Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 27 February 2024

Detoxifying government debt, part 3. The Truss crisis has no relevance for Labour borrowing to invest


Over the last fifteen years the UK has experienced or witnessed three crises stemming from financial markets, the Global Financial Crisis, the Eurozone crisis and Truss’s ill-fated ‘fiscal event’, all of which have led to a view that government debt is in some way toxic, and therefore public investment needs to be curtailed. Because it is more recent I will focus on the last, but it is worth just repeating why the other two have no relevance whatsoever.

The Global Financial Crisis occurred in large part because banks started treating risky assets issued by the private sector (US subprime mortgages) as safe assets. US, UK or Japanese government debt, by contrast, really is a safe asset. There is a literature that argues that one of the reasons for the GFC was a global shortage of genuinely safe assets, or in other words that there was too little government debt. The big increase in government debt that occurred after the GFC can be seen as a correction to that problem, rather than the problem it is usually portrayed as in the media. When Conservative politicians tried to link the Global Financial Crisis to UK government debt or deficits, they were at best ignorant or at worst lying,

The Eurozone crisis was all about financial markets refusing to buy the government debt of certain Eurozone countries. The media and political narrative was all about how these governments needed to borrow less. But the reality, hardly ever described in the media, was that the crisis arose because the European Central Bank (ECB) initially made it clear they would not be a last resort buyer of national government debt, which meant that governments could be forced to default if no one bought their debt. Once markets knew that, they were perfectly right to worry about whether they would get their money back if they bought government debt, and once that concern became significant it was almost inevitable that a crisis would unfold, and governments could be forced to default.

The moment the ECB policy changed (‘we will do whatever it takes’), and agreed to become a last resort buyer of most Eurozone government debt, then the Eurozone crisis ended. The implication, which again the media hardly ever draws, is that the Eurozone crisis has zero relevance to advanced countries with their own central bank like the US, UK or Japan.

So of the three crises, the only one relevant to the market for UK government debt is what happened before and after Liz Truss’s disastrous fiscal event. This can be thought about in three stages [1], using my simple guide to the bond market outlined in part 2 last week.

Stage one was happening before the fiscal event itself, once it became clear the event would involve tax cuts without any announcement of specific spending cuts. That put money into an economy that already had an inflation problem, so meant the Bank of England was likely to increase interest rates as a result of the fiscal event. As explained above, that means interest rates on government debt will rise. The bond markets were acting as a pricing mechanism.

Stage 2 involves uncertainty. Because spending cuts were not announced, we had no idea how plausible they would be, or even if they would happen at all, given that public services have already been cut to the bone. The uncertainty about cuts to public spending mattered to the markets because any cuts would influence aggregate demand and therefore Bank decisions on interest rates. Greatly increased uncertainty about future interest rates made markets more reluctant to hold sterling assets in general, which is why sterling depreciated despite higher expected interest rates. It made traders reluctant to buy government debt, pushing interest rates on that debt up further. (This was sometimes called the ‘moron premium’.)

Stage 3 involved UK pension funds needing to sell a lot of government debt because of a combination of their Liability Driven Investment (high leveraging) strategy and higher interest rates. Supply increased, but demand had fallen because of much higher uncertainty. We had an unusual example where supply and demand in the market for government debt influenced its price, but as we noted last week that is also when central bank intervention is likely to happen. Sure enough, It was at this point that the Bank of England stepped in as the buyer of last resort for UK government debt. However the Bank made it clear their role was to only allow pension funds time to sort themselves out, and not to reverse the impact of stages 1 and 2. [2]

The key point to note is that none of this has anything to do with ‘borrowing too much’, in the sense that an individual borrows too much and cannot pay the money back. Instead it has everything to do with trying to guess future interest rates set by the Bank of England, during a period in which further cuts to public spending were no longer politically credible. At the only point where it looked possible that a funding crisis could emerge because there were not enough people in the market willing to buy UK government debt, the Bank acted as the buyer of last resort, just as it did at the start of the pandemic.

What relevance does the Truss episode have for a future Labour government wanting to borrow to invest? It tells us that if the economy is at full capacity, and the UK government increases public investment by more than expected, paid for by borrowing rather than higher taxes, then the central bank is likely to raise short term interest rates because investment and aggregate demand will be higher. As the bond market acts as a pricing mechanism, that will raise interest rates on government debt, although by less than the increase in short term rates. [3]

In economic terms this is exactly what needs to happen. If the government wants to pay for many more people insulating homes, it needs to create the extra workforce to do that, which means reducing the demand for workers in other areas of the economy. Higher interest rates is one way the government can shift resources from the private to public sector. Note crucially that interest rates are increasing because of pressure on aggregate demand, not because government borrowing is higher. If government borrowing rose because the economy moved into recession, interest rates on government debt would follow short term rates down, not up.

Critically, however, interest rates would not rise by nearly as much as they did under Truss, because there would be no uncertainty involving possible cuts to public spending. Truss helped create a crisis because of two mistakes. The first, generally recognised, was to announce tax cuts without announcing cuts to public spending at the same time, and refusing to publish an OBR forecast that would have had to pencil in numbers for cuts. The second was to imply possible spending cuts in an environment where further cuts to spending were almost politically impossible to implement. In that sense it was a disaster created by the small state obsession of the Conservative party hitting the rocks of the political reality that you couldn’t make a state in charge of health, education and much more any smaller. It was this combination of lack of information and credibility that created the large increase in uncertainty that led sterling to fall despite higher expected interest rates.

As higher public investment should be paid for by additional borrowing, there is just no scope for the kind of shift up in uncertainty that led to stage 2 of the Truss crisis, which in turn precipitated stage 3. In that sense, the Truss crisis has no relevance to a future Labour government wanting to increase public investment.

So why is Labour acting as if the opposite is true? They may have trimmed their public investment plans on greening the economy to diminish a potential attack line from the Conservatives at the next election, but they didn’t need to justify doing so by implying the economy could no longer afford additional public investment. As I noted in part 1, saying the economy can no longer afford to borrow to invest makes no sense in economic terms, and indeed additional much needed public investment is a key way the UK gets out of its current stagnation. Starmer even talked about this government maxing out its credit card, which is a terrible analogy to use and is indicative of basic macroeconomic muddled thinking.

Next week, in the final part of this series, I will look at why there are so many myths surrounding government debt, and why it is so important that a new Labour government does not succumb to these myths.

[1] Use of the term ‘stage’ is not meant to imply a strictly sequential process, as the stages undoubtedly overlapped

[2] The Bank was undoubtedly right not to try and counteract the increase in bond rates generated by market expectations about its own future decisions on short term rates (stage 1). They were also right to intervene to provide a buyer for the government debt pension funds needed to sell (stage 3). Others can debate whether they were right or wrong not to intervene to try and offset the additional uncertainty (the ‘moron premium’) created by the government’s actions.

[3] Long term interest rates depend on expected short term rates over the period until the maturity of the long term asset. Central banks are not normally expected to keep short rates high for prolonged periods, so the interest rate on long term assets will rise by less than short term rates. 

Tuesday 20 February 2024

Detoxifying government debt, part 2. Market myths


“Labour’s biggest opponent is no longer the Conservative Party. It is the bond market.” That was the first sentence I read a few days ago in an article in a respected publication. It works as a first sentence because it sounds all too plausible given the way the media treats the financial markets in general, including the market for government debt (the ‘bond market’). I once described the media as seeing financial markets like a vengeful god: a powerful but mysterious entity that has the potential to create havoc, and that therefore has to be treated with great respect and offered the occasional sacrifice, like less help insulating homes.

Who do you get to explain the behaviour of a vengeful god? The high priests of the vengeful market are the small band of economists working for City firms who get quoted in newspaper articles or appear on our television screens because they are 'close to' the markets. But these economists are no closer to the financial markets than someone on the till at Tesco’s is close to supermarkets. They are employed by City firms mainly to sound knowledgeable to wealthy clients rather than advise market traders. The unfortunate truth is that what they tell the media is pure guesswork, based on no evidence at all.

When one of them tells you ‘the markets are nervous at the prospect of’ some event, do you think they have conducted a survey of the thousands of people trading in the market that morning to ask them how they are feeling? Of course not. But the media want them to appear like experts with knowledge, so they tell what they think are plausible stories related to recent (often political) events.

All this adds to the perception that how financial markets work is deeply mysterious, and beyond the understanding of anyone unfamiliar with finance. It also adds to the idea that market traders are making judgemental decisions about political actions. The truth is very different. When it comes to the bond market the way it works is normally very simple, and easily understandable for anyone who has thought about saving in a fixed interest rate savings account, or anyone with a mortgage who has wondered about whether to get one with a fixed or variable rate. In reality financial markets are not a vengeful god but a pricing mechanism. The best way to detoxify market myths is with some knowledge, so here is a simple guide to how the bond market works.

Imagine you need to decide whether to invest your money in a variable interest rate savings account, or one that has a fixed interest rate for 3 years. If you think the variable rate will be above the fixed rate for most of those 3 years you would choose the variable rate and vice versa. In other words your choice is based on how you think short term interest rates will vary over the next three years, plus some allowance for any lack of freedom tying your money up for three years implies (the ‘liquidity premium’).

As most government debt has a fixed interest rate for a number of years, this is all that the bond market is doing. This pricing mechanism is often called arbitrage. There is nothing inherently difficult or complex involved that is beyond the understanding of most people. Market traders are trying to guess how central banks will set interest rates in the future, and they can get that wrong as much as any macro forecaster. The aim of these traders is just to make money, not to pass judgement on some political decision. The media stories you hear are plausible if and only if political events or decisions influence central bank decisions about short interest rates over the next few years. Those central bank decisions, as we know, depend on the Bank’s expectations about inflation. [1]

If arbitrage is the right way to think about how the bond market works most of the time, it is worth mentioning two alternative ways which are wrong most of the time. The first is to think about supply and demand. That works with the market for apples, because people have preferences for consuming apples and are often prepared to pay more if the supply of apples becomes scarce. But those preferences generally don’t exist for financial assets. [2] These assets are just a way of earning interest, and are not a consumption good. If some established national bank is offering permanently 0.25% higher interest on savings than some other bank, there is no reason to stick with the other bank.

If that seems obvious, then think about how often people in the media use supply and demand in talking about government borrowing. We were told after the Global Financial Crisis (GFC) that because government borrowing was going up sharply, so would interest rates, and so we had to get borrowing back down by cutting spending. In reality interest rates on government debt fell after the GFC because central banks cut short term rates, just as you would expect from the arbitrage process described above.

The second bad analogy often used for government debt comes from personal experience in borrowing, and involves repayment risk. If you are trying to borrow money, any lender will look at how likely you are to repay that money, and what the risks are that you will default on the loan. A similar logic will apply to individual firms that borrow to invest. However this way of thinking just isn’t relevant to the debt of advanced countries with their own currency like the UK, US or Japan. The reason is that these governments can always create the money to pay back the debt.

This is why the government debt of these countries are called safe assets. There is no risk of forced default, and these governments will never choose to default because of the cost that involves. There is a risk that inflation will devalue these assets (unless they are index linked), but because high inflation will lead to central banks raising interest rates that is already part of the arbitrage pricing mechanism described above.

How can governments create money when their central banks are independent? Central banks do it for them, by creating money (called ‘reserves’) to buy government debt. The central banks of the US, UK and Japan, along with other advanced countries that borrow in their own currency, are the buyers of last resort for government debt.

While the analogies of supply and demand or individual repayment risk are inappropriate to thinking about the way markets deal in and price UK government debt, we do need to add one final factor to the more realistic arbitrage model. While traders can make their best guess about where central banks will set short term interest rates over the life of the debt they are thinking of buying or selling, that forecast is uncertain. Because government debt is a safe asset, the people ultimately buying the debt (pension funds, banks etc) want less uncertainty, not more.

If the prospects for inflation, and therefore for future short term interest rates set by the central bank, become so uncertain they are almost impossible to forecast, buyers may decide that, for the moment at least, it is better to keep their money in short term assets or some other country’s government debt. The most charitable explanation for City economists talking about ‘nervous markets’ is that they think the level of forecasting uncertainty has increased. In extreme circumstances the uncertainty may be so great that traders withdraw and the market becomes very thin. Only at that point do considerations of demand and supply matter, but equally that is exactly the point at which central banks become the debt buyer of last resort to stabilise markets.

As the job of central banks is to stabilise inflation, the economy and financial markets, they will act when the market for government debt stops working well because it has become too thin. To a first approximation ‘not working’ means that arbitrage, the pricing mechanism of the bond market, is no longer working.

We saw this globally as the pandemic hit. In those initial days that Covid swept across the planet no one knew how to forecast anymore, and the markets for government debt in the major economies froze. The central banks stepped in to buy government debt. Hardly anyone outside of the financial markets noticed.

As we will see in Part 3, this again became important in the much misunderstood crisis following the fiscal event of Truss’s ill-fated premiership. Like it or not, the major fear in politician’s minds about additional government borrowing comes from fear of a crisis like this. During the Truss crisis we will see the three elements discussed in this post at work: arbitrage (expectations about central bank decisions), uncertainty about these expectations, and finally central banks stepping in to stabilise markets.

The key point of this post is that equating higher interest rates with more borrowing will be wrong most of the time, just as it was during the GFC and the pandemic. If you want to borrow larger amounts from the bank you may have to pay more (if you can get a loan at all), but just as in part 1 we see that governments are not like individuals. Unlike an individual, there is no risk of UK government debt not being repaid. Nor is the price at which the government borrows determined by supply and demand, because in normal times arbitrage ensures it is tied to expectations about future central bank decisions about short term interest rates. On the odd occasion that arbitrage fails because of extreme uncertainty, the central bank steps in as the buyer of last resort.

So the next time some City economist is quoted in the media relating interest rates on UK government debt to some political decision or event, ask yourself how that event relates to central bank decisions about short term interest rates. The next time they say the market is nervous about something, ask yourself has there really been a step change in forecast uncertainty? The media may treat the bond market as some mysterious entity that only those ‘close to it’ can interpret for us, but in reality it all comes down to the basic macroeconomics of central bank interest rate setting.

[1] This makes it sound as if central banks have complete control over longer term interest rates through their setting of short rates. But the aim of central banks is to control inflation, and what level of short term interest rates achieve that control will depend on what is sometimes called the neutral or natural rate of interest (or r*), which in turn will be influenced by various factors beyond the central bank’s control.

[2] At the extreme, supply and demand for government debt may influence rates if either demand dries up (see discussion below) or demand increases dramatically. The latter was one theory behind Quantitative Easing (QE): that by buying huge quantities of government debt, the central bank could have some (small) additional influence on longer term interest rates. The extent to which that is true in practice is still subject to debate, but because QE involved huge changes in demand it is not relevant to the discussion here.

Tuesday 13 February 2024

Detoxifying government debt, part 1. Debt is also an asset


Perhaps Labour scaling back its proposed green investment is just a pre-election ploy, and will have no implications for what they do in government. Perhaps. But perhaps they genuinely think the country can only afford a modest increase in public investment; much less than the economy and public services need. As we shall see, this idea that the nation cannot afford to increase worthwhile public investment because it requires more government borrowing is quite wrong.

In my last post I noted that both Shadow Chancellors Rachel Reeves and John McDonnell had adopted the falling government debt to GDP fiscal rule, even though it has the real potential to hold back valuable public investment for a prospective Labour government. [1] I know in John McDonnell’s case, and strongly suspect with Rachel Reeves, that the reason for doing this has nothing to do with good macroeconomics, and everything to do with public perceptions about government debt.

In either case it looks like we need to unlearn once again all the myths about government debt that the media constantly feed us. Any advances those who argued against austerity might have felt they made may have been undone in the UK by misinterpretations of what happened under the leadership of Liz Truss. In contrast, as I showed last week, the US government under Biden has ignored worries about government debt, and partly as a result is currently in economic terms the international success story. So this post will be the first in a series that tries to unpick why politicians, the media and large parts of the public think high government debt is a bad thing, and why they are wrong to think this. My apologies in advance to those who are already familiar with some of these arguments from my earlier posts, MMT or elsewhere.

Let me start with some basic economics. There is no empirical evidence or economic theory relevant today that tells us that the level of government debt currently in the UK is too high. Advanced economies like the UK after WWII had much higher levels of debt to GDP than we do today, and that was the start of a golden era of economic growth. Serious econometric studies find no causal correlation, and one that did and got a lot of publicity around 2010 quickly fell apart on inspection.

What economists are concerned about is that fiscal plans should be sustainable, which means debt shouldn’t be constantly increasing as a share of GDP. That implies something like the golden rule, aiming to roughly match day to day spending with taxes, but it does not imply current debt to GDP is too high and needs to come down. There is no economic basis for the falling debt to GDP rule. That rule is there for political reasons, and perhaps in Labour’s case because they believe the media and the public want it there.

That people can be made to worry about government debt is not surprising. The idea of debt worries many people, and people have been conditioned to believe that they should also therefore worry about government debt. This, probably more than any political bias, was why the media completely adopted the necessity for austerity before, during and for many years after the 2010 election.

As I argued here, for both individuals and firms it is understandable that debt is worrying, because the consequences of having too much can be devastating. But I also pointed out that debt is at the same time a wonderful device, because it (in the form of mortgages) allows most individuals to buy their first house, and it allows many firms to invest and grow. Our society would be a lot poorer if debt didn’t exist.

However government debt is not like an individual’s debt or a firm’s debt in many crucial respects. One in particular means that government debt should not be something people in general should worry about. Government debt is not society’s debt, because it is also society’s asset. Most government debt is owned domestically by domestic residents or institutions, so from society’s point of view it is debt that it owes itself. You could think of it as a loan from domestic savers to taxpayers, one that both savers and taxpayers are grateful to have..

Imagine you were someone that had a mortgage purely for tax purposes, but you also had personal wealth in the form of liquid financial assets of a similar amount. Every time your mortgage interest rate changed, the interest on your savings changed by exactly the same amount. Would you worry about having to pay your mortgage in those circumstances? Of course not, because you can pay it back at any time of your choosing.

For society as a whole, in most advanced countries, government debt is just like this example. People don’t think about it this way partly because taxpayers are a different set of people to savers, and savers may not realise they hold government debt through their personal savings or pensions.

Does the fact that a significant proportion of government debt is owned overseas change this logic? Not really, because equally UK residents own the debt of overseas governments. Roughly speaking, for every £ of UK government debt there is a similar asset owned (directly or indirectly) by UK residents. To go back to the analogy with an individual with a mortgage and equivalent financial assets, it would be more realistic to imagine an individual who has a mortgage and also holds most of their personal wealth in liquid financial assets whose interest rate moves with their mortgage rate, but a proportion of their wealth is in other overseas financial assets where the interest rate might be higher or lower.

So for society as a whole, government debt is nothing like the personal debt of a normal individual with a mortgage and few financial assets. The question that is never asked when people talk about government debt is debt to whom. If instead of the term government debt we talked about non-government financial assets in government issued instruments, and talked about the government deficits as the increase in those non-government assets, I suspect many people’s views about government debt and deficits would change.

In passing we could note an interesting contrast here. When the government reluctantly raised a windfall tax there were articles in the right wing press about how this would hurt savers and pension holders who indirectly owned shares in these companies. Such claims were not empirically valid, but when it suited certain interests the connections between assets and individuals were made. So it would be perfectly possible for the media to note that UK government debt was a key asset for many savers, but this is rarely done.

What is sometimes done is divide government debt by the population or number of households and say, or imply, that this is some kind of personal liability for each person or household. This alone is just wrong, because it completely ignores that most of this debt is held as assets by domestic residents or households (and the remainder is held in the form of other financial assets). Government debt is not collectively our debt, it is collectively our debt and our assets.

Another implication is that it is wrong to say 'the nation cannot afford' more public investment financed through borrowing. Additional government borrowing creates an asset for those who buy the debt, and as we have noted most government debt is domestically owned. So directly or indirectly domestic residents are lending willingly to allow the government to invest. UK politicians would be delighted if firms increased private investment through borrowing, and are very unlikely to suggest they cannot afford to do so. It makes no sense to think in different terms when it comes to public investment.    

One reason people don’t think like this is that the media doesn’t talk about domestic residents directly or indirectly owning or buying government debt, but instead talks about ‘the markets’ doing so. For most people ‘financial markets’, like the economy itself, is something mysterious and a little frightening, because a crisis that affects everyone adversely can occur when the markets go wrong. But once again, this gets things backwards, as I will explain in a subsequent post.

[1] As James Meadway reminded me, McDonnell’s rule involves the ratio of debt to trend GDP, which is better than using actual GDP but still is likely to unnecessarily constrain public investment.

Tuesday 6 February 2024

One Rule to bring them all, and in the darkness bind them


What a future Labour government will be able to do in terms of repairing both our broken public services, our broken economy, and getting cheaper green energy will depend in part on its decisions about fiscal rules. [1] When hopes and expectations are frustrated as a result of these rules, you will hear a lot about how such rules are neoliberal and should be scrapped. So are fiscal rules neoliberal, by which I mean are they just instruments designed to suppress public spending and cut taxes?

The answer to my question is of course yes and no. First the no. Fiscal rules arose out of a problem that can occur under any government, including neoliberal ones. Politicians, particularly before an election, will be tempted to increase spending or cut taxes and pay for it by borrowing or creating money because for many voters that seems costless: there appear to be only winners and no losers. This problem used to be called deficit bias.

We can see this happening right now in the UK, with the Chancellor wanting to cut taxes in an effort to boost the government’s popularity, and his own fiscal rules reportedly constraining him in the amount he can do. When Trump was President he and a Republican Congress cut taxes, mainly on the wealthy, by increasing the deficit rather than cutting spending or raising other taxes. He was able to do so because the US government does not follow the golden rule, which aims to roughly match day to day spending against tax revenue. [2]

Why does it matter that politicians can fool voters in this way? Increasing spending or cutting taxes when the economy is not in a recessionary period [3] will increase aggregate demand, putting upward pressure on inflation. The central bank will raise interest rates to stop inflation increasing. Eventually a government is likely to have to reverse the giveaway by raising taxes or cutting spending [4]. On both counts there will be a cost to many people of unsustainable fiscal giveaways. As long as those costs are not acknowledged by politicians or the media, democracy suffers.

Other reasons often given for the need to have fiscal rules are less convincing in my view. It is often suggested that we need rules to appease the financial markets. I see no evidence for this for any advanced major economy. Did the bond markets refuse to buy US government debt when Trump cut taxes? Have the bond markets raised rates every time this Conservative government changed its fiscal rules because the old ones would be broken? The Truss episode was about interest rate uncertainty created by cutting taxes in a situation where spending plans were not specified and might not have been credible if they had been, not about breaking fiscal rules.

Another unconvincing reason for having fiscal rules is that a higher level of government debt will harm the economy. Again, for advanced major economies there is no evidence of this. Will a higher level of government debt impose a burden on future generations? It may or may not, depending on the future relationship between interest rates and economic growth, and the evidence from the past is that on average it has not. It is particularly hypocritical to use this ‘burden’ claim to stop governments borrowing for spending that will benefit future generations.

Making our democracy function better by making governments more fiscally responsible is nice to have but hardly of critical importance. It is why I have often said that bad fiscal rules are worse than having no rules at all. If you want a vivid illustration of this, compare the recovery from the pandemic in the UK and US.

Eurozone performance has only been slightly better than the UK. What do the UK and the Eurozone have in common? Adherence to fiscal rules that have constrained the recovery from the pandemic. If similar rules had been applied in the US, we would probably not have seen the post-pandemic Biden stimulus and the Inflation Reduction Act, both of which have been important in making the US an outstanding success in terms of economic recovery from the pandemic (as well as reducing inequality, tackling climate change and a lot else as well).

One class of bad fiscal rules are rules used to promote an ideological goal, like shrinking the state. A clear example of a fiscal rule that could be justly labelled neoliberal is one that limits government spending but not taxes. Unfortunately a section of the governing elite in Brussels has tended to see fiscal rules as a way of constraining expenditure. When France initially raised taxes in the early 2010s to reduce the deficit, then Commissioner Olli Rehn said “Budgetary discipline must come from a reduction in public spending and not from new taxes.” But even rules that appear balanced may in practice not be, which brings me to the UK’s debt to GDP rule.

Although the fiscal rule that debt to GDP has to be falling by the end of five years may (and I emphasise may for reasons set out here) be constraining this government’s ability to cut taxes, what it has already done is reduced their plans for public investment, which is now set to fall steadily as a share of GDP over the next five years. Indeed, when the falling debt to GDP rule is combined with the golden rule then most of the time all the falling debt to GDP rule adds to the golden rule is to place a limit on public investment. For that reason, the falling debt to GDP fiscal rule could reasonably be called the ‘reduce public investment’ rule.

Governments should always have robust means of deciding whether individual public investment projects are good value for money, and the more open these are the better. As long as this test is passed, what benefit can there be in constraining public investment at the aggregate level? Another way to see why any fiscal rule that constrains aggregate public investment is a bad rule is to go back to reasons given for having fiscal rules in the first place. 

I argued that fiscal rules are useful in stopping governments bribing the electorate by cutting taxes or increasing spending and concealing the costs by borrowing. But if public investment projects are individually worth doing, it should be paid for by borrowing just as an individual pays for a house by taking out a mortgage, or a firm undertakes an investment by borrowing. Even the unconvincing reasons for having fiscal rules don’t apply to public investment: future generations benefit, debt is matched by useful assets that benefit the economy and so on.

If bad fiscal rules like the falling debt to GDP rule are worse than no fiscal rules, why isn’t the second best of getting rid of all fiscal rules a less risky way forward? Second best is reasonable when it is much easier to achieve than the first best. But with fiscal rules the opposite is true. There is no way a Labour government is going to abandon all fiscal rules, whereas there is at least some prospect of it getting rid of bad rules and keeping the better rules. In this particular case, first best is more achievable than the second best.

In opposition Rachel Reeves has already adopted the falling debt to GDP rule, just as John McDonnell did. This rule and this alone is the reason Labour are in such a mess over its sensible £28 billion pledge to green the economy. In a rational world it would be obvious to ditch the bad fiscal rule to enable desperately needed green investment. In the run up to an election, with the media we have, we are very far from a rational world.

But once in government, what Labour says and does has to change, even if their only goal is to be re-elected. With time and new leaders memories of just how bad this Conservative government has been will fade, and are in danger of being replaced with the disappointed expectations of those that voted Labour expecting major change. Being only slightly less bad than this current government will not see a new Labour government last as long as the last one. For that very narrow reason alone, one of a Labour government’s first acts needs to be to discard the falling debt to GDP rule, or change it in such a way as to prevent it constraining investment. Labour’s success in revitalising our moribund economy will depend perhaps more than anything on getting rid of this anti-investment fiscal rule.

[1] It will depend at least as much on their willingness to raise taxes.

[2] I use ‘roughly match’ rather than ‘equal’ deliberately, because there is no magic about trying to hit a zero current balance. I also use ‘aiming to’ deliberately. For various reasons tax revenue and spending fluctuate year to year and it would be bad economics to try and suppress or counteract those short term fluctuations. Instead policy should aim to hit a rolling target for the current balance in five years time, using forecasts produced or verified by an independent fiscal watchdog. For reasons discussed here, the OBR is not sufficiently independent to play this role.

[3] Recessionary periods are times when there is either a significant chance that output growth will be substantially below trend or negative, output growth is substantially below trend or negative, or the economy is recovering from output growth having recently been substantially below trend or negative. During recessionary periods, any fiscal rule should be suspended and fiscal policy should aim to restore the economy to good health as quickly as possible.

[4] Running deficits of a sufficient size to make the debt to GDP or reserves to GDP ratio rise forever is not sustainable. Eventually the government will choose to default on its debt rather than raise taxes to pay ever higher debt interest, or more probably inflate away the debt. For this reason advanced economies do not permanently run these large deficits. It is important to distinguish this situation, of unsustainable permanent deficits, with a one-off but permanent increase in the level of debt to GDP caused by temporary large deficit, which is sustainable.

Tuesday 30 January 2024

The evolution of the UK Conservative party since 1979


This is in part a follow-up to my post two weeks ago, which argued that parties of the centre-right that adopt unpopular right wing economic policies are attracted to high profile socially conservative policies like cutting immigration or Brexit. Unfortunately that strategy over time legitimises political parties that are more socially conservative and authoritarian, so the centre-right can end up fighting on two fronts, or itself become more socially conservative and authoritarian.

I received some interesting comments on that post. One was that some of Thatcher’s and Reagan’s economic policies were quite popular, so how did that fit into my assumption that Conservative economic policies were unpopular? Others wanted to explore the role of the main centre-left party in this dynamic process. This post tries to answer both questions by widening the time frame, but restricting my attention to (mainly) the UK.

I increasingly see the core of neoliberalism in practice as being about economic power, rather than some abstract idea about the benefits of markets and the dangers of government interference in them. Before Thatcher, both the main political parties in the UK operated within a social democratic framework where the state held considerable economic power through the ownership of key industries, and workers had considerable power through the growing influence of trade unions. Economic issues were often discussed and resolved in a tripartite framework involving the state, trade unions and business.

Neoliberalism was about changing this radically, with trade unions losing almost all their power at a national level and significant power in the workplace, and the state largely deferring to business and corporate interests on key economic issues. Nationalised industries could be turned into profitable private sector businesses, and state functions could be out-sourced to the private sector. Increasingly the state was seen as enacting the interests of corporations and businesses. As these interests were whatever CEOs and shareholders told the government they wanted, it also meant that top tax rates were cut to supposedly improve firm performance, and the Conservative government put cutting taxes ahead of improving the provision of public services..

None of this happened overnight with the election of the 1979 Thatcher government, and some of the changes to a more neoliberal regime were (at least initially) popular. In the 1970s the public increasingly saw an association between trade union influence, a high level of strikes and high inflation, and so curtailing trade union power under Thatcher was popular among many. Selling off state assets, including council houses, often at discounted prices was also popular among many, although it was popularity with a clear shelf life as the government ran out of assets to sell and instead felt the consequences of a reduction in revenue. Tax cuts were initially popular, particularly when they were funded by North Sea Oil rather than spending cuts.

For all these reasons it is not surprising that gradually moving the economic compass from the left to the right might be popular at first. This of course was reflected within the centre-left party, with New Labour replacing more traditional Labour because the latter was associated with the less popular pre-Thatcher economic regime, and trade unions in particular. Many have serious misgivings about the extent to which New Labour accepted key aspects of neoliberalism, and of course popularity was influenced by a right leaning media landscape, but it seems clear to me that Labour were playing follower here, with Thatcher and the Conservatives taking the lead. (The response of the Democrats to Reagan’s success was similar in some ways.)

Yet one area where neoliberalism was not popular was in allowing public services to deteriorate in order to cut taxes. (This is often called ‘shrinking the state’, but privatisation aside in practice shrinking the state doesn’t so much mean the state does less things but rather doing the same things badly.) The substantial additional money the Blair/Brown government put into the NHS in particular was sufficiently popular (despite the higher taxes that came with it) that the Conservative party felt compelled to pledge that they would match Labour’s spending until the Global Financial Crisis gave them an excuse to do otherwise.

There can be no doubt that Conservative MPs, party members, the right wing press and party donors wanted more tax cuts and therefore to reduce public spending. On the ‘size of the state’, therefore, the Conservatives in opposition wanted to be well to the right of where public opinion was. I want to focus on this aspect of being economically right wing for the moment, and suggest later why other aspects also fit this pattern.

Cuts in public spending dominated the Conservative led Coalition government from 2010. It was justified by scare stories involving higher government debt after the Global Financial Crisis, stories that the media and enough of the public completely fell for. This deception was critical to the Conservative 2015 election victory, but the deception had an expiry date. Boris Johnson understood this, and he conducted a partial and selective reversal of these cuts when he became Prime Minister. This combination, of social conservatism but moving away from very right wing economic policies, seemed for a moment quite powerful.

However even under Johnson the associated tax increases proved too much for Tory MPs. Although partygate sealed his fate, it is far from clear whether Johnson would have wanted or been able to continue to undo the impact of Osborne’s austerity. We have now returned to a Conservative party intent on cutting taxes whatever the consequences for public services. On economic issues Conservative MPs are now well to the right of their members and voters, let alone the public as a whole

If we think about the one issue of the size of the state and the level of taxes, it is not surprising that Thatcher started as popular but over time the Conservative party became more and more out of touch. Lower taxes and a smaller state were not achieved overnight, but gradually over decades. Lowing taxes from 1970 levels (particularly if they were paid for by North Sea Oil) might have started off as popular, but as taxes and the quality of public spending were reduced further and further by Conservative led administrations that policy became more extreme and more unpopular.

To what extent has the Labour party allowed or facilitated tax cutting and shrinking the state? In government New Labour reversed it, but this didn’t stop the Conservative press writing endlessly about government waste and the Conservative opposition calling for cuts once they had the excuse to do so. Subsequently as the opposition, Labour found criticising the Coalition government’s actions increasingly futile as the media bought into austerity, so largely gave up. Conceding the argument may have helped lose the 2015 election, but it seems a stretch to suggest that had any influence on what Conservative politicians wanted to do. Perhaps pressure from Corbyn (after 2017) had something to do with Johnson’s limited and partial reversal of austerity, but I suspect it had more to do with needing to sell Brexit. I still think Labour has played a minor part at most in the Conservative party’s journey to the political right.

Other aspects of neoliberalism that might at first have been popular were always inherently at risk of losing that popularity. Privatised utilities could easily become natural monopolies that ripped off customers in favour of shareholders. Regulators were meant to prevent this, but if the government is not careful or is indifferent regulators can be captured, and we get the kind of situation we are now in with the water industry. There is currently widespread support, with caveats noted here, for renationalising many industries privatised under Thatcher.

Just as the Conservative party wanted to move further on cutting taxes and ‘shrinking the state’ than Thatcher, they also wanted to go further in outsourcing public sector provision. In particular, they increasingly saw the NHS as becoming a purchaser of health services from the private sector companies. While this might have gone under the radar for most people using the NHS, introducing the profit element with little evidence of compensating efficiency gains would mean the deteriorating services we are now seeing.

All this leaves one remaining puzzle. How did MPs from the UK’s most successful political party find themselves so divorced from public opinion on these critical economic issues? While in the past it has been claimed that the UK is a naturally Conservative country, such claims now cannot be true with Conservative politicians so far away from public opinion on economic issues. The answer isn’t just attachment to an ideology. In addition there is another dynamic that has been a theme of my posts for some time, which is how a party representing neoliberalism can easily become captured by monied interests to become a party representing the very wealthy.

The key moment in this transformation in the UK was of course Brexit. Although it is just about possible to rationalise Brexit in neoliberal terms, if we think about power, Brexit was far from neoliberal. The overwhelming majority of businesses and corporations selling to and from the UK suffered serious damage at the hands of newspaper owners and a few very wealthy individuals. This kind of capture of a neoliberal party by monied interests is not really surprising, because once a politician sees themselves as representing the interests of corporations and businesses generally rather than society, it is a small step to start representing the interests of particular and potentially unrepresentative corporations and businesses (and their ‘think tanks’), especially if those businesses happen to be newspapers or party donors or future employers. Corruption inevitably follows.

Which is why the Conservative party is stuck. If politicians in practice represent a selection of the very wealthy rather than the public then of course they prefer tax cuts to improving public services. It is why they believe the only hope of staying in power is to lead on socially conservative issues. As so often over the last few decades, many Conservatives will look to the US and the Republicans for how to get themselves out of this hole. All they will need, some (but not all) will suggest, is a leader with the charisma of Johnson (at first) or even, as Tim Bale suggests, Farage to sell what has truly become the nasty party. This is just one more reason why Trump’s fate in this year’s election for President will matter for the UK.

Tuesday 23 January 2024

2024 will be the year UK fiscal policy became a sad joke


The media is full of stories about tax cuts in the Budget, stories encouraged by the Chancellor. Let's put aside the fact that the country really needs better public services rather than tax cuts. Let's also put aside that the economy will be far better off with additional public investment than tax cuts, but Jeremy Hunt is planning to reduce public investment over the next five years. Focus instead on the reality that any tax cuts the Chancellor makes will be a joke on the electorate where only he will be laughing.

To see why, it's useful to start with a similar joke it has been playing for a decade involving fuel duty. The government pretends that it will, in future years, uprate fuel duty in line with inflation plus a bit more. This increases OBR forecasts for future tax revenue, giving the Chancellor what the media calls extra ‘headroom’ to cut taxes. Then when each budget comes along the Chancellor announces they are freezing fuel duty, but just for this year.

Now any forecaster, seeing the government play this trick year after year for the past decade, would expect them to carry on doing it. But, to quote the OBR: “Parliament has stipulated that our forecasts be based on the Government’s stated policies and that we must not consider alternatives.” So the OBR is stuck making unrealistic forecasts.

It’s obvious why this trick is an easy win for the Chancellor. He gets to do the ‘protecting the motorist’ spiel in every budget by presenting the duty freeze as a ‘tax cut’, but gets to make any tax cuts look more affordable in the longer term than they actually are by pretending he will, despite his actions over the last decade, increase fuel duty in the future. The problem is that, when it comes to government policy, the OBR have to take the numbers the government gives them rather than do a forecast of their own based on the government's past behaviour.

Unfortunately Jeremy Hunt has found a new way to exploit this flaw in the way our budgets are done as we head towards the election, and its magnitude and importance is much greater. The Chancellor desperately wants to cut taxes, but does not want to break his fiscal rules in doing so. These fiscal rules, for whatever their flaws, are designed to stop Chancellors doing pre-election tax cuts (or spending increases) that they then reverse after the election because they were never going to be sustainable.

Hunt can get round this constraint because the OBR is forced to use the Chancellor’s numbers for future public spending in its forecast. All Hunt needs to do to ‘afford’ to cut taxes is give the OBR unrealistically low numbers for public spending after the election, and the OBR forecast will show he has room for tax cuts while still meeting his fiscal rules. Which is exactly what he did in 2023 [see link in postscript below].

It’s a joke he can keep on telling. With each new fiscal event (Budget or Autumn Statement), if the OBR’s forecast shows he doesn’t have enough room for another tax cut, he can just reduce the assumptions for future public spending until it does. Of course this makes a mockery of the UK’s budget process, the independence of the OBR and the government’s fiscal rules, but for this Conservative Chancellor and his predecessors politics and being in power wins out over all that. If you believed these Chancellor’s claims about being fiscally responsible then I’m afraid the joke is on you.

You might have thought that making unrealistic assumptions about future public spending should cause the Chancellor some political grief. They don’t, because the numbers for spending in four or five years time are just aggregates, and are not split down by department. The government can avoid difficult headlines by saying they will ‘protect’ spending on things like health, whatever these totals are. Fiscal experts, like the IFS, will do their best to calculate the implications for individual departments, but by then the headlines have been written.

Everyone who knows anything about UK budgets knows what is going on. Chris Giles was being very charitable recently when he said that the next budget will show us whether the Chancellor thinks he can win the election. The idea is that if he thinks he could win, it will be him who has to raise taxes after the election so he will be restrained in playing the tax cut trick now. If he thinks the election is lost, then he will have no problem playing this trick because it will be Labour that has to raise taxes after the election. Chris is being charitable because in reality Hunt will play this trick as far as he can whatever he thinks his chances are of winning the election, because as I said earlier for recent Conservative Chancellors power and short term politics trumps everything else.

In an earlier post I talked about how to mend this flaw in the UK budgetary process by giving the OBR more discretion. But that is not going to happen before the election for obvious reasons. As a result, fiscal policy in the UK will become a sad joke (or for those who already think it always is a joke, an even sadder one.). It’s a joke that those in the know will understand, but most voters will not. It will be yet another example of where the media is unable or unwilling to tell people the truth (because the truth might be 'controversial'), and instead actively misleads the public.

We can see something similar happening with the charade about the government trafficking some of those seeking asylum in the UK to Rwanda. The Rwanda scheme is a cruel joke. Cruel if anyone is eventually forced on to a plane to Rwanda. But a joke because the numbers planned are tiny compared to the total numbers claiming asylum in the UK, and for this reason alone the scheme will not act as a deterrent. If you think that I’m exaggerating the absurdity and pointlessness of the Rwanda scheme, read this by Ian Dunt.

As a result, journalists should be laughing in Conservative ministers’ faces when they talk about the importance of the Rwanda scheme, and repeatedly ask them why they are spending so much of their time and our money on this nonsense. Unfortunately most of the time this doesn’t happen. The result is that voters get seriously misled. About half of voters believe that more people seek asylum after crossing the Channel (‘illegals’) each year than migrants who receive visas (‘legals’), when the opposite is true by a mile. Because most viewers will not find this out from the newspapers they read, broadcasters need to make telling people part of their duty to inform and explain. Most of the time they just don’t.

So when the budget comes around, journalists will go through the same routines as they do for every budget, examining the fiscal projection numbers in great detail, even though those numbers are based on assumptions that are pure fiction. They will talk about the Chancellor meeting his fiscal rule, even though with any sensible assumptions about future public spending he wouldn’t. Political journalists will obsess over whether Labour will reverse Hunt’s tax cuts, even though Hunt will have to reverse his own cuts. In other words journalists, by treating these numbers as they would any normal budget, will be making sure the trick the Chancellor is playing will work.

This in turn tightly constrains what the Labour opposition can do. When it looks like a normal budget to voters, and is treated as a normal budget by the media, Labour calling it what it is - a sham - will probably be seen as far too high an electoral risk. Yet if they don’t say why the Chancellor’s tax cuts are built on sand, and will have to be reversed, they not only further legitimise the process, but they make life more difficult for themselves in government. If the media was more honest, so could the Labour opposition.

The best we can hope for is that anyone who gets a chance makes it clear that any tax cuts this year will be reversed after the election whoever wins. In addition, any government that wants to improve the dreadful state of our public services will need not only to reverse this year’s tax cuts but in addition to raise taxes further. But if this happens it will be the exception rather than the rule in both Budget and election commentary. Instead most participants will continue to pretend not only can you get better public services without additional tax revenue. They will pretend that any tax cuts made this year, or promised for the future, will be permanent rather than the temporary election gimmick that they actually are. 

Postscript (24/01/24) Here is the head of the OBR describing the public spending numbers he has to work with. 

Tuesday 16 January 2024

Why the centre-right has helped cause the drift to the far right in Western democracies

The far right now holds power in Hungary, Italy and Argentina. Trump, undoubtedly a far right figure, has a good chance of not only becoming the Republican’s presidential candidate but also beating Joe Biden. Nigel Farage was welcomed at this year’s Conservative party conference. Tim Bale notes similar trends in other European countries. The tide is not uniform, as defeat in Poland shows, but it does seem as if the far right is both gaining ground and becoming more respectable in many Western democracies.

A key question is how much this drift has been caused by or facilitated by the actions of centre-right political parties. This could involve the actions of centre-right parties encouraging support for parties further to the right, or it could involve the dominant centre-right party itself moving further right. In this post I want to draw on some of my earlier discussions to answer why this might be happening.

A prior question is what we mean by moving further right, or far right political parties. It is, as ever, helpful to distinguish between economic policies on the one hand, and social policies on the other. What most seem to focus on when worrying about the far right is the latter, and particularly a trend towards more authoritarian policies that reduce democratic freedoms and which scapegoat and harm minorities like immigrants or welfare claimants. The argument I will put forward in this post is that, for some countries like the UK at least, it is the right wing nature of economic policies pursued by centre-right parties that lead them to adopt or encourage more right wing or authoritarian social policies, which in turn encourages the far right both outside and within these parties..

The first point to make, which I explored in this post, is that it is quite possible for centrist parties to attempt to ostracise rather than encourage or adopt policies from parties less near the centre. Famously Edward Heath fired Enoch Powell after his ‘rivers of blood’ speech. On the left Starmer has excluded many left wing candidates, including the previous leader Jeremy Corbyn, from standing as MPs. In a predominantly two party system, excluding rather than embracing policies further from the centre makes perfect sense in a simple model where the two main parties try to capture the support of the median voter, and where there is little risk of many more right or left wing supporters voting elsewhere or not voting.

But what if the centre right party is committed, for ideological or other reasons, to economic policies that are quite far from the centre ground? To get elected, it needs to do two things. First, it needs to focus its campaigning away from these unpopular right wing economic policies. This is possible if the centre-right party has substantial support in the media, which it often does. Second, it needs to focus on more social issues, and try to attract socially conservative voters who may also have relatively left wing economic views. This inevitably moves it away from the centre on these social issues, unless it can successfully paint parties to the left as very liberal. I will call this the ‘culture war’ mechanism.

Focusing the policy debate on social issues, like immigration or nationalism, in itself allows political parties with more authoritarian policies the space to attract support. It also makes it more difficult for the centre right party to ostracise more extreme views. For example, if the centre right party is focusing on the dangers of immigration, it is difficult to suggest a party that believes immigration should be curtailed further is somehow beyond the pale.

This problem, of parties further to the right attracting the support of voters, members or even MPs, becomes even more acute if, while in office, the centre right party fails to implement policies that satisfy socially conservative voters. The example of the 2010 Coalition government in the UK’s immigration targets is an obvious example. As I argued here, there are strong economic reasons why a centre right party would not want to strongly curtail immigration, but if it campaigned on the basis that it will it leaves itself open to challenge from a party further to the right.

In large part, political parties that campaign to strongly and quickly reduce immigration are involved in deceit, unless they are explicit about the economic costs. I argue this here, but Nesrine Malik probably puts it better when she writes “apparently vexingly high [immigration] numbers are, to a large extent, the outcome of economic and political decisions that mean we invite immigrants to fill labour gaps that policymakers either did not anticipate, or ignored warnings about.” In the UK this also involves filling gaps that the centre right party deliberately created in the public sector by reducing the relative pay of medical, social care or teaching staff.

There is a second mechanism by which a centre right party that is committed to strongly right wing economic policies may encourage the far right. Part of having a strong right wing economic policy typically involves wanting a smaller state. In this post I looked at the strong evidence that austerity in the 2010s played an important role in increasing support for the far right. The key point I made is that this link is not just (or even mainly) because voters are reacting to being poorer, but because when cuts occur or real wages fall socially conservative voters tend to focus on ‘outsiders’ who they either feel are responsible for these bad times or who they feel do not deserve their meagre share of a shrinking pie. In this second political dynamic, the ‘austerity mechanism’, it is the right wing economic policies that directly encourage support for socially conservative policies.

With both the ‘culture war’ and ‘austerity’ mechanisms we have the adoption of right wing economic policies (e.g. neoliberalism) by the centre right leading to increasing support for far right political parties, and/or a further drift to the right (in the social/authoritarian dimension) within the centre right party itself. In both cases neoliberalism creates a drift to the far right and, because the centre right party itself moves, encourages the media to make these more far right views respectable.

To the extent that the far right (or the more right wing centre right) party is about encouraging internal divisions within society (us and them), it is likely to become populist, where its leaders represent ‘the will of the people’ (us) against the elite, their supporters and outsiders (them). This in turn can provide the platform for policy that severely curtails human rights (the rights of ‘them’ of course), and actions that bias democracy in favour of the right wing party. Such actions can range from requiring photo ID at polling booths to mounting insurrections when an election is lost.

The relative importance of these two mechanisms will obviously vary from country to country, and my focus on these two mechanisms obviously reflects the national experiences I know most about. It leads me to be able to say, in the UK and US at least, that the centre-right has played a large part in the way politics has drifted further to the right over the last decade or so. In other countries the role of the centre-right in facilitating more right wing figures taking power can be much more direct, as Tony Wood describes in Argentina here.

Both the dynamic processes I have highlighted have been pursued by centre-right parties for ideological or electoral gain, but whether those gains will be sustained or indeed reversed over time remains an open question. This is because the strategy either creates a big threat to the centre-right party from further right, or it shifts the party further right than many of its politicians wish. Both could make the centre-right party less likely to win elections in the longer term, because it opens up space for an opportunist centre-left party, particularly if that party is prepared to suppress its natural social liberalism.

Will this lead to a re-evaluation of strategy within centre-right parties? From what I know there is no sign of centre-right parties moving to the left (and therefore towards the centre) on economic or social issues as yet. I suggest here that the forces keeping them where they currently are or moving further right are too strong, and these forces in the UK include the influence of the media, the membership and those providing political donations. (Andrey Tomashevskiy finds that parties which receive a greater percentage of their income from private donors tend to adopt more extreme positions on socio-cultural issues.)

If this analysis is correct, then the global political landscape for some time to come will involve both opportunities and distinct dangers. The opportunity is that centre left parties who are prepared to appeal to the centre ground will find it easier to win elections, as centre-right voters are put off by the drift to the right of centre-right parties. The danger is that a far right party (or a previously centre-right party that has moved to the right) will come to power and curtail democratic freedoms.

Unfortunately, as I have noted before, there is no way the opportunity and danger offset each other. Even if centre-left governments became more common as a result, democracy inevitably leads to changes of power. As we are seeing in the United States, even quite obvious threats to democracy can be insufficient in dissuading enough of the electorate from voting a far right party or leader into office. If a far right party comes to power and starts distorting democracy to entrench its own position this may become very difficult to reverse.

Postscript 18/01/24

On evidence that centre-right parties adopting socially conservative, anti-immigration policies helps rather than hinders the far right, see here 

For discussion of the success of the far right in the Netherlands, which is consistent with the 'culture war' mechanism described above, see here. (HT Anand Menon)