U-turn if you want to: Part 2

I wrote a piece yesterday which indicated how the UK government’s position on Brexit is no longer tenable and needs to change. The extent to which this impacted on the election is questionable. But one issue which did appear to resonate during the campaign was that of fiscal austerity. Like Brexit, this is a subject where I believe the government has adopted an ideological rather than a pragmatic approach, and the evidence from the election campaign is that it is wearing a bit thin.

During the election campaign of 2010, the Conservatives portrayed the Labour Party as having bankrupted the country as the public deficit headed above 10% of GDP. Labour were admittedly fiscally profligate in the years prior to the crisis but the crash in public finances was purely the result of the massive collapse in activity in the wake of the recession. Nonetheless, the Conservatives played on the image relentlessly, usurping Labour from government in 2010 and embarking on a fiscally prudent course to eliminate the current deficit by 2016 and reduce overall borrowing to 1% of GDP.  As is well known, for various reasons Chancellor George Osborne continued to fall short of his targets and the fiscal squeeze became ever tighter.

What was deemed to be particularly unfair about Osborne’s approach is that he relentlessly targeted the welfare budget. Access to welfare has been severely restricted as those people previously judged unfit for work are subject to more stringent tests, which are almost impossible to pass unless the individual is virtually dead. Leave to appeal has been strictly curtailed, with a recent Freedom of Information request revealing that the Department for Work and Pensions has a target to reject 80% of benefits appeals. As even The Economist noted recently, welfare spending has fallen “by one percentage point of GDP, with working-age families bearing the brunt. Since 2015, however, the Tories have turned a hard-nosed welfare policy into a punitive one. Osborne used cuts in working-age benefits as a way to balance the books … A four-year cash-terms freeze on most benefits began in April last year. That policy was announced when inflation was close to zero. Now it is nearing 3%, the purchasing power of everything from tax credits (top-ups for low-paid folk) to housing benefit is falling.”

The recent tragic terror attacks on the British mainland threw the issue of public spending cuts into sharp relief. I have noted previously that politicians are quick to praise public services when they are needed but otherwise have no compunction in cutting their budgets. Having survived in government by the skin of their teeth, the Conservatives now realise that a further parliamentary term of fiscal austerity is not going to win them votes. But what exactly might that entail? Does it mean simply not reducing the share of spending relative to GDP any further? Or does it mean holding the deficit constant versus GDP, which allows scope to raise spending so long as it is funded by higher taxes? As it is, spending as a share of GDP is still high by past standards, at just over 39%, but it is 6 percentage points below the 2010 peak. But revenues, at just below 37% of GDP, are only slightly higher than their long-run average. My sense is that taxes will have to rise at some point in order to fund additional spending – and as I have long argued, the policy of cutting corporate taxes to amongst the lowest in the OECD is putting an unnecessary hole in public revenues.

But austerity is not just about making the books balance: It becomes a state of mind, whether you are in government, the private sector or making your household finances stretch further. It is in this wider context that we have to view the horrific fire which engulfed the Grenfell Tower in London yesterday. I am not suggesting for a moment that government neglect had any bearing on what happened. But abstracting from the grim horror of what happened, one of my thoughts was that 30 years ago, as the UK was going through a similar period of government retrenchment, we experienced a similar series of tragedies (the Bradford City fire; the Kings Cross fire; the sinking of the Marchioness and the Clapham rail disaster). David Aaronovitch, writing in The Times today, evidently came to the same conclusion. As he put it, these disasters “arose from the use of old, near-obsolete and dangerous infrastructure … Stuff like this usually comes down to attitude and to money.” Elsewhere in the same newspaper, the point was made that “cost-cutting by private firms brings public danger.”

This is not the voice of the Labour Party: The Times represents the voice of the political centre with a bias towards the Conservatives. This shift in attitudes must act as a wake-up call to politicians of all stripes that government – whether central or local – cannot continue outsourcing functions to the private sector. Citizens pay their not-insubstantial taxes and expect a decent level of services in return. When even the BBC news reporter covering the fire (here at 5:24 if you can play the video) – who as a rule remains impartial at all times – stated “in the 21^st century, in a country with some of the strictest fire regulations in the world, a desperate tragedy like this just should not happen,” you know that something is afoot.

Fund the police

The terrible attack on the UK parliament last week which claimed the lives of four innocent people would have been a lot worse were it not for the actions of the security and other emergency services. As it was, one police officer was killed in the line of duty and politicians from all sides were quick to praise the work of the police on the front line in maintaining law and order. But we should not allow these warm words to deflect us from the fact that the police service, like many other publicly funded bodies, has had its funding slashed over the past seven years.

The Mayor of London warned in January (here) that  “it would become increasingly difficult to keep Londoners safe from growing security threats if the Government continues to underfund the Met, or makes further cuts in funding” and this is a message which is being heard up and down the country. A report last year from the impartial House of Commons Library (here) noted that between fiscal 2010-11 and 2015-16, the central government grant to police was cut by 22% in real terms. Although the police in England are able to rely on some local government funding, the report notes that two-thirds of its revenue derives from central government. The total number of full-time police officers in England and Wales has fallen by 11.8% since 2010 compared with a planned decline of 11.2% and total staff numbers are down by 15.6% versus a planned 12.7%. In fairness, the report also notes that most police forces have coped well with the additional austerity. But this does not disguise the fact that there are limits as to how much further budgets can be cut.

Another report issued by the HoCL around the same time (here) reported that since 2010-11, funding for the fire and rescue services has been slashed by between 26% and 39%.  Taken together with the cuts to police funding, it is clear that these are not insignificant cuts and they underline the belief of a growing number of people that we have gone way beyond the point of trimming fat from the public sector and we are now cutting into the bone and muscle. A recent article in The Economist  – not exactly a supporter of big government – made the point that the public sector is under increasing strain and that it may be about to break under the load. Citizens Advice – a voluntary organisation that provides help and support to those who are struggling to get what they need from the state – has seen a sharp rise in demand for its services. The government’s decision to cut back on its Legal Aid budget has left many people with no recourse to legal representation, with CA taking up the slack, and changes to the benefits system have resulted in many people falling through the cracks.

I have highlighted before the excellent report by the Institute for Government which argues very strongly that recent additional cuts in government spending are beginning to erode the fabric of public services. The evidence-based analysis makes the point that although there has been a big rise in real spending on hospitals since 2010, admissions rose at an even faster pace. Or take the case of prisons, where the prison population has remained unchanged since 2010 but the number of officers has fallen by almost 25% with the result that assaults on staff have risen by 70%.

None of this is news. Nor is it an ideological point about how we have to spend more money on public services. However, the evidence before our eyes is mounting to suggest that public services are struggling to cope and they are increasingly unable to offer the level of service which the public demands of them. With the best will in the world, a police officer cannot be in two places at once.  If we continue to starve our public services of resources, this will continue to eat away at morale and they may reach a tipping point beyond which it is very difficult to recover. Indeed, taxpayers as a group are not finding that the exchequer is taking any less tax yet they are getting far less in return.

I am reminded of the story that was frequently told of British Rail – the old and (at the time) unloved nationalised body responsible for running Britain’s railways – about how in the 1970s it was one of the world’s most cost-effective railways in terms of spending per passenger mile (even today, UK railways still receive far less public money per passenger mile than other major European networks – see chart). But it was criticised for poor service; lack of staff morale; the frequency with which workers went on strike; the quality of the food served and the general state of the trains. It did, however, get people from A to B, even if it was a utilitarian service, before it was abolished in the 1990s when the railways were privatised.

Today, people look back to the halcyon days of an integrated railway network which conducted world class research and built its own rolling stock, providing jobs for many thousands. This demonstrates that if governments do not put money into public services, the quality of service deteriorates and public trust is eroded, even if in accounting terms it offers good value for money. But when you replace it with something else, it is often not perceived to be as good. As Joni Mitchell put it, “You don’t know what you’ve got till it’s gone.”

Running out of road on austerity

Next Wednesday will see the occasion of the annual UK parliamentary set piece otherwise known as the presentation of the annual budget. The principle of parliamentary approval of the budget plans date back to the late seventeenth century when the nation’s finances were squandered once too often by a spendthrift monarch. The final straw came during the reign of Charles II in 1667, whose navy was laid up due to a lack of funds and which was subsequently caught unawares by a Dutch raid.

Budget presentations in their current form began in the early eighteenth century, with the word budget itself derived from the French "bougette", which was the little bag from which the Chancellor of the Exchequer would reveal his plans. Incidentally, this explains why the Chancellor "opens" his Budget. The UK is just one of a handful of countries whose fiscal year begins in April (of which Japan is the only one not a former British colony) reflecting the historical fact that when the economy was primarily based on agriculture land tax was collected in April, hence budgets are held in spring.

Over the years the budget became one of the main parliamentary events of the year although its importance in recent years has dwindled somewhat. Nonetheless, it provides us with a good opportunity to focus on the state of UK government finances and fiscal policy. The good news from a macro perspective is that the budget deficit has fallen sharply, from a peak of 10.1% of GDP in FY 2009-10 to an expected 3% in 2016-17 (it reached exactly 3% in calendar 2016, chart). The previous policy of targeting a surplus by the latter part of this decade has been abandoned in favour of a rule which requires reducing the structural deficit below 2% of GDP by 2020-21 and ensuring that the debt-to-GDP is on a downward trajectory ratio by the end of this parliament – both of which seem highly achievable.

But the fiscal improvement has come at a significant cost. Total managed expenditure (the sum of public sector current expenditure, net investment and depreciation) fell from a peak of 45.3% of GDP in 2009-10 – the highest since the mid-1970s – to current levels just below 40%. At the same time, receipts have risen by less than 1% of GDP which is a clear indication of the extent to which the squeeze on public finances has come from spending cuts. Additional spending cuts are already baked in thanks to measures taken by former Chancellor George Osborne. One of the measures which most worries me is the reduction in central government grants to local authorities, which by 2019-20 are set to fall by 80% relative to 2008 levels. This is without a doubt the key reason why local authorities are having to cut frontline services, and I remain of the view that this savage austerity was one of the reasons why the electorate voted to stick two fingers up to the government last June.

Former minister David Laws has already warned that the UK is “reaching the socially acceptable limits to public sector austerity,” and the Institute for Government reported last week that public services are reaching a breaking point (here). It suggests that whilst “the 2010 Spending review was largely successful” in achieving its objectives, “the Government is struggling to successfully implement the 2015 Spending review … [with] clear signs of mounting pressures in public services.” Newspaper headlines over the winter have highlighted the strains on the NHS and the IfG notes other areas where strains on public services are mounting. The report makes four key points which the Chancellor ought to take note of when framing his budget plan: The government:

• is failing to develop alternative strategies despite the clear warning signs in the data
• is continuing to pursue approaches that are no longer working
• is being forced into emergency actions in response to public concern
• is providing emergency cash to bail out deeply troubled services.

In other words, austerity has gone as far as it can. Moreover, there has been no recognition from the UK government (or, for that matter, from most European governments) that fiscal multipliers have proven to be far higher than expected before the financial crisis. Fiscal austerity has had a bigger adverse impact on European growth than policymakers expected. Undoubtedly Chancellor Hammond will point out that the UK has been one of the better performing growth economies in recent years. But that is not how it feels to many people outside the south east of England. Employment growth has been very strong in the last four years but real wages remain below pre-crisis levels. Workers have priced themselves back into a job but their position feels a lot more precarious than it once did.

I am not convinced that Mr Hammond is going to substantively address these concerns next week. His is a government which has an ideological conviction that deficit reduction is an end in itself. But it is not: After all, it’s not government money – it’s ours and we hand it over to the government to facilitate the running of the state. The government thus has a duty to use that money to manage the economy in the best interests of its citizens. And despite the evidence from the macro numbers, I remain as convinced today as I was in 2008, that fiscal policy has a key role to play in helping to make life better for taxpayers.

It's not only economists who see the obvious

Alan Bennett is best known as a playwright (The History Boys, The Madness of George III) although he is also a prolific screenwriter, actor and author. In addition to all this, he is an inveterate diarist and in his 2015 journal, an edited version of which was published in the London Review of Books (here), he made the following entry: 

“11 September. David Cameron has been in Leeds preaching to businessmen the virtues of what he calls ‘the smart state’. Smart to Mr Cameron seems to mean doing as little as one can get away with and calling it enterprise.“ 

In a recent TV documentary I heard Bennett repeat the comment in his cosy, affable tones which makes it even more devastating. It accurately captures the thrust of fiscal policy over the last six years and is a withering indictment of thirty years of market economics. But before we swallow this soundbite wholesale, we should acknowledge that there is a genuine discussion to be had about the role of the state in a modern economy. One of the big issues is the size of the safety net that the state should be expected to provide, and the answer will differ according to the prevailing mood. Nonetheless, according to Jonathan Bradshaw of the University of York (here) “the real damage has been done by this present government … The uprating of working age benefits by substantially less than inflation since 2010 and cuts made in tax credits has resulted in falling living standards. This was the first time that the real level of the safety net had fallen since Unemployment Assistance began in 1934. 

No one should be in any doubt that life at the bottom is tough, and getting tougher. Ironically, when the German government introduced a series of welfare reforms in the first half of the last decade, which cut benefits in order to force people back into the labour force, it was lauded for the boldness of its move. Other European countries are being urged to follow suit – notably France and Italy. And with Germany today held up as a paragon of economic virtue, there does appear to be some merit in a policy of welfare reform. Indeed, the UK reforms of the 1980s are credited with kickstarting the economic recovery of the Thatcher era. But like many economic policies, there are diminishing returns to more of the same, and I wonder whether in the UK we have hit the limits of what people are prepared to tolerate.

But it is not only those at the bottom who are being squeezed: middle income groups across the industrialised world are not faring well either. According to the Institute for Fiscal Studies, real average wages in the UK in 2021 are expected to be lower than they were in 2008 and it concludes that “we have certainly not seen a period remotely like it in the last 70 years.” At issue is what the government can and should be expected to do about it. In an economy where the government’s direct role has been reduced as many activities have been privatised, it can only play a limited role by setting the framework. After all, it is no longer in a position to set wages for large parts of the workforce.

Bennett’s criticisms go deeper, however. The UK government under David Cameron adopted a laissez faire approach to many economic problems which frankly failed to deliver the desired results. Bennett was undoubtedly referring to Cameron’s flagship Big Society project which was designed to give more power to local communities by encouraging a transfer of power from central to local government. It was a nice idea in theory, but it was the wrong policy at the wrong time. Faced with the aftermath of the biggest economic crisis since the 1930s, most economists would argue that more government rather than less are what is required.

Moreover, with around 60% of UK local government spending being funded by central government, it was always a pipedream to assume that more local decision making was ever going to work without more local control over budgets. With central government funding for local activities such as the police having been cut by 22% in real terms between FY 2010-11 and 2015-16 (source: National Audit Office) Bennett’s criticisms start to hit home. It is indeed hard to avoid the suspicion that government policy in recent years has focused on shrinking the size of the state whilst telling the electorate that it is promoting enterprise or increasing choice. And I still hold the view that at least part of the reason for the Brexit vote was directed at the failure of government to manage the economy in ways that benefited large parts of the electorate.

As we look ahead to 2017, it would be nice to think that the UK government will spend less time fretting about cutting the deficit and more about how to use fiscal policy as an instrument to promote growth. But from what we have heard so far, which amount to words rather than actions, I have to say that I am not confident.

Life at the bottom in the 21st century

It says in The Bible that the poor are always with us. As the fallout from the bursting of the Great Debt Bubble continues to spread, we begin to realise just how many people in western societies are indeed poor. Obviously, we cannot compare poverty levels to those of Victorian Britain: There have been significant improvements in public sanitation, health and education which have lifted millions across the world out of the desperate poverty which prevailed at the end of the nineteenth century. It is treated today as a relative problem: Those earning less than 60% of the national median income are defined as “poor”. It seems, however, that there are a lot of them about.

There has long been a puritan streak in western societies which blames the poor themselves for their lot. You see this in large sections of the British press, which has for many years called for an end to state distributed largesse – a view which has percolated into the mainstream of the Conservative party. You see it in Germany, where the terms imposed on the Greek debt bailout were designed to bring the Greeks to their senses so that they would not fall from the path of fiscal righteousness in future.

Yet it is not always easy to determine where to draw the line between offering self-help and financial support, primarily because people find themselves struggling for different reasons. An alcoholic and a divorcee may face very similar financial problems but very different personal circumstances. Moreover, lack of money is not the only cause of poverty: Social exclusion is a powerful factor reinforcing the downward spiral. How often do we hear tales of people who lose their job and end up living on the street? (Answer: More often than we should in a developed economy).

There are those who argue that UK government policy, which has hacked away at the welfare bill in order to get public finances under control, threatens to exacerbate the UK’s poverty problem. This is not wholly without foundation but also not the whole truth. The Labour government of 1997-2010 did try to reform the welfare system to simultaneously get more people into work whilst providing support for the poorest in society. But by 2013, the UK was spending more on family benefits as a percentage of GDP than any other OECD nation. Moreover, the system was extremely complicated, relying heavily as it did on a series of tax credits and a variety of taper rates with welfare support progressively withdrawn as individuals entered paid employment.

There is general agreement that the system needed reform and the Conservative-Lib Dem coalition government of 2010-15 began the process.  Its centrepiece was a system called Universal Credit which was designed to replace a number of other benefits whilst also being less generous than the previous system. But although it was announced in 2010, it still has not been fully rolled out and as the Institute for Fiscal Studies has pointed out, “changes to its future design have been … apparently at chancellorial whim.” Furthermore, one of the government’s first policy actions in 2010 was to restrict access to Legal Aid – a state supported means of financing access to the legal system to those who would otherwise be unable to afford representation. Combined with rising legal costs, this has contributed to restricting access to the justice system (see here for a summary of the Bach Commission analysis).

A less generous welfare system, coupled with implementation delays and restricted access to the legal system means that voluntary organisations such as Citizen’s Advice have been overwhelmed, with the majority of their cases dealing with debt-related issues. CA reckons that one in every five pounds on disputed debt which they deal with is owed to government (here). Indeed, Council Tax arrears (a local tax) are now the most common source of personal debt. This is partly the result of national reductions in benefit payments but also local council cuts in discounts offered to vulnerable groups and reliefs to low-income residents, which in turn is the result of funding cuts by central government.

Moreover, CA “found evidence of poor practice, including a lack of consideration given to whether people can afford repayments and people forced to pay a debt when it is under dispute.” Whilst government would doubtless argue that the debts they are trying to reclaim (such as Council Tax) are classed as priority debt that can result in serious legal action if not settled, the net result is to push people further into debt. It is hard to avoid the conclusion that the system is creaking at the seams.

It is no wonder that anger is rising amongst the so-called just-about-managing (JAM) households. A policy of getting benefit dependent households back into work, as the government desires, is laudable. But what sorts of jobs are available for them? Globalisation has wiped out the decently paid jobs for low-skilled workers, many of whom feel that work does not pay. At the same time, benefits are being squeezed.

Whilst from a macro perspective the policy is being conducted for the right reasons, it is also leading to a series of unintended consequences. As one case worker said to me, “it’s as if the government does not really understand the magnitude of the problems which the JAMs face.” That being the case, failure to get to grips with the social consequences of fiscal austerity measures could have far more profound political effects than the Brexit decision. And the fact that this problem is being repeated to a greater or lesser degree in many other industrialised countries is a matter of great concern.

Time for a policy rethink?

There are few indications as yet that the UK real economy has taken a hit in the wake of the Brexit vote, but the release yesterday of a snap post-referendum consumer sentiment poll does not bode well. The GfK index collapsed by 8 points, the biggest monthly fall in 21 years. It is early days yet and the initial reaction might prove an over reaction. Nonetheless, it will give the Bank of England food for thought as it meets next week to set interest rates.

It really is a toss up as to whether rates are cut in July or August, but either way the Bank looks set to react with a rate cut over the summer as Governor Carney has already hinted. But in a keynote speech last week he pointed out that "monetary policy cannot immediately or fully offset the economic implications of a large, negative shock." Indeed, it is increasingly looking as though the BoE has little real ammunition left to counter the Brexit shock, with the policy rate already at all-time lows on data back to 1694.

I have long been of the view that the BoE missed a trick in not raising rates in 2014 when it became clear that the economy was recovering faster than anticipated and the unemployment rate was falling nicely. In some ways it is understandable that the MPC was hesitant: After all, members did not want to be accused of derailing the upswing which had taken ages to get going. But however sluggish the recovery, the economy was not facing the life-or-death problems which prevailed in 2009. For that reason it was becoming increasingly difficult to argue that interest rates needed to remain at these emergency levels, although perhaps a tight fiscal stance did restrict the BoE's room for manoeuvre.

Some good news is that the BoE has an instrument  which was not available in 2009 in the form of the banks' countercyclical capital buffer, which this week was lowered from 0.5% to 0%. In principle this will raise the lending capacity of the banking system by almost 9% of GDP. But this may not do much good if the private sector does not want to borrow, as BoE officials readily admit.

So the policy cupboard looks a little bare, unless the government does what it should have been doing all along, and relaxes the fiscal stance to take advantage of the lowest bond rates in history - rates which have surprisingly collapsed further after the referendum, with 10 year gilts yields now at less than 1%. The Chancellor has tried to argue over the last 6 years that austerity is the best way to get the economy back on its feet in the long-term. But one thing we perhaps learned from the Brexit vote is that the electorate is not buying that. It may be too late to turn back the referendum vote, but it still isn't too late to have a rethink on fiscal policy. The UK's near term fortunes may depend on it.