common ground as both parties seek to ease fiscal policy
Dealing first with the details, the Conservatives have ripped up their old fiscal rulebook in order to allow them to spend an additional £22bn (1% of GDP) per year. The Labour Party, which in 2017 campaigned on a platform of much higher spending, is committed to a plan that envisages an additional £55bn (2.5% of GDP) per year. Neither party will therefore abide by the current fiscal mandate designed to limit borrowing to 2% of GDP by 2020-21. The current framework also has two supplementary aspects: (i) to eliminate borrowing altogether by the mid-2020s (the ‘fiscal objective’) and (ii) that net debt should be falling as a share of GDP by 2020-21 (the ‘supplementary target’).
The fiscal objective is a non-starter and the supplementary target will also be blown out of the water. To a large extent, the fiscal objectives had been blown off course anyway by changes to the treatment of student loans in the national accounts, which raised borrowing by around 0.5% of GDP. But on the basis of my preliminary calculations, even a modest additional £20bn per year of public investment will raise the deficit ratio to at least 3% of GDP by fiscal year 2023-24 (the March OBR projections put that figure at 0.5%).
The Chancellor Sajid Javid noted in a speech on Thursday that the Conservatives are committed to balancing the current budget on a three year horizon (i.e. excluding investment). Whilst this will leave little room for additional day-to-day spending on issues such as social care or tax cuts, this is eminently achievable on the basis of my estimates. But calculations reported in the FT suggest that the Chancellor only has around £7bn of headroom on his current spending plans, which essentially rules out big tax cuts such as Boris Johnson’s promise to raise the threshold for higher rate taxpayers.
One of the reasons the Conservatives have changed tack is that ongoing fiscal austerity is not politically popular and they risk being outflanked by Labour. I will deal with the specifics of the Labour proposals another time but essentially they involve a "social transformation fund" which would spend around £30bn per year on upgrading the social infrastructure (schools, hospitals, social care facilities and council homes) and a "green transformation fund" spending around £25bn a year on areas such as energy and transport and insulating existing homes. Labour also remains committed to a National Investment Bank in order to manage the disbursement of funds. This is not a bad idea and I looked at some of the specifics of this policy in the run-up to the 2017 election (here).
But it will not come cheap
The big question is how all this will be funded and the obvious answer is that it will require a huge increase in borrowing. Whilst it does make sense to loosen the purse strings at a time when interest rates are at all-time lows a huge increase in borrowing could actually force bond yields up, particularly if the UK is outside the EU which might raise the risk premium on debt anyway. Moreover, given the market’s scepticism towards Labour’s plans, particularly on tax, it is unlikely they will be able to fund the plans at anything like current market rates. In the event that a Labour government is elected (unlikely, but you never know) my guess is that they will not be able to enact a fiscal expansion on this scale. Recall that Francois Mitterrand’s victory in the French Presidential election of 1981 on a platform of nationalisations, wealth taxes and a wage increase was followed by a swift U-turn two years later as economic orthodoxy was restored.
... and international investors may get cold feet
The outbreak of fiscal largesse was accompanied yesterday by Moody’s downgrade to the UK’s credit outlook. My initial reaction to this was “so what.” As I have long pointed out, it is incongruous that the UK should have a lower credit rating than Germany when the UK issues debt in a currency which it controls but Germany does not. Sovereign credit events tend to occur when countries issue debt in foreign currency and run out of the necessary funds to repay creditors. Whoever is in office after the election, this is not a problem the UK will have to worry about.
But on closer inspection, Moody’s statement provided a damning indictment of the institutional framework: “The increasing inertia and, at times, paralysis that has characterised the Brexit-era policymaking process has illustrated how the capability and predictability that has traditionally distinguished the UK’s institutional framework has diminished … This broad erosion in the predictability and cohesion of policymaking is mirrored in areas of policy that are significant from a credit perspective. Most importantly, the UK’s broad fiscal framework characterized by features such as multi-year budget plans and more detailed revenue and spending decisions … has weakened.”
Politicians of all stripes want to play fast and loose with the institutional framework. Let us not forget that last year Labour wanted to expand the role of the BoE to target UK productivity growth – a ridiculous strategy if ever there was one. But since the Tories have been in office during the last three years, they deserve most of the blame for the Brexit-related policy debacle by trying to ride roughshod over parliament. From an economic policy perspective, the fiscal and monetary frameworks devised in recent years have done much to improve the transparency of policy and prevent governments from twisting it to meet their political needs. If Brexit is about a political return to the 1970s, governments seem to be doing their best to ensure a return to 1970s policy ad hocery – and we all know how that turned out.
Common ground as both parties seek to ease fiscal policy
Dealing first with the details, the Conservatives have ripped up their old fiscal rulebook in order to allow them to spend an additional £22bn (1% of GDP) per year. The Labour Party, which in 2017 campaigned on a platform of much higher spending, is committed to a plan that envisages an additional £55bn (2.5% of GDP) per year. Neither party will therefore abide by the current fiscal mandate designed to limit borrowing to 2% of GDP by 2020-21. The current framework also has two supplementary aspects: (i) to eliminate borrowing altogether by the mid-2020s (the ‘fiscal objective’) and (ii) that net debt should be falling as a share of GDP by 2020-21 (the ‘supplementary target’).
The fiscal objective is a non-starter and the supplementary target will also be blown out of the water. To a large extent, the fiscal objectives had been blown off course anyway by changes to the treatment of student loans in the national accounts, which raised borrowing by around 0.5% of GDP. But on the basis of my preliminary calculations, even a modest additional £20bn per year of public investment will raise the deficit ratio to at least 3% of GDP by fiscal year 2023-24 (the March OBR projections put that figure at 0.5%).
The Chancellor Sajid Javid noted in a speech on Thursday that the Conservatives are committed to balancing the current budget on a three year horizon (i.e. excluding investment). Whilst this will leave little room for additional day-to-day spending on issues such as social care or tax cuts, this is eminently achievable on the basis of my estimates. But calculations reported in the FT suggest that the Chancellor only has around £7bn of headroom on his current spending plans, which essentially rules out big tax cuts such as Boris Johnson’s promise to raise the threshold for higher rate taxpayers.
One of the reasons the Conservatives have changed tack is that ongoing fiscal austerity is not politically popular and they risk being outflanked by Labour. I will deal with the specifics of the Labour proposals another time but essentially they involve a "social transformation fund" which would spend around £30bn per year on upgrading the social infrastructure (schools, hospitals, social care facilities and council homes) and a "green transformation fund" spending around £25bn a year on areas such as energy and transport and insulating existing homes. Labour also remains committed to a National Investment Bank in order to manage the disbursement of funds. This is not a bad idea and I looked at some of the specifics of this policy in the run-up to the 2017 election (here).
But it will not come cheap
The big question is how all this will be funded and the obvious answer is that it will require a huge increase in borrowing. Whilst it does make sense to loosen the purse strings at a time when interest rates are at all-time lows a huge increase in borrowing could actually force bond yields up, particularly if the UK is outside the EU which might raise the risk premium on debt anyway. Moreover, given the market’s scepticism towards Labour’s plans, particularly on tax, it is unlikely they will be able to fund the plans at anything like current market rates. In the event that a Labour government is elected (unlikely, but you never know) my guess is that they will not be able to enact a fiscal expansion on this scale. Recall that Francois Mitterrand’s victory in the French Presidential election of 1981 on a platform of nationalisations, wealth taxes and a wage increase was followed by a swift U-turn two years later as economic orthodoxy was restored.
... and international investors may get cold feet
The outbreak of fiscal largesse was accompanied yesterday by Moody’s downgrade to the UK’s credit outlook. My initial reaction to this was “so what.” As I have long pointed out, it is incongruous that the UK should have a lower credit rating than Germany when the UK issues debt in a currency which it controls but Germany does not. Sovereign credit events tend to occur when countries issue debt in foreign currency and run out of the necessary funds to repay creditors. Whoever is in office after the election, this is not a problem the UK will have to worry about.
But on closer inspection, Moody’s statement provided a damning indictment of the institutional framework: “The increasing inertia and, at times, paralysis that has characterised the Brexit-era policymaking process has illustrated how the capability and predictability that has traditionally distinguished the UK’s institutional framework has diminished … This broad erosion in the predictability and cohesion of policymaking is mirrored in areas of policy that are significant from a credit perspective. Most importantly, the UK’s broad fiscal framework characterized by features such as multi-year budget plans and more detailed revenue and spending decisions … has weakened.”
Politicians of all stripes want to play fast and loose with the institutional framework. Let us not forget that last year Labour wanted to expand the role of the BoE to target UK productivity growth – a ridiculous strategy if ever there was one. But since the Tories have been in office during the last three years, they deserve most of the blame for the Brexit-related policy debacle by trying to ride roughshod over parliament. From an economic policy perspective, the fiscal and monetary frameworks devised in recent years have done much to improve the transparency of policy and prevent governments from twisting it to meet their political needs. If Brexit is about a political return to the 1970s, governments seem to be doing their best to ensure a return to 1970s policy ad hocery – and we all know how that turned out.
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