Austerity matters

I happened to dip into a TV programme the other day that looked at the life of a school over the course of an academic year (here for anyone able to view it). Aside from shining a light on the increasing pressure which teachers face in the wake of significant social change, what was particularly striking was the financial burden under which schools are constrained to operate. It really highlighted the extent to which eight years of fiscal squeeze are now cutting into the bone of public services now that the fat and muscle have been stripped away.

One of the teachers expressed particular concern at the extent to which pastoral care has been hard hit. Pupils were reported to have demonstrated rising levels of misbehaviour and anxiety, and there is increasing concern that schools simply do not have the resources to cope with the stresses that these issues pose to the smooth running of the school. Since I was at school, more years ago than I am prepared to admit, the pressure on students to pass exams has increased exponentially and not surprisingly a much greater support network is required to help them cope. If it is not there, the well-being of the students is not being supported in the way that it once was with adverse consequences for performance.

As an aside, it is notable the extent to which performance is very much at the heart of the education system today. One teacher openly admitted that his prospects for a pay rise depend on generating a certain level of performance from pupils in their exams. This in turn creates a series of perverse incentives whereby certain pupils may be steered away from particular subjects for fear that their exam performance drags down the school average. Indeed, there are many stories of schools which refuse to teach certain subjects for fear that they will drag down the overall performance. This is particularly the case for subjects where the marking is subjective. One example is the teaching of literature, where the marking system is so variable across geographical locations that schools cannot be sure of the outcome.

But it is the cost squeeze on the education system that is the biggest problem. Despite claims in the budget two weeks  ago that the age of austerity is over, the Department of Education’s capital outlays will fall by 20% over the next two years though this offset by a rise in current spending. According to analysis by the Institute for Fiscal Studies whilst total spending per child is 42% higher than it was 20 years ago, much of the increase has been spent on the most severe cases. Almost half of the £8.6bn children’s services budget in England is now spent on 73,000 children in the care system, leaving the rest to cover another 11.7 million. Spending per head on the most vulnerable children is more than 100 times that spent on the rest. Small wonder that teachers in “normal” schools feel hard done by.

It is not just the education system that is struggling to keep its head above water. A report three weeks ago from the House of Commons Home Affairs Committee highlighted the strains on the police force as a result of a persistent budgetary squeeze. For example, the time taken to charge an offence rose by 25% between March 2016 and March 2018. The Committee concluded that the current system that determines police funding is “not fit for purpose” and requires radical reform, including reduction in the reliance on Council Tax receipts (a local property-based tax) and must recognise “the true cost of policing.”

A recent series of reports by the Times journalists Rachel Sylvester and Alice Thomson (summarised here) highlights the extent of the rise in poverty over recent years which has raised the numbers of working poor. When even The Times is pointing out the extent to which people trapped in the welfare system are being left behind, you know there is a problem. As Sylvester points out “the education system has made matters worse because the focus on test results has fuelled a rise in exclusions as schools ease out pupils who might bring down their league table rankings.” And as is now being recognised, one of the biggest problems with the current system is that Universal Credit, which is being patchily rolled out across the country, only pays out in arrears whereas previously applicants were entitled to benefits immediately. Consequently, those with little to no savings who are entitled to benefit (a large proportion of them), find that their problems are not over once they are accepted for Universal Credit.

Even though the government has promised that “austerity is finally coming to an end” it will take a long time to undo much of the damage caused by eight years of slashing the public sector. For one thing, the economy is growing more slowly than in the past – partly due to secular factors, which I will deal with another time, but in recent years as a consequence of Brexit-related uncertainty. Consequently, the government cannot simply turn on the spending taps. As a society, we need a proper debate about the levels of taxation required to fund the level of public services we demand. But Brexit itself has absorbed so much of the government’s own time and energy for the last two years – and is likely to continue to do so for some time to come – that it has taken its eye off the ball on social policy.

I do not wish to sound like a broken record on either fiscal policy or Brexit but they happen to be two important policy areas where the government has failed to cover itself in glory. As I pointed out in my previous post government efforts a century ago to slash the public sector exacerbated many of the economy’s underlying weaknesses. Given this historical lesson, the increasing headwinds now facing the economy suggest that a little bit less austerity would go a long way.

Reflections on policy errors

On this of all days, when we remember the centenary of the Armistice that ended World War I, it is worth reflecting on policy errors and their consequences. War is perhaps the ultimate policy error. No rational country chooses to go to war. The decision can usually be linked to a chain of circumstances which, if they had been dealt with differently, could have produced an entirely different outcome.

Unsurprisingly big conflicts generate the biggest headlines which explains why the western world still remembers the two global conflicts that scarred the twentieth century, whilst the US was scarred by the experience of the Vietnam War: For anyone who is interested in the scathing criticism of the errors of that campaign from the people who were there, the film by Ken Burns and Lynn Novik is a must-see (currently available on Netflix). There again, whilst history focuses on the consequences of events that went wrong, there are some instances where things went right that otherwise could gone tragically wrong. For example, history suggests that had the Cuban missile crisis of 1962 not turned out the way it did, we might not be here today to tell the tale.

We tend to remember wars in terms of the human cost. Anywhere between 15 and 19 million were killed during WW I and a further 23 million were wounded. Estimates of global fatalities during WW II are even higher, at over 60 million (3% of the world population in 1940). But there are also significant economic costs associated with wars. According to an authoritative study by Stephen Broadberry and Mark Harrison, World War I cost France and Germany more than 50% of their pre-war national wealth. In Germany’s case, this was primarily the result of the huge reparations bill imposed after the war, which is now perceived to have been a major mistake. Indeed, the economist John Maynard Keynes wrote a best-selling book in 1919, The Economic Consequences of the Peace, in which he warned of the adverse consequences of a punitive settlement.

It is interesting to note the contrasting British and German approaches to dealing with the huge debt incurred as a result of WWI. Both had debt-to-GDP ratios in excess of 100% in 1918. But the German government printed vast quantities of currency, and the resultant collapse in the value of the mark led to hyperinflation and a sharp decline in the value of public debt relative to GDP (see chart). The British approach was to deflate the economy, with the Geddes Axe of the early-1920s designed to slash public spending. It became a byword for how not to conduct fiscal policy, since the huge cuts  were made all at once rather than being phased gradually, with the biggest falls in social security spending, defence and education rather than ‘equal misery’ across all policy areas. It succeeded only in exacerbating the already-sluggish economic performance and the high levels of unemployment it was intended to mitigate, and had no impact on the debt burden.

Fortunately, most policy errors have less grave consequences but the economic costs can still be enormous. The bubble economy that developed post-2002 in the western world was largely the result of policy failures, driven by a laissez-faire attitude towards debt/credit creation that eventually produced the biggest economic crisis in 80 years. It is also notable that many European governments have subsequently adopted a 1920s-style UK approach to fiscal management (including the UK) by tightening fiscal policy at a time when the economy least needs it. In an economic sense, it is as though we have learned nothing from past experience.

They do say that those who cannot remember the past are doomed to repeat it. If nothing else, the day of remembrance across Europe serves to remind us of the futility of war and that it should only ever be the last option. On the whole, generations of Europeans have absorbed the lessons of history well. Whether economic policymakers have been quite as diligent is a matter for debate.

A gambling man

Getting in on the act

The phone message had been brief and to the point. “Show up by 10 pm; bring lots of cash and your A Game. This is a card game for big boys with cojones. Minimum entry requirement £100,000. Be there or be somewhere else. And be lucky.”

I was intrigued. After all, I played a bit of poker in my youth and had kept my hand in over the years. And I wasn’t bad either: I worked on the basis that statistically a good hand always came around once in a while and the trick was not to lose too much on the bad ones. Of course, I had never played for anything like these stakes and I didn’t have £100,000 to splash around. But I knew people who knew people, and could probably get hold of the cash. I reckoned I could win enough to pay them back with a bit of interest. The thought of losing never entered my head. Probably just as well: The folks putting up the money would not hesitate to make life difficult if I didn’t pay them back.

The motley crew

So it was that I arrived at the flat in the backstreets of Westminster at 9.55 pm, carrying an anonymous looking bag containing 100 grand. After confirming my identity, I handed the money over in exchange for gambling chips and entered the room where the event was to take place. I was the last to arrive and my opponents were already seated around the table. The dealer was a Frenchman called Michel and unusually he insisted that all players identify themselves before play commenced. Immediately to the dealer’s left was Dave, a pink-cheeked well-spoken gentleman who said with typical understatement that he liked a flutter. To his left sat Bozo, a journalist who worked – in his words – “for the gutter press.” Going further round the table, DD was a hard-bitten used car salesman from the East End of London, whilst Jake was a languid city banker whose cut-glass accent made him sound like a pantomime villain. The circle was completed by Nige, a gentleman of no fixed occupation who seemed very fond of alcohol and the only woman present, Tessa, who it transpired, was a geography teacher.

Michel brought proceedings to order by announcing we were to play seven card stud: The initial hand would consist of two cards face down and one face up with a minimum bet of £100. “Good luck everyone,” he said as play commenced. As is usual in any poker game, the first few rounds consisted of checking out the strength of the opposition and assessing their tactics. After a couple of hours things were starting to take shape. Dave was an impulsive player, who took some big risks but generally was looking good and had significantly increased his pot over and above his initial stake. Bozo, Jake and DD played safe, exploiting opportunities as they opened up and making small gains as a result. Nige was pretty hopeless, having funded most of Dave’s gains, whilst Tessa clearly tended to fold under pressure by avoiding entering into a bidding war when the stakes were raised. I was breaking even and bided my time, content to see how things panned out. 

Sorting the men (and women) from the boys

Shortly before 1 am, the first significant move took place. Dave had a full hand of seven cards, with a pair of nines; a ten and a Queen face up on the table and three in his hand. He was betting heavily. Bozo’s two Queens, a Jack and a King looked strong to me and I dropped out of the betting, as everyone else did soon afterwards. But Dave kept raising the stakes until the pot stood at £75,000. Finally, Dave called Bozo’s hand: Three Queens and two Kings versus Dave’s three nines and assorted rubbish. Bozo’s three of a kind plus a pair was stronger than Dave’s three of a kind. All his gains from the night were gone and his cash reserve was below his initial stake. This need not have been a problem if he had played judiciously, but after a small loss in the next hand, Dave went for broke again and this time was wiped out by a concerted effort from Bozo, DD and Jake. “Thanks for the game chaps. No hard feelings.” said Dave as he left the room.

“Probably going back to the family estate,” grunted DD after Dave had gone. “Now we can really play.” Nige was the next to fold. He had played dreadfully all night and was clearly out of his depth. I was just about hanging on as Bozo, DD and Jake really piled on the pressure, winning hand after hand. After having initially appeared to be playing as a team, it was obvious the threesome were now competing against each other, which allowed Tessa and me to stay in the game. As the hours ticked by, it was evident that Bozo bluffed more than was good for a decent card player and we were reeling him in. Tessa’s caution was paying off and after a few more hands, Bozo was clearly losing a lot of cash. Surprisingly, it was DD who folded first. Tessa had played him well, allowing him little wins in some hands but generally taking more off him in others. He was far from bust but his pile of chips was worth far less than his initial £100k, and he had evidently decided that enough was enough. A flushed and apparently panicked Bozo dropped out soon after.

A losing streak

So it was down to Jake, Tessa and me. Jake was a good player. He took calculated risks but didn’t give much ground, and he was an excellent bluffer. But I was confident and told myself that you just have to trust the numbers: the good hand always arrives eventually. Jake also had a weakness: He occasionally – just occasionally – pursued a doomed cause, which left him vulnerable. Six hours in, and we were all feeling pretty tired. At this point, Jake’s face-up cards were showing two tens and two nines. Two pairs – a pretty strong position. Tessa had nothing on show. Nor, on the face of it, did I. Queen of spades, 10 of spades, 8 of clubs and a four of hearts. But I had three cards that Jake could not see.

I had been fairly cautious all night, so when I called Jake’s hand and raised another 100 he must have thought I was bluffing. Tessa immediately dropped out whilst Jake responded by raising the call by a further 200, which I countered by raising him another 500. In a bid to test my mettle, he raised by 1000. I appeared to hesitate to give the impression that I was reluctant to bid. In reality I was anything but, and raised the call by 5000 which Jake promptly doubled. He had a good hand, but I trusted in what I knew and doubled his call. Jake didn’t like losing, especially to an oik like me. So he promptly raised the pot by 50,000. I gasped. Surely he was not going to be that stupid. But I raised to 100,000 and awaited his response. Jake tossed five 20k chips into the pot and drawled “call.”

I turned over my three hidden cards one at a time. First the Jack of spades followed by the King of spades. Jake blanched: He knew what was coming next. And sure enough, it was the Ace of spades – the death card. I had a straight whereas the best Jake could manage was three nines and a pair of tens. He was so fixated on the strength of his own cards that he had failed to see that others might have a stronger hand, and was wiped out as a result.

At that point, Tessa remarked that she was also done for the night and although she had expended a considerable amount of her initial capital, she was smiling broadly as she departed into the darkness of a cold early morning.

“Well done, my friend” said Michel who had played an important but low-key role throughout the night. As I cashed in my chips, I turned to Michel and said “I believe this is yours,” handing him £100,000 in cash. “A great pleasure to do business with you,” he replied. “You are not merely a gambler. You calculate the odds and act accordingly and I always knew we would get our stake money back. Now if you are interested, I have some friends in Washington DC who are keen on a high stakes game in the US. Here is the number. Just ask for Don.”

Preparing for a post-Merkel Europe

We all know that nothing lasts forever and that economic and political change is inevitable. Nonetheless, Angela Merkel’s decision on Monday not to stand again as the chair of the CDU party in December, with a view to bowing out before the 2021 election, was one of those moments when you could hear the tectonic plates shifting. Following a second consecutive poor showing for the CDU/CSU in state elections, this time in the state of Hessen, Merkel took the pragmatic view that she is part of the problem and no longer part of the solution. It takes a special kind of politician to know when to leave the stage rather than being forced out by the rest of the cast, and for that she is to be applauded.

It is also a reminder of just how much the European – and indeed global – political axis has shifted. Merkel is the embodiment of European centrism who has tried hard to keep the EU on track despite the headwinds it has faced over the past decade. Remember how she was cast as the standard bearer of responsible western values following the election of Donald Trump? Yet even she fell foul of the fault line running through western politics – immigration. It took a couple of years to make its presence felt in German politics, with the first signs evident in last year’s general election, but it has been running like a sore in France, the Netherlands and the UK for far longer.

Her anticipated departure raises a number of questions about the future direction of the EU. There is little doubt that it requires a shove in a different direction. Until now, Merkel-style German politics has supported the caravan of countries moving together at roughly the same pace. But there is increasingly a sense that this may not be what the EU needs. There is no doubt that in order for the single currency project to work requires a greater degree of integration. Some form of fiscal burden sharing would appear to be a prerequisite but it is hard to see any German politician agreeing to go down that route. Perhaps the old idea of a Europe with flexible geometry will be given a renewed hearing. This is an attempt to allow various EU countries to move towards their goal at a different pace and perhaps even with different goals in mind. It would certainly be a form of the EU that would be easier to sell to the UK which is struggling to come to terms with its EU-based schism (though too late I fear).

Whilst Merkel’s reputation amongst her opposite numbers at international forums remains high, she is less well-loved in southern Europe. German insistence that Greece deflate its economy has won Merkel few friends amongst the Greek people. It may thus be time to look again at some of the rules underpinning the single currency project. As the current spat between the European Commission and Italy has shown, a strict rules-based approach to domestic fiscal policy can lead to conflict. Despite suggestions in Germany to the contrary, Italy has actually run a pretty tight fiscal stance over the last decade, with cumulated primary surpluses on a par with Germany despite much weaker GDP growth (chart).  Moreover, as is common with most monetary unions, the euro zone struggles with the problems posed by differential external balances. With Germany running a current account surplus around 8% of GDP, this puts upward pressure on the euro and imposes significant strains on those countries that run a current deficit.

Of course, the structure of the euro zone is not specifically attributable to Merkel since it clearly pre-dates her. But Merkel assumed office in good times when the fault lines of the monetary union were nowhere near as evident as they are now, and since the single currency was working for Germany she had little incentive to push for change. However, if the single currency is to work efficiently and endure, the next few years might provide the opportunity to think about where we want to be ten years hence.

Unfortunately, I cannot see any of this happening. Emmanuel Macron has already set out his vision for Europe only to find that when it came to the crunch he got less support from Germany than he would have liked. One of the biggest seismic political shifts in recent years is the extent to which politics has become local rather than global. This probably should not be a surprise – after all, politicians are elected by their own tribe and have to do what is right for them. This makes it even more ironic that in Angela Merkel, Germany has a leader who is respected by her international peers but has been brought low by domestic issues.

UK fiscal policy: The Augustinian budget

The death of fiscal austerity has been proclaimed in the UK following Chancellor Hammond’s 2019 budget to parliament in which he managed to reduce the borrowing requirement whilst simultaneously increasing spending on the NHS, with a little bit set aside for defence, and some cuts in income taxes to boot. But there is a different way to look at it. The fact that the OBR raised its projection for tax revenues in the current fiscal year by £11.5bn (around 1.5%) proved to be the main source of the largesse, with additional help provided by lower funding needs in some key areas (interest outlays). Like a gambler who wins a modest amount on the lottery, Hammond has blown his good fortune in one fell swoop.

Admittedly, much of it has gone on good causes but as the OBR pointed out, “experience shows that a favourable revision in one forecast can be followed by an unfavourable one in the next.” The OBR continued by describing the package of measures as one which ”has the familiar Augustinian pattern of a near-term giveaway followed by a longer-term takeaway.” Indeed, the OBR adopted a very circumspect approach to the whole Budget process, pointing to “repeated failures [by the government] to observe the agreed timetable” which sounds like a lot of last minute horse-trading went on as the Chancellor tried to accommodate the prime minister’s desire to end the age of austerity.

All this comes at a time when growth continues to underperform relative to pre-Brexit projections, running at a rate close to 1.5% per year over the next five years when ordinarily we would expect something closer to 2% per annum. Then there is the looming spectre of Brexit itself. When asked by the OBR whether it wished to provide any additional information on post-Brexit policies, the government merely directed it to the White Paper published in July, which is widely believed to be a lame duck. However, the Chancellor did make it clear that if a no-deal Brexit results in March, the Spring Statement may have to be a full fiscal event as the government contemplates a bigger hole in the public finances.

Whilst Hammond was able to ease the purse strings somewhat, it is premature at this stage to sound the all-clear on austerity although the budget was definitely a step in the right direction. Key front line services such as the prison service are creaking at the seams and additional funding for the police is long overdue. Indeed, a key chart in the Economic and Fiscal Outlook (shown below) indicates that once we strip out the impact of additional health spending, real per capita spending across other departments implies a modest squeeze well into the 2020s.

Indeed, the damage being done by cuts in non-health spending are wide and pervasive. Local spending has borne a huge amount of the burden as central government seeks to reduce the grant to local authorities. Services which are provided locally have had to be cut and local government has had to find ways to fill the gap – not easy when its main source of revenue is council tax which can only be raised to a limited extent. It is austerity at this level that people tend to notice first and the measures announced this week do little to address such concerns. It will thus take considerably more fiscal boosts of the same magnitude as those announced in the October 2018 budget to begin to redress the balance.

I have made the point previously that the austerity initiated by George Osborne during his time as Chancellor was overly harsh and appeared to be driven by ideology as much as economics. Perhaps the Brexit vote was the first sign that the electorate was beginning to tire of the relentless assault on public services, and the 2017 election affirmed that Labour’s message that austerity was damaging the country was beginning to be heeded. Accordingly, we should view the Conservative Party’s message that austerity is over as an indication that it believes taking further steps down the austerity path will be electorally counterproductive. Having driven the deficit from 10% of GDP in 2009-10 to a projected 1.2% in 2018-19, enough appears to be enough – so long as Brexit does not torpedo the plans in five months’ time.