Not what it said on the tin

As I have noted many times before, UK budgets are a strange mixture of policy announcements and pantomime and they exist in their present form purely for reasons of tradition. Once upon a time they were put together behind closed doors with ministers sworn to secrecy in case any of the details leaked out. Back in 1947 Chancellor of the Exchequer Hugh Dalton resigned after an off-the-cuff remark which hinted at forthcoming tax changes. But the era of ‘Budget Purdah’ is no more: We have been bombarded with news of what was likely to be in the autumn budget for weeks as the process morphs from a one-off event to a rolling news story. Indeed, the Speaker of the House of Commons expressed concerns that budget measures were leaked to the press before being announced in the House of Commons, which is a breach of protocol. The Deputy Speaker who presided over proceedings on Wednesday welcomed Chancellor Rishi Sunak to the Despatch Box with the pithy comment that she looked forward to the “remainder of your announcements.”

This does not mean that the process of digesting the information is any easier. The government’s 2021 budget was accompanied by the usual 192 page Budget Redbook, which this year also contained details of the Spending Review, whilst the OBR put out its regular 244 page Economic and Fiscal Outlook. Once we factor in the plethora of supporting documentation, it is clear that there is a huge quantity of material to digest. You can thus be sure that a serious amount of work has gone into the impressive overnight summaries produced by think tanks and the detailed analysis conducted by the quality press.

There are essentially three things to focus on in this year’s budget analysis: (i) what are the economic assumptions underpinning the budget; (ii) what fiscal measures has the government announced and (iii) how big is the spending envelope within which government departments have to work? These allow us to form an overall impression of the fiscal stance: The bottom line is that the projected outturns do not square with the message which the Chancellor has tried to put over. In short, living standards are likely to improve much more slowly than in the recent past; we are all going to be paying more taxes and the voracious health sector will continue to gobble up an increasing proportion of the nation’s resources. If the low tax, small state policies of Margaret Thatcher have long since been buried, this latest budget represents a dance on their grave.

The state of the economy

One of the defining features of the economic forecast is that real output is projected to get back to its pre-pandemic level by end-2021 which is slightly earlier than in the March projection and far sooner than anticipated last year. The OBR also reduced its estimate of the impact of the pandemic and now anticipates a permanent output loss of 2% (this was projected at 3% in March). However, it reckons that Brexit will lead to a permanent output loss of 4% in the longer-term. For all the concerns about the economics of the pandemic, it is Brexit that will inflict the most long-term damage. Obviously the pandemic feels like a big deal because the economic impacts are compressed into a relatively short time frame. Moreover the wider social costs are incalculable (140,000-plus deaths and counting) but much of the economic damage will be recouped quickly.

In many other ways the economy is predicted to quickly resume its pre-pandemic state with the unemployment rate on a two year horizon projected to fall to 4.2% – close to pre-2020 levels. One thing we will have to get used to is higher inflation, which the OBR forecasts will peak around 4.4% in the second quarter of 2022 – more than twice the BoE’s target rate – with risks tilted to the upside. Whilst this will squeeze real household incomes it will also inflate the tax base which will support tax revenues. All in all, there is not much to get excited about in the macro forecast. There are always areas for discussion but on the whole it seems a solid enough assessment. The real areas of disagreement lie in the fiscal detail.

The fiscal measures

The biggest single giveaway represented changes to Universal Credit designed to provide a boost to low earners (a £3bn giveaway over five years). This was welcome following the announcement last month that the temporary uplift to welfare payments during the pandemic was to be scrapped. In response to the storm of criticism that followed this decision, the Chancellor announced that the taper rate at which benefits are phased out as claimants transition back into employment is to be lowered. This was previously set at 63%, meaning that above a certain income threshold claimants lose 63p of every pound of benefit they receive, implying a very high marginal tax rate. This is to be reduced to 55% and is a move I have been advocating for a long time. However, as the Resolution Foundation points out, this is “not sufficient to compensate most UC recipients for the loss of the £20 a week uplift introduced at the start of the pandemic.”

Looking down the list of items, the next biggest giveaway was a further freeze on fuel duties (£1.6bn) – somewhat ironic given next week’s COP26 Summit at which the UK is hoping to take credit for brokering a global climate deal. Sunak also announced a 50% reduction in domestic Air Passenger Duty in order to “bolster UK air connectivity” which is similarly incongruous.

The spending envelope

The good news is that almost all departments will receive an increase in their day-to-day budgets over the period to fiscal 2024-25. The bad news is that in real terms many departmental budgets will remain below the levels prevailing when the Conservatives came to office in 2010. The era of austerity may be over but not by enough to overcome the damage done in the decade prior to the pandemic. One of the lessons we have learned the hard way is that spending on health is important and that it was underfunded prior to 2020. Thus spending on health and social care is projected to be over 40% higher in real terms by 2024-25 than in 2009-10. However, spending by the Department of Transport will be 32% lower in real terms and the Ministry of Justice will suffer a 12% cut (chart below). Sunak made great play of the fact that “the health capital budget will be the largest since 2010” and that the budget “will restore per pupil funding to 2010 levels in real terms.” Yet it is hardly a great boast that spending levels are to be restored to levels prevailing when the Tories took office 11 years ago, and calls into question what was achieved by the years of austerity.

What to make of it all

By common consensus this was a high tax and spend budget. It marks a seismic shift in the fiscal philosophy of a Conservative Party that has extolled the virtues of a small state and lower taxes for the last 40 years. Sunak’s goal may be to reduce taxes, as he told us in his budget speech, but in reality the overall tax burden is set to rise to its highest in 70 years. In some ways this is an inevitable response to the challenge posed by the pandemic. 

In his parliamentary speech Sunak outlined his old-style Tory leanings: “Do we want to live in a country where the response to every question is: “what is the government going to do about it”? Or do we choose to recognise that Government has limits.” The truth is that many people do want more government – or at least, they don’t want less. For a start they want some return on the large slice of income that they hand over in taxes. Furthermore the pandemic has highlighted the importance of having government act as a backstop (ditto the GFC of 2008-09). 

Sunak is an intelligent man and I am sure he knows this. The thought therefore persists that the budget was in part a job application to the Tory faithful in the event that they tire of Boris Johnson as leader, whilst simultaneously following Johnson’s requirement to shower the electorate with money. In the end all budgets come down to politics but this one perhaps more so than usual.

No expectations

Inflation remains one of the big items on the policy agenda with the IMF’s latest World Economic Outlook devoting a considerable amount of space to the topic, warning that “central banks should remain vigilant about the possible inflationary effects of recent monetary expansions.” In fairness the IMF does use the stock phrase beloved of policy analysts that “long-term inflation expectations have stayed relatively anchored.” However this comes at a time when parts of the macroeconomics profession are beginning to question just how much we really know about the inflation generation process, with the role of expectations coming under particular scrutiny.

Like many areas of economics the forces underpinning inflation have been subject to various fads over the years. Between the 1950s and 1970s, attention focused on the labour market and the role of the wage bargaining process. During the 1980s monetary trends were the flavour of the period but over the last 25 years the main area of focus has been the deviation of output from the NAIRU and the determination of inflationary expectations. Given the change in fashions over the years, it is difficult to take seriously the idea that there is a generic theory of inflation: like theories of the exchange rate, different factors drive the process at different times.

For my part, I have long harboured doubts about the way macroeconomics treats inflation (see the posts Do we know what drives inflation? from August 2017 and Monetary policy complications from October 2017 for more detail). It was thus heartening to see that economists at the Federal Reserve share similar reservations. In a highly readable paper published last month, which received considerable media exposure, Jeremy Rudd of the Fed staff posed the question ‘Why do we think that inflation expectations matter for inflation? (and should we?)’

As the paper’s abstract noted, “A review of the relevant theoretical and empirical literature suggests that this belief [in expectations] rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.” Rudd goes on to describe competing models of inflation used by macroeconomists over the past 50 years and concludes that the use of expectations to explain inflation dynamics is both unnecessary and unsound. In his view it is unnecessary because it can be explained more readily by other factors and unsound because it is not based on any good theoretical and empirical evidence. Moreover, the theoretical models are influenced by short-term (usually one period ahead) expectations, which “sits uneasily with the observation that in policy circles … much more attention is paid to long-run inflation expectations.”

The empirical evidence suggests little evidence of a direct effect of expectations on inflation. According to Blinder et all (1998)[1], “what little we know about firms’ price-setting behavior suggests that many tend to respond to cost increases only when they actually show up and are visible to their customers, rather than in a pre-emptive fashion.” Evidence from the Atlanta Fed survey of business inflation expectations over the past decade confirms that expectations have been remarkably constant until relatively recently with unit costs one year ahead generally expected to grow at an average rate of 2% (chart). However, it is notable that during 2021 there has been a sharp pickup as the economy suffered bottlenecks in the wake of the pandemic.

The standard central bank view of inflation expectations was highlighted in a 2019 speech by BoE MPC member Silvana Tenreyro. It is a perfectly fine piece of conventional economic analysis as befits an orthodox central bank economist. She noted that household inflation expectations are a key input into the BoE’s thinking, arguing that for any given interest rate, higher inflation expectations increase households’ incentive to spend today rather than saving. But once you start digging below the surface, the argument rests on some weak foundations. For example, the evidence from both the US and UK suggests that households consistently expect CPI inflation to average close to 3% at horizons of between one and five years ahead. In other words, despite the best efforts of central banks, households continue to expect inflation to run above their target rate. Tenreyro was also forced to concede that “households do not always adjust their expectations even when prices start rising more quickly or slowly than they had expected” which really ought to raise some questions about their usefulness.

A more serious criticism of inflation expectations came from Rudd who pointed out that “the presence of expected inflation in these models provides essentially the only justification for the widespread view that expectations actually do influence inflation … And this apotheosis has occurred with minimal direct evidence, next-to-no examination of alternatives that might do a similar job fitting the available facts, and zero introspection as to whether it makes sense.” Instead Rudd offers the explanation that the absence of a wage-price spiral is one of the key defining features of recent inflation dynamics. He goes on to suggest that “in situations where inflation is relatively low on average, it also seems likely that there will be less of a concern on workers’ part about changes in the cost of living … But this is a story about outcomes, not expectations.” In other words, when inflation is below a certain threshold level workers stop pushing for bigger wage hikes which has contributed to keeping inflation low – unlike in the 1970s.

This has a number of important policy implications:

• First, it will be important to keep an eye on whether wage settlements are responding to higher price inflation. 
• Second, because central bank economists, who are influenced by latest academic thinking, generally tell policymakers that “expected inflation is the ultimate determinant of inflation’s long-run trend, [they] implicitly provide too much assurance that this claim is settled fact. Advice along these lines also naturally biases policymakers toward being overly concerned with expectations management, or toward concluding that survey- or market-based measures of expected inflation provide useful and reliable policy.” 
• Third, precisely because inflation dynamics are influenced more by outcomes than expectations, “it is far more useful to ensure that inflation remains off of people’s radar screens than it would be to attempt to “reanchor” expected inflation.” 
• Finally, “using inflation expectations as a policy instrument or intermediate target has the result of adding a new unobservable to the mix. And … policies that rely too heavily on unobservables can often end in tears.”
  

Even if you do not accept Rudd’s premise (and many mainstream economists do not) this is an important contribution to the debate. One of the criticisms being bandied around as the economy rebounds from the 2020 collapse is that there is insufficient diversity of thinking around some of the key underpinnings of mainstream macro. If nothing else, Rudd forces us to think more critically about how we think of inflation and our understanding will be all the stronger for it.

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[1] Blinder, A., E. Canetti, D. Lebow, and J. Rudd (1998). ‘Asking About Prices: A New Approach to Understanding Price Stickiness’. New York: Russell Sage Foundation.

Hiding in plain sight

They say that if you are going to lie then you might as well lie big by distorting the truth in plain sight, and by so much that people cannot possibly credit that what you are saying is false. Yet when it comes to the economics of Brexit, that is exactly what is happening. All the downsides that the government was warned about are not perceived as problems: They are now being sold as features of the new system as the economy transforms from one model to another. You have to hand it to Boris Johnson for being able to deliver his closing message at this week’s Conservative Party conference with a straight face. Indeed, I have to regularly check the calendar to make sure that it is not 1 April because the British electorate are now being taken for fools.

As a former journalist, Johnson is without a doubt a great wordsmith as his conference address demonstrated. But a journalist is meant to engage in a modicum of factual reporting: Johnson’s journalism career as a reporter from Brussels was more akin to a purveyor of fiction. His speeches as prime minister are often no different. To quote the blond bombshell himself, “after decades of drift and dither this reforming government, this can-do government, this government that got Brexit done … [is] dealing with the biggest underlying issues of our economy and society, the problems that no government has had the guts to tackle before, and I mean the long-term structural weaknesses in the UK economy.” I don’t want to be overly pedantic but the Conservative Party has held office for 29 of the last 42 years (almost 70% of the span since 1979). If there has been “drift and dither” surely they have to take some responsibility for that?

To quote Johnson further, “we are not going back to the same old broken model with low wages, low growth, low skills and low productivity, all of it enabled and assisted by uncontrolled immigration.” That is an astonishing statement – and it is wrong. The evidence suggests that economic migrants tend to be better educated than the host population. In 2016 the Rand Corporation reported that “In England and Wales, for example, 23% of the working-age, native-born population has no qualifications. This compares with only 13% of migrants from [EU12] countries.” Education and training should in theory show up in total factor productivity growth – the intangible factors which are external to labour and capital inputs. Reducing the education input by turning away better educated foreign workers ought to make productivity worse in the long run and there is some evidence from the official data to suggest that between mid-2018 and end-2019 TFP actually deteriorated (chart below).

Even before the conference, business was not happy about being lectured by government on how to deal with the reduced flow of EU workers upon which they have heavily relied. Simon Wolfson, CEO of Next plc and also a prominent Brexit supporter, has argued strongly that the UK needs to import labour. As he noted in a newspaper article, “the only thing Brexit decided was that the UK must determine its own immigration policy. The vote did not decide what that system should be; nor did it determine that only those on one side of the Brexit debate should have a say going forward.”

Johnson’s answer to the queues which have built up outside petrol stations is to pay tanker drivers more in order to alleviate the underlying labour shortages. You don’t have to be an economist to work out that a pay rise not backed by productivity improvements is inflationary. Perhaps we should not expect anything more serious from a prime minister who is known for his “f*** business” message (there was a lot more truth in that quote than we knew). Beneath the bluster, there is a more serious underlying point. Brexit was meant to set UK business free to connect with more rapidly growing parts of the world and liberate it from the constraints imposed by the EU. It was after all, heavily backed by the free market lobby. What the government has instead done is to impose additional red tape by raising tariff barriers with the EU where previously there were none, and is now telling business how to operate. As Johnson put it, companies must not “use immigration as an excuse for failure to invest in people, in skills and in the equipment the facilities the machinery they need to do their jobs.” It’s a message worthy of a Soviet May Day speech in Red Square.

The think tank and business community did not respond positively to the message they heard from Johnson. The free market Adam Smith Institute, which has traditionally been a supporter of the Tory agenda, described it as “bombastic but vacuous and economically illiterate ... It’s reprehensible and wrong to claim that migrants make us poorer.” The similarly free market Institute of Economic Affairs noted: “Boris Johnson’s rhetoric is always optimistic and enterprising, but insofar as there were actual policies behind it, they seemed to involve yet more state intervention and spending.” The CBI commented, “what businesses urgently need are answers to the problems they are facing in the here and now … The economic recovery is on shaky ground and if it stalls then the private sector investment and tax revenues that the prime minister wants to fuel his vision will be in short supply.”

We always have to take conference speeches with a huge pinch of salt. They are designed to appeal to the party faithful and are not a platform for delivering policy prescriptions. But even against this low benchmark, Johnson’s vision of the post-Brexit UK economy was heavy on the feelgood factor and light on the specifics of how it can be realised. But maybe this is to miss the point of what Johnson is trying to do. As the Frankfurter Allgemeine Zeitung noted, maybe he “is not striving for Thatcherism 2.0, but for an almost Rhenish capitalism, with a caring state at the top. A Tory government under Johnson no longer wants to see itself as an extension of business, but as a "people's government" that also seeks conflict with business.”

There is no doubt that in order to deal with the economic challenges which lie ahead Johnson will have to get a large slice of the electorate onside. Whilst his economic position looks very difficult today, and it is one which has felled prime ministers in the past, we should not dismiss Johnson’s ability to generate a feelgood factor when there is little to feel good about. He is a political phenomenon. Admittedly economics is not his strong point but this has never been a hindrance to those seeking high office, as the Brexit referendum showed.

The Labours of Keir Starmer

A few months ago I pondered on the fate of the centre left in Europe and suggested that it “will struggle to remain relevant unless there is a radical change of tack.” Last week’s strong showing by the SPD in the German election demonstrated the unerring (in)accuracy of my political predictions. Against that backdrop, the Labour Party in the UK held its annual conference last week, giving Keir Starmer his first opportunity as leader to speak to the party faithful in person. As with most political events these days it polarised opinion. Unfortunately for Starmer, the polarisation came from within his own party with a significant minority unable to forgive him for usurping the sainted Jeremy Corbyn who was always ever one last push away from delivering the socialist utopia that the British electorate has spent the last forty years rejecting.

It has indeed been a bleak couple of years for Labour. In December 2019 they suffered a historical election defeat, registering their lowest number of parliamentary seats since 1935. Following Corbyn’s resignation he was later suspended from the party on anti-Semitism grounds. Although he was subsequently readmitted, Corbyn remains suspended from the parliamentary party (he is not counted as a Labour MP, despite having won his seat in the 2019 election). This triggered an internecine conflict between the faction supporting Corbyn and the group of centrists backing Starmer who realise that he is Labour’s best chance of being re-elected to office. It has been an unedifying spectacle at a time when the UK has been convulsed by the pandemic and when the economic costs of Brexit are becoming more evident. This navel gazing has contributed to Starmer’s poor approval ratings, with only 20% believing him to be doing a good job compared with 59% who disapprove, whilst Labour trails by 5 points in the overall polls (chart).

Starmer inherited the leader’s mantle in April 2020 as the pandemic was taking hold, at which time the Tories had a poll lead in excess of 20 points. It is a well-worn political phenomenon that incumbents tend to enjoy a popularity surge during times of national emergency. But Labour did sufficiently well that by November 2020 it had reduced the Tories’ double digit poll lead to zero. Within six months, however, the Tories had widened their lead back out to 12 points. Obviously the vaccine bounce gave the government a boost but there was more to it than that. Starmer was open to the charge that Labour did not have clearly defined policies on a lot of issues and the internal splits within the party were playing badly with the electorate.

Holding office but wielding little authority

At one point, following the loss of a critical by-election,Starmer removed his deputy from the position of chair of the party only to have to appoint her to another high-profile position following unrest from the left-wing. During the conference, unions voted against a motion that would have committed the party to pushing for a change in the UK voting system towards proportional representation. This was widely seen as one of the few ways that Labour has a real shot at getting into government now that it can no longer rely on winning seats in Scotland.

All this has given rise to a perception of a leader who holds office but does not wield control. So it was that Starmer’s conference speech was widely recognised as vitally important if he was to generate any form of cut through with the wider public. In the event it was well received (although at 90 minutes, it was long by any standards). However it cannot gloss over the fact that a significant swathe of the Labour Party prefers slogans to election winning policies. The left-wing element which continues to follow the Corbynite policy stance so heavily rejected in 2019 has given no sign that it is prepared to make the necessary comprises required to defeat their political opponents. So long as this is the case, Labour will remain a party of opposition rather than government.

What can they do?

UK elections are usually lost by the incumbent rather than being won by a coherent opposition, and with three years until the next scheduled election it is too soon to write off Labour’s chances. However, it is clear that they need to offer a compelling vision for the future and for all the positive noises surrounding Starmer’s conference speech, there was little of any substance. Perhaps this is partly because in recent years the Conservatives have appropriated many of Labour’s policy ideas, but not before first denigrating them and then repackaging them as their own. In this context it is therefore understandable that Starmer does not want to give too much away. Moreover, the Conservatives, who for years sold the idea that Labour was the party of big government that would “bankrupt Britain”, have moved into Labour’s territory with their huge public support schemes and recently-announced tax rises. So what can Labour do to differentiate themselves in areas that will make a difference? I offer four simple prescriptions:

1. Repair relations with the EU by committing either to rejoining the EU Single Market or establishing a customs union (assuming, of course, that the EU is willing to open negotiations). In doing so, Labour would have to be quite clear that this does not mean rejoining the EU – that idea would be a sure-fire vote loser. Tactically, such a policy would open up some clear water between them and their political opponents and highlight that the form of hard Brexit adopted by the current government is making life more difficult for the UK. 
2. Fix the Universal Credit system. As I have outlined previously, there are two quick fixes that can be made: (a) reduce the waiting time between claiming state assistance and actually receiving any funds and (b) reducing the taper rate at which benefits are withdrawn when people transition back into work. Such a policy would be of most benefit to those at the lower end of the income scale – precisely those who Labour say they most want to help (I will come back to this in a future post). 
3. Commit to not raising the rate of corporation tax following the hikes implemented by the current government. This would go some way to allay fears that Labour will take measures that weaken the UK’s international competitiveness and, in Starmer’s words, will help reset “the relationship between the government and business.” 
4. Invest in the infrastructure necessary to meet the aim of transitioning towards electric cars. I have long been of the view that this needs to be done well ahead of the point at which the sale of vehicles powered by petrol or diesel is phased out. With the deadline for this having been brought forward from 2040 to 2030, we have only eight years left and arguably the network needs to be substantially completed within six.

Why this matters

You do not have to be a supporter of any particular party to realise that a credible opposition is required to keep the government on its toes. Without this moderating factor, governments become complacent and formulate policies to suit the interests of their supporters rather than the country as a whole. Keir Starmer may yet be the man who can drag Labour back to the centre of the political spectrum and make them a credible political force again. But if he is to be successful at the ballot box, his party members have to get behind him and start to sound like they want to govern rather than merely act as a protest movement.