The Markets, the Budget, the Media and electing a Fascist

 

Our readers are too stupid to understand financial arbitrage and very basic macroeconomics, so we will pretend financial markets are like economic oracles or jealous gods. This seems to be the attitude of much of the media when it comes to events like the Budget.

Let me start with a brief summary of what actually happened after the Budget. For those who want a more detailed account and can read the FT, this from Toby Nangle is (of course) very good and very clear. The Budget was what macroeconomists call expansionary, which means that it had the effect of increasing the total demand for UK produced goods and services. This was because government spending was increased by more than taxes, with the balance made up with higher borrowing. An expansionary budget tends to raise output in the short term compared to what it otherwise would have been, which puts upward pressure on inflation. This in turn will mean that interest rates set by the Bank of England are likely to be higher than they otherwise would have been in the short term as a result of the Budget.

The financial markets, like most commentators including myself, had been expecting a Budget like this, but the degree of expansion was a bit more than average market expectations. As a result, these markets revised up a little their expectations of near term rates set by the Bank, which because of financial arbitrage meant that interest rates on financial assets with a longer term duration, like government debt (‘gilts’), increased slightly after the Budget.

How this was portrayed in the media depended on politics. Among the propaganda media in particular there were clearly some who wanted to make this into Labour’s Truss event. It has to be said that excited talk of this kind was not limited to this section of the media, and I was reminded of this. But elsewhere we mostly got the personification of markets. To take just one example, consider these opening two paragraphs from an article in the Guardian.

“Rachel Reeves has been warned an extra £9bn of tax rises may be required to avoid a fresh austerity drive in key public services as her record tax-raising budget sent tremors through the financial markets.

Threatening to undermine the chancellor’s claim that her budget would restore economic stability to Britain, government borrowing costs rose sharply in the City on Thursday as traders turned on Reeves’s tax and spending measures.”

To say that the “record tax-raising budget sent tremors through the financial markets” is doubly misleading. The use of hyperbole with the earthquake analogy I’ve grown used to from the black hole nonsense. What is worse is the implication that what surprised markets was the high amount of taxes being raised, whereas the opposite was true. What surprised the markets was that the tax increases were smaller than expected given the Budget’s spending projections.

In the second paragraph, in what world is mildly higher longer term interest rates a threat to what the Chancellor means by stability? I doubt that if the Bank cuts interest rates this week anyone will write that this threatens Reeves’s stability claims. Indeed the Bank moving interest rates up and down is designed to give us economic stability! So when interest rates on government debt move slightly because of expectations of the Bank doing their job in the future, how does that undermine economic stability? But what is really bad is the idea that “traders turned on Reeves’s tax and spending measures”.

Financial traders are trying to predict future decisions by the Bank of England. Their individual or collective views about the Budget measures are neither here nor there. Suppose the budget had raised the top rates of income tax paid by market traders, and had also been unexpectedly contractionary, leading to lower interest rates. It would be silly to write about the latter as ‘traders welcoming the budget’s measures’. It is equally silly to use that language here.

If you get beyond the first two paragraphs, then it becomes clear that the authors do understand what is actually going on in the markets, although they do their best to suggest different views when all their quotes they give are consistent with each other and with what actually happened. It is as if a sub-editor had taken a factual piece and said ‘this is dull: here are a couple of opening paragraphs to spice it up a bit, and make sure you mention Truss at every opportunity’.

Why does this kind of thing bother me so much? (I wrote something similar just before the budget.) The answer is that I believe it matters a lot, and is an example of something very dangerous. It matters because this budget is all about beginning the process of extracting us from the disaster of 2010 austerity, a disaster which at the time the media thought was great economics, in part because they believed and wrote nonsense about imminent disaster in financial markets using the same type of language as I flagged above.

The media got 2010 austerity so wrong because they chose to believe their own stories, and the stories of the politically motivated, over the knowledge that every first year undergraduate student in economics is taught. Most journalists are overworked and have little time to think, let alone consult experts. In the case of economics, representative bodies make little attempt to provide information about consensus views to journalists. Ironically for something that is supposed to be about reality, journalism is a self-referential system in which speed and novelty is valued more than being informative. It is therefore possible for the media to present readers or viewers with a completely distorted view of reality, and for most journalists to be almost unaware that this is happening or that it is a problem.

We see the aversion or inability to provide information and knowledge most clearly in political journalism. Policy differences are rarely discussed in any depth, while endless time is given to surveys of popularity, horse races, insider information and other trivia. In part this comes from an obsession with balance, even though in practice balance often seems to be just an excuse for making life easier for those that run media organisations. Providing knowledge may often be incompatible with preserving political balance, particularly when one side routinely lies and distorts the truth.

This is one reason why the potential disconnect between the media and expertise is magnified when one half of the media are doing simple propaganda, but the rest of the media act as if this wasn’t happening. So the right wing press sets the agenda for the BBC. So, when Joe Biden mumbles something that was wilfully misinterpreted by his opponents as being disparaging about Republican voters it is headline news, while when Trump routinely describes Democrats as the enemy within it is not, perhaps because he does it all the time.

It was in large part because the media thought austerity was good economics that we got Cameron re-elected in 2015, which led to the Brexit referendum. One side lied constantly and called consensus views about the economic and other consequences of leaving ‘Project Fear’. The propaganda media amplified those lies. Yet the other half of the media said our job is to be balanced rather than to convey knowledge. In these circumstances is it any wonder that UK voters chose narrowly to commit one of the most obvious acts of collective self harm in recent history.

In countries like the UK and US where half the media is promoting political propaganda, what the rest of the media need to do above all else is not to provide balance but to provide good information and expose misinformation. When the propaganda media want to pretend that the market reaction to Reeves’s first budget is like what happened under Truss, writing that “traders turned on Reeves’s tax and spending measures” promotes misinformation rather than knowledge. When the propaganda media want to claim that Biden insulted all Republicans, calling it a gaffe and saying it is a problem for Harris is promoting misinformation rather than knowledge.

We will see very shortly whether that kind of journalism will help US voters commit perhaps their biggest act of self harm in recent history.

A budget that points the way but doesn’t get us very far

 

Did Rachel Reeves set Labour on a path to ending austerity, and making up for the lack of public investment over the last fourteen years? In this post I will follow the format of my pre-budget post, splitting the discussion into three sections: public investment, current public spending and taxes. I’ve also added an extra, rather annoyed section on fiscal rules, and a summary.

Public investment

The chart below compares the net public investment plans Reeves inherited from the last government, with her Budget plans she gave to the OBR.

Under the Conservatives public investment as a share of GDP was projected to fall steadily from current levels of around 2.5% to 1.7%. The assumptions that Reeves has given the OBR imply, to the first approximation, public investment staying flat at 2.5% of GDP. That is an improvement, but a relatively modest one, given the lack of public investment over the last fourteen years.

Current public spending

Current spending is everything that isn’t gross public investment. The chart below compares pre and post-Budget assumptions given to the OBR.

Here we have a similar story. The Conservatives had pencilled in further cuts to the public sector compared to current (23/4) levels, while Reeves has assumed the share of public spending in GDP will be, to the first approximation, pretty flat through the next five years at around the current level of 40%. So no additional austerity compared to where we are now, but no attempt to return spending to the levels needed to restore the public services to the state they were in just before austerity began in 2010. In particular, with health services around the world absorbing an ever growing share of GDP, flat in overall terms means most departments will see a falling share of spending in GDP.

If that seems a little disappointing, it is worth remembering two points. The first is the extent of additional austerity implied by the inheritance Reeves received, all to enable unsustainable tax cuts. Avoiding that required the budget undertake substantial tax rises and considerable additional borrowing. As the OBR sets out in the chart below, most but not all of the additional current spending is matched by higher taxes, with some covered by additional borrowing thanks to revised fiscal rules.

The second point to remember is that this is just one budget. My overall impression is that, compared to the potential tax changes I went through in last week’s post, Reeves has in most cases been relatively modest in the increases implemented this time. That leaves scope for further increases in spending matched by higher taxes, if necessary, in later budgets.

Taxation

In my last post I looked at areas of taxation where I thought significant amounts of money could be raised (or, if you prefer talking about resources, where a significant amount of resources could be released to allow for additional public spending), without violating the pre-election pledges not to raise income tax, employees NIC, VAT or corporation tax.

1. Employers National Insurance Contributions

Raising employers NICs can be thought of as partially undoing the reckless (in terms of unsustainable) cuts to employees NICs made by the last government. In fact employers contributions are slightly more progressive than employees, because there is no upper earnings limit on employers contributions. (As I noted in that earlier post, removing the upper earnings limit on employee contributions would raise a significant amount of money in a very progressive way, but was presumably precluded by pre-election pledges.)

This change in employers' NICs accounts for more than half of the additional revenue raised in the budget (£26 billion out of £42 billion by the end of the decade).

2. Other tax increases

As expected, both Capital Gains Tax and the Inheritance Tax regime have been changed to increase revenues, but the scale of the former in particular is modest compared to some of the possible changes I outlined last week. In that sense, this is not so much a ‘soaking the rich’ budget, but a ‘mildly inconveniencing the rich’ budget. As I noted then, there is a strong case for gradualism with taxes that few pay and where behavioural changes are potentially important, so this may not be the last time these taxes are increased.

3. Fuel duty

In last week’s post I noted some tax increases that the Conservatives had pencilled in which Reeves could cancel, but doing so would only make her job harder. Fuel duty was one of those, and here Reeves has not only decided to not increase the duty yet again (on a day after floods generated by climate change killed dozens in Spain), but is in danger of continuing the Conservative practice of planning future Fuel Tax increases but never implementing them. Depressing.

Fiscal rules

Yes, counting government financial assets as well as liabilities makes more sense than just counting liabilities, and this change to the fiscal debt rule allows more public investment which is good. However counting financial assets but ignoring physical assets still makes little economic sense, so the new debt rule run alongside the golden rule still has no purpose other than to suppress public investment.

More unexpected was the gradual move to a three year rolling target for the fiscal rules rather than a five year rolling target. This is simply a mistake. The rationale for a five year ahead target is that forecasts over this time frame exclude cyclical effects. This is clearly not the case for three year ahead forecasts. The Treasury document says that moving to three years ahead will ‘enhance fiscal discipline’, but so would balancing the budget each year! Designing good fiscal rules tries to combine fiscal discipline with good fiscal policy, and good fiscal policy should be counter cyclical not pro-cyclical. This change will do almost nothing to improve fiscal discipline but will make good fiscal policy more difficult. (On fiscal discipline, see also Fuel Duty above!)

The reality is, unfortunately, that the design of fiscal rules is increasingly a political exercise where good analysis is regarded as far less important than short term expediency, the thoughts of Krugman’s ‘Very Serious People’ or political journalists (mediamacro). This is a problem because, as I always say, bad fiscal rules are worse than no rules at all.

Summary

As most of the media will attack this budget for increasing taxes to ‘record highs’, without appearing to give a moment’s thought to why taxes are rising to record levels in most countries, it is natural to be defensive of it. It is, after all, much better to travel in the right direction, albeit slowly, than to keep on going the wrong way.

However, the political danger of moving gradually, in part because one hand is tied behind your back (no tax rises on working people), is that you disappoint those who are naturally impatient to see improvements in public services across the board. A political environment where voters know taxes are rising but where problems in public service provision (including child poverty) continue to fill the headlines is not a comfortable one for any government, because it raises issues of competence in voters’ minds (where is the money going?). Equally risky is continuing to try and flatter the marginal voter (or petrol user!) when you are in danger of losing your political base. I suspect, once the immediate and rather predictable political controversy is over, this budget will be seen as the minimum that could have been done, and that something bolder might have been less risky in the longer term.

October Budget 7: Soaking the rich?

 

This, my final post on the forthcoming budget, is designed to provide a guide to how to read what Reeves announces (or doesn’t announce) in a way that goes rather deeper than the normal media commentary. My perspective, along with a large part of the UK population, is how much does the budget get us on a path designed to end public service austerity. (See here for what I mean by that.) As I argued here, a budget that focuses on filling black holes rather than restoring public services will be a political failure. So I will start with current public spending, go on to talk about what taxes might be raised to match that spending, and finally talk about public investment.

Public spending

As I outlined in an earlier post, the share of public spending in GDP needs to rise substantially to get back to an acceptable level of provision. Below are the headline numbers for total current spending (excluding gross investment) and taxes from the OBR’s databank. We see the share of public spending in GDP rise under the last Labour government and fall under the Conservatives. The pandemic (with a little earlier help from the Johnson government) provided a sharp increase, but the plans Reeves inherited suggest a resumed decline.

A critical point that I made in that earlier post, which is routinely ignored in most analyses, is that this GDP share needs to rise over time because, in the UK and most other countries, the share of health spending in GDP has historically been on an upward trend for well known reasons. In that post I estimated that, compared to levels today, current public spending needed to rise by 3% of GDP to return to 2010 levels of public service. However a better point of focus is the end point of the OBR’s projections, and because of the decline in spending Reeves has inherited the increase in spending has to be over 4% of GDP by that date.

Although a spending review for that period is yet to take place, Reeves will have to give the OBR some indicative numbers, and these are what we need to focus on. I don’t expect to see the share of current spending rise from its 2023/4 level of 40% to 43% by the end of this decade, if only because restoring public services to 2010 levels is a ten rather than five year project. The key question is how far will Reeves go, which in turn will depend in part on how much she can raise in tax, and in part on the forecast the OBR gives her. As I noted in my first post on the budget, economic growth does not give you much in the way of additional resources for public spending as a share of GDP, unless it is accompanied by public sector productivity gains.

The OBR publishes revised numbers for current public spending immediately after the budget. There is always a risk that there will be an element of Treasury/Cabinet game playing in the numbers Reeves gives the OBR, However I would have thought anything less than a projected real term increase in departmental spending, after allowing for much more for the NHS, would be politically disastrous for the government. In addition it will be very difficult (and wrong!) for Reeves not to at least begin rolling back child poverty, and in particular abolishing the two child limit and benefits cap. (See this from the IFS on the impact of these policy options on poverty.)

Tax increases

For tax increases the numbers you will see in budget commentary will be in £ billion (or £ million), so to give you an idea of scale raising public spending by 1% of GDP in today’s prices will cost around £30 billion by the end of the decade, and after adding in inflation more than £33 billion.

The tax rises in Labour’s manifesto are small in comparison. VAT on private school fees, a higher windfall tax on energy, closing non-dom loopholes and ending the carried interest tax exemption raise about £4 billion. Labour also hopes to raise £6 billion by spending more on tax collection, but the OBR will need to make a judgement about how realistic that is.

There are some tax increases due to come in that were scheduled by the last government, most notably the freezing rather than indexing of tax allowances. In addition Covid business tax relief is due to end, fuel duty is due to rise (ending a temporary cut and adding in uprating which the last government routinely assumed but never did), and lowering the stamp duty threshold. Reeves could reverse any of these, but that would only add to the taxes she needs to find elsewhere.

So where are large tax increases going to come from? Reeves has pledged that they should not come from ‘working people’, but in practice that seems to mean not from income tax, personal NIC contributions and VAT. Labour has also pledged not to raise the rate of corporation tax. What is left that would yield large amounts of money?

1. Employers National Insurance Contributions

Raising the contribution rate by 1% for employers would raise about £5 billion net. (Beware larger numbers quoted in the media that include contributions paid by the public sector.) Another possibility is to extend national insurance payments to employers’ pension contributions, which could raise £12 billion (net of the public sector). Finally she could remove the NIC higher earnings cap, which could raise over £12 billion. Strangely (not really!) this possibility is hardly ever discussed in the media. It is one of the steps needed to make national insurance contributions more like income tax, with perhaps the eventual integration of the two taxes on income from employment, but Reeves may feel it is precluded by Labour’s pre-election promises.

2. Capital Gains Tax (CGT)

At present, capital gains are taxed at a much lower rate than incomes, which if nothing else leads to a lot of tax avoidance. The details of what Reeves could do quickly get quite complex, as are estimates of how much the tax increase would raise. The key uncertainty is how much owners will (initially at least) hold on to assets to avoid paying the higher tax, hoping for a change of government. The OBR will have to take a view on this. Equalisation is also not straightforward, because it could involve just income tax, or it could involve all taxes on income from employment including National Insurance. A recent study suggested that equalisation with income tax (with rates of 20%, 40% and 45%) plus a system of allowances and other changes could raise £14 billion. Leaks to the Guardian suggest Reeves is looking at increases in the CGT rate from 20% (for most) to between 33% to 39%.

3. Investment income

Reeves could raise the tax rate on rental and dividend income. These are currently taxed at similar rates to earned income, but they could be taxed at higher rates. More radically, she could extend National Insurance Contributions to investment income, which Advani estimates could raise £11 billion.

4. Inheritance tax

Raising this from 40% to 45% would only raise a billion according to the IFS ready reckoner. (I would advocate a much bigger rise - sorry kids! - on equity grounds.) There is probably more scope to raise money by removing various exemptions (e.g. business and agricultural reliefs are worth 2 billion), and Reeves could be more radical still and replace it with a gifts tax. I don’t expect it, but Reeves could also introduce a wealth tax. Advani suggests a 1% annual tax would raise £13 billion.

5. Extending the freeze on tax thresholds

These are currently frozen until April 2028. Reeves could extend these over the full OBR forecast period, raising around £8 billion, but this really is an income tax increase. Budget leaks suggest she intends to do this, and perhaps she thinks this is politically safe as the Conservatives will find it difficult to condemn her for continuing what they started.

There are a lot of detailed changes that Reeves could make, which tend to be small in revenue terms but can add up. For those who want to get into the nitty gritty of all that and the above, there are plenty of good resources around from, among others, the IFS (their ready reckoner and Green Budget), the Resolution Foundation, Centax, the Financial Times and Dan Neidle.

The numbers above indicate that there is clear scope for substantial increases in taxes, even within the limits Labour has imposed on itself (with help from the Conservatives). Whether they amount to enough to bring public services back to 2010 levels is more doubtful. Most, but not all, of the proposals mentioned above will mainly hit individuals who are well off. Unfortunately the obvious redistributive tax change, raising taxes on very high earned income, is probably ruled out by Labour's pre-election pledges.  

Two final points. The first is to look out for tax increases that could be extended further in later years. In many cases gradualism makes economic and/or political sense, and also see the point about Cabinet game playing above. The second is to see if Reeves makes any initial moves to introduce new taxes, such as road pricing for example.

Public investment

There has been plenty of discussion in the media of how she could amend the ‘falling debt to GDP’ fiscal rule to allow more borrowing for investment, and almost no discussion of my own preferred option of getting rid of the rule completely. This makes perfect sense as the rule is designed to appease mediamacro rather than economists or the markets!

Whatever she decides to do, the key issue is how much extra public investment she plans for by the end of the OBR’s forecast period. On present plans net public investment is set to fall from 2.5% of GDP currently to 1.7% by 2028/9. In my view this decline needs to be turned into a substantial rise if we are going to catch up with all the investment lost under the Conservatives.

As the budget is on Wednesday next week, I will not do the usual post of Tuesday, but instead delay it until Thursday or Friday to give my own reactions to the budget.

October Budget 6: Thanks to Truss, bond market scare stories are back

 

In truth they never went away, but after Truss there is a danger that they will be taken more seriously. The FT recently published a classic of its kind, entitled “Gilt investors urge Reeves to keep investment ambitions in check”. The subheading read “Markets on edge ahead of overhaul of fiscal rules that could result in tens of billions of pounds of extra borrowing capacity”. Sounds scary, but worse is to come.

The article warns that Reeves may “bump up against tight constraints in the bond market as investors warn they have a limited appetite for fresh UK debt”. One trader suggested that anything more than £10bn to £20bn in additional borrowing could “push gilts over the edge”. The language of ‘constraints’, ’on edge’ or ‘over the edge’, and ’limited appetite’ all suggest the potential of a crisis where the government can no longer sell its debt.

As a result of this and other similar articles, I have seen plenty of pieces from political commentators warning that the budget might ‘spook the bond market’. This suggestion, along with the accompanying language, is complete and utter nonsense. The idea that if Reeves wanted to borrow an extra £30 billion, say, the markets would refuse to lend that to the UK government is just ludicrous. Reeves will not bump up against any constraints from the bond market for anything she is realistically likely to do.

What is possible is that a lot of extra borrowing might lead lenders to the UK government requiring a better interest rate. But this has little to do with supply and demand for UK government debt, and instead reflects expectations about what the Bank of England might do in the future (‘arbitrage’). If additional borrowing is associated with additional aggregate demand for UK goods, this will increase inflationary pressure, which in turn will mean the Bank keeps interest rates higher than they might otherwise have been. I discussed the mechanism for this in more detail here. At the end if this post I briefly discuss what the inflationary impact of additional public investment might be. 

This is exactly what happened initially with the Truss fiscal event. With inflation high and rising, the Bank of England were raising interest rates because they thought that strong labour demand coupled with weak supply could make the impact of the energy and commodity price shock more persistent. A fiscal event that cut taxes would only add to aggregate demand, meaning that the Bank would have to raise short term interest even further. If short term interest rates are expected to rise, so will the longer term interest rates in the market for government debt. Markets didn’t stop buying government debt, but they made it clear they wanted a higher interest rate on this debt because short term interest rates were expected to be higher as a result of the fiscal event.

With Truss, two factors turned normal market behaviour into a crisis. The first was peculiar to what Truss was doing. By announcing tax cuts without an accompanying OBR forecast, and with no clear indication of whether these would be followed at a later date by spending cuts (and if so, by how much and how credible were such cuts with public services already in crisis), accompanied with suggestions more tax cuts were to come and maybe Truss and others thought these tax cuts would ‘pay for themselves’ by boosting growth (which most people in the markets knew was false), the overall direction of fiscal policy suddenly became much more uncertain. [1]

By throwing a well established fiscal framework out of the window, Truss greatly increased the amount of uncertainty in the markets. If the return on an asset suddenly becomes much more uncertain, then other things being equal most would feel less inclined to buy that asset. The demand for Sterling assets fell, which is why Sterling depreciated when an appreciation would normally have been expected.

This increase in uncertainty led to interest rates in the market for government debt rising further still. That produced a second peculiar event, which was that pension funds suddenly had to sell a lot of their government debt (more details here). With few buyers and many sellers, the market for government debt became too thin for arbitrage to work, leading the Bank of England to step in as buyer of last resort (just as they did during the early stages of the pandemic).

These two factors, Truss’s departure from the OBR monitored method of fiscal policy making and the pension fund crisis that caused, were what turned what might have been a normal and relatively modest upward movement in interest rates into a crisis. Nothing Rachel Reeves will do in her budget is comparable with this. She has not sacked the most senior Treasury civil servant, she has not dispensed with the services of the OBR, and it is the OBR not Reeves that is making the reasonable case that additional public investment will almost pay for itself.

Which makes all talk of markets going ‘over the edge’ if Reeves increases borrowing to fund that investment just ludicrous. So why do we see that kind of nonsense written in otherwise sensible newspapers like the FT, alongside similar scaremongering from more predictable sources. A lot is simply political. Do you remember all the articles warning that the Truss fiscal event would spook the bond markets in the weeks before it happened? I don't.

Scaremongering works because of an absence of understanding, with most people having little idea of how financial markets work. Two things follow. First, articles warning of a crisis will be read rather than dismissed, which is good for the journalists that write them. Second, the words of market participants are given far too much weight, because they are seen as people who do know how markets work. That means all too often that financial markets are treated like a capricious god, and City economists like high priests. 

The reality is that it is not hard for any journalist to find market participants willing to say that extra borrowing will lead to a crisis, but the market also contains analysts who are much more sensible. As an example here is a piece by Will Dunn, which first quotes a City economist warning of a buyers strike if borrowing rises, but then quotes another giving a much more reasonable analysis along the lines outlined above.

The lesson is to ignore any article or any City economist that predicts a bond market crisis as a result of any normal budget where borrowing might be higher than previously planned. Higher public investment financed by additional borrowing might add to inflationary pressures, which might mean the Bank cuts interest rates more slowly than it otherwise might have done leading to moderately higher interest rates on government debt, but that ain’t no crisis and in my view is a price worth paying for much needed investment and improving economic growth.

But will additional public investment add to inflationary pressure? I ask because I read this, where Dan Davies discusses a brief interchange between himself and NIESR head Jagjit Chadha. Jagjit suggests that because public investment supports future supply, and because inflation setters are forward looking, any short term pressure on aggregate demand might not find its way into inflation.

I don’t buy this argument, even on its own terms. Yes, public investment will directly or indirectly improve the future capacity of the economy to supply goods and services, but there is no reason to think that aggregate demand will not expand to fill that capacity of its own accord. For example, if public investment helps improve future productivity, wages are likely to rise in line with that as they normally do, leading to higher consumption and aggregate demand.

What the Treasury can do is be aware of any inflationary dangers in choosing what investment to prioritise (as well as ensuring that projects are worthwhile in standard cost benefit terms). For example, as I have mentioned before, projects that involve buying stuff from abroad (e.g. MRI scanners) put less pressure on aggregate demand than projects that are entirely home produced. The US experience suggests it is possible to substantially increase investment without creating significant persistent inflationary pressure, and with sensible planning it may be possible to do the same in the UK. 

[1] If these tax cuts were quickly followed by credible spending cuts, the overall impact on aggregate demand would be negative, because some of the tax cuts would be saved. This would mean the Bank would lower, not increase, interest rates. In contrast, if those in charge really did think these tax rises would pay for themselves, and intended to do more of them, then the Bank would have to increase interest rates by a lot. 

Why are the Conservatives ignoring the median voter?

If the candidates for the Tory leadership sound much like ministers in the last year of the Conservative government, it’s because the leadership campaign started well before Sunak lost the election. But they lost that election very badly. To many it seems odd that the leadership contenders, at least publicly, appear in complete denial about this loss, and are carrying on as if it hadn’t happened. Given the nature of the leadership election, that puzzle quickly becomes why Conservative party members appear to be in disbelief about why they lost so badly.

It is easy to say that this is what happens when a party loses after being in government for so long. Many compare the current contest to what happened after Callaghan was defeated in 1979, or Major in 1997, or Corbyn’s victory in 2015. I think these comparisons are not very helpful. Let me start with the comparison that tells us very little. Corbyn’s victory in 2015 was five years after the previous Labour government, and it happened not because the membership were in denial about why they lost power in 2010 but because many shadow ministers were in denial about the appeal of austerity.

You could argue that Labour lost in 2010 because of its large budget deficit and their failure to prioritise reducing that deficit. [1] It is certainly true that the Conservative victory in 2015 owed a lot to the almost total acceptance by the media that reducing the deficit was more important than declining living standards and a pathetic recovery from recession. Perhaps as a result, the consensus among shadow ministers in 2015 appeared to be that Labour had to accept even more of the austerity agenda than they already had.

But that consensus was wrong, and the instincts of Labour members to want a much stronger opposition to austerity was correct. As I argued at thetime, the appeal of austerity was always going to be time limited, and Labour did well in 2017 partly because it wanted a larger rather than smaller state. The reasons for Corbyn’s failure in 2019 were not the reasons why he won in 2015.

A potentially more relevant comparison is with the victory of Ed Miliband after 2010. Yet one of the big mistakes Miliband made was not to defend the Labour government’s record, which allowed the Coalition to get away with ridiculous ideas that the country had been on the brink of a financial crisis in 2010 and that the recession was all Labour’s fault.

Is Labour’s shift to the left after its 1979 defeat a better comparison? Just as Labour then was deeply split between left and centre, you could say the Conservatives are split between the right and a One Nation centre. But whereas the split within Labour in 1979 onwards was both very evident and extended to the membership, if the Conservatives are split the centre is both remarkably quiet and appears largely absent from the membership.

In addition, 1979 is very different from 2024 in terms of the government the opposition is facing. It became quickly clear that Thatcher represented a sea change in ideology on the right, while Starmer’s victory was based on ensuring that the policy differences between Labour and the Conservatives were both minimal and minor. Starmer might be bolder in government, but the extent of that is far from clear at the moment.

Such comparisons also fail because of the unique feature of both the last election and the current contest, and that is the presence of a strong party further to the right of the Conservatives. Reform showed in 2024 that it was able and willing to win large numbers of votes at a General Election at the cost of seats lost by the Conservatives.

For party members it is convenient to believe that Reform was why they lost so badly, in part because many of those members have considerable sympathy for Reform’s agenda and would quite like Farage as part of the party. Little that they read in the right wing press would lead them to ask more fundamental questions about why their party became so unpopular. In addition, the victor of the 2024 election hardly presented a radically different policy platform to the last government, which can be read (if you are predisposed to) as suggesting that there wasn’t that much wrong with what the last government was doing.

However it is too simple to suggest that the nature of the leadership contest would be very different if members didn’t have the final say, for two reasons. Many Conservative MPs appear to believe that Reform poses an existential threat to the Conservative party ever returning to government. The idea that a far right party could dominate a more centre right party is not that fanciful if you look at what is happening in many other countries. Even dominance is not necessary to prevent the Conservatives winning if Reform continues to split the right wing vote.

Of course such comparisons need qualifying for various reasons. Trump dominates the Republican party because he took over the leadership of that party, and so far Conservative MPs have been sensible enough not to let Farage repeat the same trick in the UK. The first past the post system in the UK is also pretty effective at preventing a third party replacing the big two.

Nevertheless Conservative MPs may feel that they have to at least match the Reform offering on immigration and other socially conservative issues, so voters where these issues are a priority will go back to voting Tory once memories of the failures of the last government fade away. If the Labour government becomes unpopular enough, then the Conservatives can persuade potential Reform voters that they need to vote Conservative to get Labour out. This might work if enough disillusioned Labour voters switch to the Greens or LibDems.

Even on its own terms, the strategy of following rather than confronting Reform has significant problems. Reform will always be able to outflank the Conservatives on immigration and other issues because they can suggest policies that are even more fanciful, which can survive because the party is subject to less media scrutiny than the Conservatives. (They also survive because media scrutiny can be pretty poor - see Rwanda - and the political right is increasingly able to ignore evidence - see climate change.)

In addition, Reform has Farage (Reform is Farage!), and a strong charismatic leader has particular appeal to socially conservative voters. None of the current Conservative candidates can match Farage in this respect. In addition, some analysis suggests that among all potential Tory voters, those voting Reform are more difficult to win over than those who switched to Labour, the LibDems or who did not vote at all. Finally the emphasis given to very socially conservative policies may alienate some traditional Blue Wall Tories.

An equally significant problem is that this strategy ignores economic policy. Where the current Conservative party really appears to be in denial is its faith in the appeal of low taxes, its silence on how to improve public services, and the failures of Thatcher’s privatisation policy. It is the unpopularity of these policies that require the Conservatives to emphasise issues like immigration in the first place, which in turn gives credibility to the likes of Farage. Some Conservative MPs must understand this, but the wishes of the right wing press, party donors and members prevent those MPs even suggesting a move to the centre on economic issues.

As a result basic questions remain unanswered, or their answers can only be voiced in private. How can you be a tax cutting party when the health service continues to require a larger share of total national resources (GDP) over time? The only answer the Conservatives have is for the NHS to become a bare bones, inferior service which the majority of the middle class opts out of, but that answer is electoral suicide. How can you insist on cutting red tape when that leads to tragedies like Grenfell and a water industry exploiting both its customers and the environment. The only answer the Conservatives have is that these are acceptable costs in order to free the burden on business, but again saying this publicly would be electoral suicide. They have no answer to how can you cut immigration without damaging industry, universities or the public services, or how ‘taking back control’ has led to less international influence and power (as well as economic harm) And most fundamentally of all, how did fourteen years of a policy supposedly designed to help business thrive lead to the worst period of UK economic growth since WWII?

The best comparison for the Conservative party today is what happened after Major’s defeat in 1997. It also failed to ask whether some of its Thatcherite/neoliberal economic policies might have been responsible for its defeat, and relied on issues like immigration to attack Labour. That strategy failed in two general elections, and eventually Shadow Chancellor Osborne was forced to move to the centre by accepting Labour’s public spending levels. They only just won in 2010, but even that was largely down to luck (Labour being blamed for the Global Financial Crisis) and disastrous opportunism (convincing both the media and voters that reducing the budget deficit should become the country’s macroeconomic priority).

In 2024 the state of the public services is far worse than in 1997. In addition, the privatisation of rail companies is ending and the privatised water industry is a national scandal. Simple median voting models imply that being so far to the right on both social and economic issues compared to the views of the average voter should condemn the party to perpetual opposition. Does denial by the Conservative party of the unpopularity of its economic policies condemn it to indefinite opposition?

That ignores a key lesson of 2024, which is that the popularity and competence of the government matters more than the policies of the opposition in influencing votes. It ignores that Labour too need to worry about losing votes on both flanks thanks to the success of the Greens in 2024. It ignores the lessons of 2010 and 2015, which is how easily the wider media can be manipulated. For these reasons, even a party in denial about the unpopularity of its policies can win elections. For this reason it will take more than one election defeat for any party leader to challenge the views of party members, financial donors or press barons, and attempt to move the Conservative party away from the ideological cul-de-sac it now occupies.

[1] I have argued the opposite: that the Treasury persuading Darling to put deficit reduction on a par with recession recovery played into Conservative hands.

October Budget 5. The UK’s Fiscal rules: one good and one bad

 

On 30th October Rachel Reeves will be setting out her first budget, rather than responding to someone else’s decisions. She will be leading the public discussion, not following the narrative set by another. That will be obvious in terms of tax, because she will be raising taxes rather than pretending to permanently cut them. But it should also be true for the fiscal rules that she commits the government to follow.

In his first budget of 1997, Gordon Brown set out his own fiscal rules. They were very different from anything followed by his predecessor, and they were innovative at the time. They lasted for ten years, derailed only by a global crisis and the worst recession since WWII. The forthcoming October budget is also a chance for Rachel Reeves to establish her own fiscal rules that are better and last much longer than those of her predecessors. [1]

Last week’s discussion of why we have fiscal rules gives us three basic properties that good fiscal rules should have:

1. They should discourage politicians from using deficit finance (paying for higher spending or lower taxes by borrowing or creating reserves (money)) simply to avoid the unpopularity of raising taxes or cutting spending, rather than for any good economic reason.
   
   

2. Conversely they should not prevent deficit finance when this makes sense in economic terms. For example there are good reasons why fluctuations in public investment should be financed by borrowing, and overwhelming reasons why a deficit financed fiscal stimulus should be used when an economy is at risk from, in, or recovering from a recession.
   
   

3. Fiscal rules should focus on underlying trends, rather than short or medium term fluctuations in spending (wars, pandemics, greening the economy) that have no strong implications for sustainability.
   

Fiscal rules that do not have these properties are bad rules, and it is better to have no fiscal rules than bad fiscal rules.

One of the fiscal rules that Reeves says she will follow largely has these properties, and one clearly does not. The rule that does is sometimes called the golden rule, and it states that in the medium term day to day public spending (all spending except investment) should be equal to total taxes. Specifically this involves a rolling five year ahead target for the current budget deficit (public spending excluding public investment minus taxes) of zero. However, as governments since Cameron/Osborne have acknowledged, and as first proposed in Portes and Wren-Lewis, this target has to be conditional on the economy not being close to, in or recovering from a recession. [2]

The conditional golden rule achieves property (1). It achieves (2) because it doesn’t apply during a recession, and the current balance excludes public investment. A rolling five year ahead target helps achieve (3), because forecasts five years ahead almost always involve the economy being on its medium term path. It is often suggested that having a rolling target rather than a target for a fixed date is bad because it ‘lets politicians off the hook’. This is false, particularly if forecasts are done by an independent body like the OBR. In contrast having a target for a fixed date fails property (3). As we move closer to that date fiscal policy will be responding to short term shocks, which makes for bad policy.

Although a conditional medium term golden rule goes a long way to satisfying property (3), it fails to take account of spending that is medium but not long term. The clearest example of that today is spending that helps the transition to green energy. For this reason, if I were Chancellor I would task the OBR with calculating how much of the current deficit is due to policy aimed at encouraging this green transition, and adjust the target to exclude this spending. Any government that lets a fiscal rule delay the green transition has got its priorities criminally wrong.

I have seen it recently argued that the last year of the last government showed that deficit based fiscal rules failed, because it didn’t prevent that government from making incredible assumptions about future spending so it could cut taxes. That is a misunderstanding. What the fiscal rules did, combined with an independent OBR forecast, was force the last government to make assumptions that amounted to further austerity in order to make tax cuts. That these plans amounted to further austerity was widely commented on by experts in the independent media. Without a fiscal rule and the OBR to monitor compliance, I’m sure the last government would have claimed that it would cut taxes and increase public spending! [3]

The other fiscal rule that Reeves appears to have adopted, which does come from her predecessor, is for a falling debt to GDP ratio five years ahead. This, when you already have the golden rule, is a terrible fiscal rule. I have not come across a single serious economist who defends it, and plenty of eminent economists who understand the damage it is doing (e.g FT here, or ungated here). The rest of this post is about all the reasons why this rule is not fit for any purpose except keeping economic growth down.

The first point to make is that, if the medium term conditional golden rule is in place, there is no need for an additional rule to achieve property (1). The golden rule does that just fine. In that sense the falling debt to GDP rule is completely superfluous [4]. Unfortunately that rule fails properties (2) and (3), because it discourages much needed investment. This is the reason I sometimes call it the suppressing public investment rule.

Suppressing public investment is exactly what the previous government was doing for fourteen years, and the terrible state of our public sector is partly a result of that. This was perhaps why that government was so attached to this rule. In contrast, Reeves has spoken many times about the need for additional public investment, so it makes no economic sense for her to adopt a rule designed to suppress that investment.

We currently need a surge in public investment to catch up all the ground we have lost. But the case for much higher public investment is even stronger than that, as recent research from the OBR clearly shows. Their paper first shows how public and private investment are really low in the UK compared to other G7 countries.

Public investment began rising towards the G7 average in the first decade of this century, but austerity cuts set that back. Private investment is no better, but that is partly because public and private investment are often complements.

The OBR, using very reasonable assumptions, calculates that if public investment was increased by 1% of GDP permanently, potential output would be 0.4% higher after 5 years. The impact on potential output goes on rising steadily, to reach 2.4% after 50 years. The paper also looks at what these assumptions imply for average rates of return and benefit to cost ratios. Of course the whole point of a good investment strategy is to choose individual projects that have a high return, and make sure these projects are not thwarted by some archaic fiscal rule. What the OBR’s analysis shows clearly is that increasing public investment is an excellent way to help improve the UK’s recently dire growth performance.

The falling debt to GDP rule is classic mediamacro. It comes from the idea that government debt is a 'bad thing' by making false and selective comparisons to household debt, that current levels are 'obviously' too high, and so debt needs to be brought down. It’s a rule that economists advise against but political advisers say is essential to maintain ‘political credibility’, which is code for what non-economists in the media think should happen. Everyone from political journalists to the great and the good like to opine about fiscal rules while having little knowledge. It is they, not economists, the markets or even GOD, that think maintaining such a bad fiscal rule is essential for credibility, and they are wrong about this just as they were wrong about 2010 austerity.

Reeves should take the opportunity of her first budget to consign this rule to the dustbin. The new OBR analysis of public investment provides the perfect excuse to do so, if she needed an excuse. [5] A comment from the National Institute argues that the OBR's analysis may underestimate the impact of public investment on economic growth.   

What should take its place as Reeves’ second fiscal rule? Nothing. You don’t need a second fiscal rule. It serves no purpose, beyond the bad one of suppressing useful public investment. As I argued here, replacing it with a target for falling net public sector worth to GDP is just double counting. It makes sense to look at public sector net worth when looking at sustainability over the longer term (beyond five years), but having it as part of a fiscal rule is not sensible.

Yes, the Conservative opposition will claim that abandoning the falling debt to GDP rule allows the Chancellor to have slightly higher spending (about half a percentage point of GDP, according to the last OBR forecast) and higher public investment. Most voters will be happy about that. No one in the bond market will be worried - why should they be, when the OBR calculates that public investment almost pays for itself in generating higher taxes. [6] Much more importantly, abandoning this rule will allow the Chancellor to expand public investment to boost economic growth and green the economy. Getting rid of the falling debt to GDP rule is really a no-brainer for any Chancellor whose main concern is the health of the economy rather than what the media commentariat might say. 

[1] Part of the cynicism surrounding fiscal rules is a consequence of the last government, which changed fiscal rules even more frequently than the Prime Minister. Sometimes this wasn’t because the rules they replaced would have been broken, but just as a political ploy to wrongfoot the opposition. Essentially the last government used the misconceived media credibility they got from austerity to devalue the concept of a fiscal rule.

[2] Formally, the lower bound for nominal interest rates makes it essential that we have fiscal stimulus to prevent, moderate or recover from a recession. The exact form this conditionality takes is a second order, though important, problem.

[3] There is an issue about the OBR being forced to make forecast assumptions it strongly suspects are false, which I discussed here. This is an issue about the OBR's mandate, not about fiscal rules.

[4] In fact the falling debt to GDP rule has nothing to do with the basic principle of ensuring debt sustainability. Instead it is based on the presumption that the current debt to GDP ratio is too high, and as I discussed in my previous post there is no evidence for this.

[5] If Reeves is planning to keep this silly rule, and has already adjusted her plans so that the rule is met, it is not too late. She could be politically clever and announce both the end of this rule, but also that her fiscal plans would have met the rule anyway, showing that the rule is being ditched on good economic grounds rather than so she can spend more or tax less.

[6] That doesn't mean that long term interest rates will not rise. They may if additional public investment adds to already strong aggregate demand (in the face of weak aggregate supply), and markets anticipate that this will put upward pressure on interest rates. The obvious way to avoid that is to increase taxes.