Interest rates and Budget Deficits

 

In the weeks surrounding the UK budget you will hear a great deal about the link between the UK budget deficit and interest rates on UK government debt. [1] Most discussion will be predicated on a simple idea: the way to get interest rates on government debt down is to run smaller budget deficits. There is a bit of truth in this, but not for the reason that many journalists suggest. This post is about this relationship.

The first and most important point to note is that the continuing increase in interest rates on government debt is a global phenomenon. That means that the impact any UK specific action on longer term UK interest rates will be small relative to recent increases. I discussed possible reasons for this global trend in this recent post, although as Chris Giles notes the range of explanations indicates how little we really know. One possible influence is the AI boom. Another is inflationary pressure caused by the US attack on Iran, coupled with belief that this will keep short term interest rates set by central banks higher.

Another factor may be a global abundance of safe assets (i.e. government debt). While there appeared to be a shortage of such assets before the Global Financial Crisis, the aftermath of that crisis, the pandemic and large US deficits may have reversed this. However any impact a smaller UK budget deficit would have on this global phenomenon would be negligible, and (unlike the US and others) the UK budget deficit is forecast to fall to sustainable levels, so this is not a reason why small UK budget deficits would reduce longer term UK interest rates.

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Although longer term interest rates are higher in all G7 economies, the UK has the highest, and this has been true for some time. It is important to emphasise that this is not because investors think the UK government is more likely to default than other countries (see Eric Lonergan here). Countries that create their own currency cannot be forced to default, and the UK government will never choose to default. Default only becomes an issue for governments that don’t issue their own currency, or who borrow in another currency.

Eurozone countries are the most important of these, and for them the behavior of the European Central Bank (ECB) becomes critical. The ECB both created the Eurozone crisis and solved it in the early 2010s. The ECBk probably wants to let rising rates act as a warning to individual Eurozone countries to avoid unsustainable deficits, as in France at the moment, but not let them rise so much that it causes a fiscal crisis. This is a hard act to pull off because the ECB has little control over politics in France. As Paul Krugman notes, a lack of economic realism on both the political right and left over fiscal policy leads to political paralysis and unrest as well as rising longer term interest rates..

The most plausible and commonly cited explanation for why UK longer term interest rates are the highest in the G7 is that markets expect inflation to be most persistent here, which in turn means they expect short term interest rates set by the Bank of England to be higher for longer than in other G7 countries. Longer term interest rates are closely related to current and expected future short term interest rates through arbitrage.

This is where the size of the deficit can matter, but only if changes in the deficit reflect policy changes that impact current or near future aggregate demand in the economy. If the current or near future deficit increases as a result of a Budget because the government is spending more on domestic goods or labour, that adds to inflationary pressure, meaning the Bank is more likely to keep short term interest rates high. If the deficit falls because it is taxing more from people who will respond to higher taxes by reducing spending rather than savings, the opposite is true. But if budget deficits rise because the economy is weaker, that indicates a reduction in aggregate demand and therefore lower short term interest rates, so longer term rates are more likely to fall rather than rise.

This potential duality between financial variables like budget deficits and real concepts like aggregate demand in the economy is the source of so much confusion in policy debates. Sensible fiscal rules in advanced economies with their own currency are essentially a device to stop governments succumbing to the temptation to inflate aggregate demand by cutting taxes or increasing their spending. This temptation is generally increased when there is an independent central bank setting interest rates to control inflation, because the government that does succumb to this temptation will not suffer higher inflation as a result. True the government’s actions will lead to higher interest rates, but roughly as many voters gain from higher rates as lose. However a sensible fiscal rule has to recognise that the relationship between deficits and aggregate demand is far from precise, and in particular why it is folly to try and raise taxes or cut spending when the deficit is rising because the economy is weak. [2]

The relationship between government budget deficits and longer term interest rates (including the interest rate on government debt) is all about inflationary pressure, and is not about market worries that the government might default. All the language beloved by journalists about ‘market jitters’, ‘government credibility’ and similar phrases obscures this basic fact. Just as primitive man didn’t have science and so explained changes in the weather as the actions of gods, so many journalists without economic training treat financial markets as an unpredictable and vengeful god and City economists as high priests.

If the Chancellor did reduce the deficit by raising taxes or cutting spending (going beyond what is necessary to meet fiscal rules, as Martin Wolf suggests here) this probably would reduce UK inflationary pressure, which in turn could lead to a modest reduction in UK longer term interest rates. [3] However in all likelihood this effect would be pretty small, and not change the fact that UK interest rates on government debt are higher than they have been for at least fifteen years. [4] Equally policy actions that increased near term deficits (by for example providing help on energy prices for some) would help keep UK longer term rates among the highest in the G7. However one fairly reliable projection is that the size of this effect is likely to be greatly exceeded by the amount of media discussion of it in the coming month or two

[1] An example was the Bank of England governor’s recent comment that “whatever the stance of fiscal policy, it must be credible and be seen as such by financial markets”.

[2] Why don’t governments focus on the implications of their policies on aggregate demand and interest rates rather than follow fiscal rules? One reason is that the impact of policies in financial terms can be calculated more reliably than attempts to assess future excess demand in the economy and the impact of policy on that. The OBR doesn’t try and forecast future interest rates, but instead uses market expectations.

[3] There are still circumstances where it might not. For example buying less military aircraft from another country raises the deficit but does nothing to increase UK aggregate demand. Equally increasing the taxes on agents (maybe the very rich or some firms)) that will hardly alter their spending plans as a result does little to reduce aggregate demand. A temporary tax on bank profits, for example, is unlikely to lead banks to cut their workforce, although it might reduce aggregate demand by other means.

[4] The big dilemma for those advocating a quicker reduction in the deficit now is that this would increase the chances of a Conservative/Reform government at the next election, and populist governments are much more likely to blow up the deficit than cut it. It’s a dilemma that I don’t think genuine (rather than instrumental) deficit hawks have resolved.

Misconceptions following Burnham’s speech

 

The Prime Minister’s conference speech was a week ago, but there is still plenty of confusion about how it should be interpreted. Indeed that confusion may be partly shared by Burnham himself. Here is what I think it all means.

The Triple Lock

The Triple Lock is the way the UK state pension has been uprated every year for more than a decade, and it has led to pensions rising faster than earnings. Whatever you may think about this so far, it is clearly unsustainable in the long run without additional tax rises or spending cuts, given that the state pension is paid for by those currently working, and the ratio of those receiving a pension to those working is rising not falling. This unsustainability is clear in the OBR’s long term projections that I discussed here.

The UK state pension is well below the level in many European countries, but that is because the UK has always had a mixed system of public and work-based pensions. There is a good argument for increasing the state element in that mix, but also a clear argument against. [1] However the Triple Lock is a strange way of increasing the state element, because it does it in an unpredictable way. It would be better for many reasons to make a shift towards a bigger state pension an explicit policy goal.[2] .

The reason why ending the Triple Lock is such a political risk is that it will be portrayed by political opponents as an attack on current pensioners, and pensioners tend to vote in greater numbers than workers. Since Burnham’s speech that is exactly what has happened. This is the first misconception. Pensioners only benefit from the Triple Lock when earnings increase by less than inflation or 2.5%, and the number of periods when that will happen for most current pensioners will be small. The real benefit comes for those currently working, because the number of such periods will be larger by the time they start receiving a pension. Unfortunately intertemporal thinking is beyond most political/media discourse, so ending the Triple Lock will be portrayed as an attack on current pensioners.

Burnham is to be congratulated for having the political courage to adjust the Triple Lock so that it moves with rather than beyond earnings over the medium term. He is also to be congratulated for having the political skill to link ending the Triple Lock with the establishment of a National Care Service. He has made it look like the former is necessary to create the latter, producing a benefit that goes with the cost of slightly lower pensions. Polls taken just after the speech confirm this. But in this case linking extra spending to budget savings is about politics rather than economics, as I note below.

Although the Triple Lock is not planned to end until 2030, legislation will be introduced before the next election, so the battle over this is not being postponed until the next election.

A National Care Service

Getting the state to pay for elderly care in the same way as it pays for most other health needs through the NHS is about insurance. We don’t know when we might need health care, and such care is very expensive, so it makes sense to take out insurance against that possibility. But for well known economic reasons it is very difficult for the private sector to provide that insurance, and much easier for the state to do so, which is why the NHS makes sense. Exactly the same arguments apply to insuring against the need for non-NHS care when we grow old. (In fact most state spending is about insurance.)

Extending state insurance to cover elderly care requires people to pay insurance premiums, which means paying more tax, or cutting some other spending. Resistance to higher tax is a key reason why previous attempts to do this have failed. For the moment at least, Burnham has avoided this problem by suggesting that ending the Triple Lock will fund the new National Care Service.

Which may be fine politically, but as the OBR’s fifty year projections make clear this doesn’t hold water in economic terms, because this element of the Triple Lock was never sustainable beyond the short term. Saying otherwise means the government is in effect replacing one unsustainable element of spending with another. Whether Burnham understands this but just wants to keep the trade-off alive for political reasons is unclear. The reality is that introducing the National Care Service will require higher taxes, and if this service is also to raise the quality of care and the wages of carers (as Burnham suggested), taxes will have to be significantly higher. More than ever a new Labour leader needs a Chancellor who is able to deliver what he needs. Whether he will is the biggest question mark behind Burnham’s speech.

The EU, Electoral Reform and more

One other notable feature of Burnham’s speech was the acknowledgement that Brexit has not worked and that some substantive reversal of it will be required, including the possibility of rejoining. Another misconception among some is that the speech didn’t talk enough about economic growth. This misses the fact that a substantive realignment towards the EU on trade is the most assured and probably largest pro-growth measure the government could take.

Burnham’s recognition that the tipping point in terms of popular opinion on Brexit has been reached is overdue. In addition, it allows the government to pinpoint the blame for the lack of growth in living standards over the last decade on Brexit and those that campaigned for it. The government can now investigate whether popular opinion would be happier to move towards the EU incrementally, or whether a seat at the table will be seen as sufficiently important for ‘going all the way’ to become the preferred option. Of course a lot of additional questions remain, but on this issue once again incrementalism has been replaced by more decisive action.

In a post in June I suggested three major medium term policies besides undoing Brexit that Burnham needed to start putting in place over the next three years. One, greater power to English regions, was a reasonably sure bet. The second, setting out the alternatives to FPTP and choosing among them, he put in place in last week’s speech. The third, doing something about Leveson 2 and OFCOM, has yet to happen.

Ending the Triple Lock in this parliament, creating a National Care Service and a new electoral system in the next, together with probably a significant reduction in trade barriers with the EU and possibly rejoining, are the kind of major changes both I and I think a lot of the electorate were looking for two years ago with the election of a Labour government, but which Starmer was unable and I think unwilling to deliver. Starmer and his team thought the safest option was to do small things but otherwise stay close to their enemies because that had worked in opposition. The opposite was obviously and predictably true, and Burnham and his team seem to understand that..

More importantly, these issues are much easier to argue for than their detractors would have you believe. Do you really want pensions to rise faster than the earnings of those who pay for them? Why shouldn’t the elderly and their relatives be able to insure themselves against the cost of long term care? Brexit has clearly made us a lot poorer, so this isn’t Project Fear anymore. Does it make sense for so many votes not to count in a general election?

For this reason my biggest concern is not whether Labour can sell all this to the electorate, but whether it has understood that some of them, together with additional defence spending, require additional increases in taxes on incomes. The effective tax rates on incomes for middle earners is still below levels in the mid-2000s, and even lower than levels in the 1980s, yet a growing elderly population and other pressures have increased health spending from 4% in the 1980s to over 8% today. The bit of honesty that has so far deserted all our politicians is that taxes on income have to increase.

This is not just about fiscal rules, still less about treating the government like a household. It is about competition for real resources, particularly labour. If the government starts paying for elderly care but does nothing else then the private sector has more money to spend on other goods and services, adding to inflationary pressure. Bond markets already require a higher interest rate on UK debt compared to other G7 countries because they believe UK interest rates will have to stay relatively high to combat inflation. In these circumstances, and with the public sector needing more rather than less resources, it is just basic macroeconomics that taxes need to rise.

[1] A major argument for a state pay as you go pension is that the value of that pension does not fluctuate with movements in the stock and bond markets. In a funded scheme that is not the case, and that means that those that receive the pension bear at least some of that risk. The major argument against a larger state pension is that those who work hard during their working life get the same pension as those that don’t, which will certainly feel unfair to the former. Entitlement rules only get around that to some extent.

[2] Part of the reason for this is that such a goal would influence the uptake of private pensions.

Populist tendencies on the UK left, and the puzzle that never was

 

Don’t shoot the messager

The Treasury Select Committee (TSC) has just published a report on the Office of Budget Responsibility, the UK’s Fiscal Council or Independent Fiscal Institution. It addresses in particular many calls from some on the left for reform of the OBR, amid claims that the OBR rather than the elected government is running fiscal policy. The TSC largely rejects such claims. It argues that critics, including those within government, “must resist the temptation to blame the messenger when confronted by politically difficult decisions in a fiscally constrained space.”

It will come as no surprise to regular readers that I agree with the Select Committee’s conclusions. The OBR provides a fiscal forecast, and nothing more. It doesn’t choose the fiscal rules, or how the government meets those rules. In those circumstances describing the OBR as ‘undemocratic’ amounts to an attack on expertise rather than a call for greater democracy. Such calls reveal an unfortunate populist tendency on the left.

Of course criticism of the OBR’s implementation of technical knowledge is to be welcomed. Someone could believe that, for example, the OBR underestimates the beneficial impact of public investment on economic growth. If so, they need to look at the academic evidence and make a case based on that. Fortunately the OBR is very open about its methods and why it makes the assumptions it does. Indeed one of the great advantages of allowing technical decisions behind government policy to be made by an independent body is exactly this openness.

Some suggest that the OBR makes economic assumptions that are conservative, or reflect an establishment view. What this criticism often means in practice is that the OBR follows mainstream economics rather than heterodox economics of a left wing variety. As the great majority of academic economists work within this mainstream I think the OBR is correct in doing this. Of course mainstream economics is not immune from political influence, but I have seen no evidence that the OBR’s economic judgments are particularly affected by this.

The whole point about delegating technical decisions to independent bodies is to open up how governments use expertise, and to avoid the government making technical judgements just because those particular judgements are politically convenient. It is about making evidence based decisions, rather than finding evidence to justify politically motivated decisions. [1]

That means, of course, that the judgements the OBR makes will often be politically inconvenient for the government. A recent example is the downgrading of expected productivity growth. No politician likes this, but populist politicians in particular hate it. One of the first decisions that the former leader of Hungary, Victor Orban, took in his long populist reign was to abolish the nation’s independent Fiscal Council. Nigel Farage has toyed with the same idea.

Populists dislike expertise that goes against their politics or policies. Brexit is a clear example for the UK. The overwhelming economic consensus was that Brexit would harm the UK economy and reduce GDP, and the populist response to that was to attack the messenger. Just as right wing populists justify such attacks by claiming that they are implementing the will of the people, it is difficult not to see attacks from the left claiming that independent institutions like the OBR are undemocratic in a similar light.

On a more positive note, one idea that did find favour with the Select Committee was looking at forecasts over ten years as well as the more familiar five year horizon. To quote

“The OBR should continually seek to improve its forecasts and economic modelling, especially by incorporating a new, additional medium-term 10-year forecast.”

Here I’m a little sceptical. The OBR already produces a 50 year projection that I examined recently. What those fifty year projections typically assume is that the economy five years ahead is at trend, and then project the trend forward. It’s not clear how a ten year forecast would be different from the ten year point of this fifty year projection.

It is possible that focusing on ten years ahead rather than fifty would allow the OBR to highlight the longer term costs or benefits of government policies. Public investment, for example, is likely to begin to have a significant impact on GDP after ten years. Ten year forecasts could also discourage governments from measures that met its fiscal rules only by postponing fiscal costs just beyond those rule’s horizons.

Critical to any ten year forecast would be the assumptions made about government spending. In their fifty year forecast the OBR after the five year point makes its own estimates of spending taking into account longer term pressures like an aging population. If instead the government was asked to estimate spending levels ten years ahead, the fiscal forecast would be a lot less informative, because the government would probably choose to ignore those pressures.

More productive than we thought

In most advanced economies productivity growth has been slower in the decades following the millennium than before. But this slowdown appeared to have been particularly acute in the UK from 2007 onwards. This became known as the UK’s productivity puzzle. It was a puzzle, because there was no obvious explanation. Over the last decade many economists have investigated this puzzle with attempts at an explanation, but I think it is fair to say that no one has come up with a compelling story.

The obvious place to look was the financial crisis itself, but a number of problems emerged, not least the absence of any productivity impact on the country that originated the crisis: the US. I would have loved to blame austerity, but the UK wasn’t the only country to cut back public spending sharply in the decade after the crisis, and the obvious transmission mechanisms didn’t seem enough to explain much of the puzzle.

It turns out that our collective failure to explain this puzzle was a good thing, because there never was a puzzle. What appears to have happened is that the Office of National Statistics' normal way of measuring hours worked, using the Labour Force Survey, has become increasingly unreliable. It now looks like the ONS had overestimated the number of hours we all worked, and therefore underestimated UK productivity.

The Resolution Foundation has a good short explainer here. Below is a chart from this.

While UK productivity growth after 2007 has hardly been spectacular using the new data, it is no longer below most other countries. In short the UK productivity puzzle has disappeared. As I noted here, using this new data also paints a more optimistic picture of UK productivity growth in the last two years.

This episode is a good example of something most seasoned macroeconomists already knew, which is that the data we work with is a lot less reliable than we might wish. But otherwise not having to explain the puzzle of relatively poor UK productivity is good news. As the Resolution Foundation notes, the UK still has a lot of catching up to do when comparing productivity to France, Germany or the US, but at least before Brexit this gap was not getting worse.

[1] A terrible argument against the OBR is that it was created by George Osborne, so it must be a bad idea. I’m hardly a fan of Osborne’s economic policy, but setting up the OBR was one thing he got right. In doing this he was following many advocates for independent fiscal institutions, including myself, from the political left, centre and right. Some argue that Osborne created an independent fiscal institution that suited his austerity policy. This is correct, but ironically it undermines rather than justifies attacks on the OBR. What Osborne did was ensure the OBR couldn’t look at alternative economic policies, which avoided the OBR exposing the basic macroeconomic problems with austerity. I have always advocated removing this restriction on what the OBR can do.

How should the government meet its Golden Rule when debt interest increases?

 

As you are almost certainly aware, the government is having to pay much more in interest on its debt than it used to do. Here is a chart based on the last OBR forecast, and the likelihood is that their next forecast will revise these numbers upwards. An increase worth 2% of GDP may not sound big, but it is nearly as much as the current defence budget.

Should this additional spending on debt interest be matched by higher taxes or reduced spending elsewhere? It has to be one or the other to meet the government’s sensible fiscal rule, sometimes called the golden rule, which matches current spending (i.e. excluding public investment) to total taxes. In my post about rising interest rates two weeks ago, I gave my opinion that the government should raise taxes, but not the reasoning behind it.

To many the issue is simply political. Right wing governments would choose lower public spending and more left wing governments would choose to raise taxes. If you look at past trends in UK public spending it is normally obvious which government was in power, but not always. The chart below looks at the ratio of all government consumption except health spending divided by private consumption. My reason for choosing this ratio will become clear.

Government consumption differs from total public spending because it excludes debt interest payments, government investment but also transfer payments (e.g. state pension payments). In the UK and pretty well every other country health spending is strongly trended upwards for well known reasons, which is why I have excluded it from government consumption in the chart above. While the austerity period is obvious from the chart, the Johnson administration did start to raise spending in some areas. [1]

The breakdown of government consumption over time, again as a ratio to private consumption, is shown here.

‘Soc prot’ stands for social protection (e.g. spending on care homes, foster care, social benefit or the salaries of those administering the welfare system), and other spending is split between central and local government. Note the rise in spending on education under the last Labour government, and the sharp cuts in other local authority spending during the austerity period.

Why have I looked at the ratio of public consumption to private consumption? As an economist, it seems to me that private consumption is the natural comparator when thinking about public spending on goods and services. If the state did not provide schools, for example, then all spending on schools would be part of private consumption, and its ratio to total consumption would represent the aggregate choice of consumers. In other words, consumers have preferences over public goods as well as private goods, and it is the government’s job to satisfy those preferences given the tax constraint.

For this reason I don’t think saying the level of public spending is just a political decision is good enough. To put it very simply, governments should provide roughly the amount of, say, education spending that the private sector would choose if these were not public goods. It could be the case that left leaning voters prefer more public goods than right leaning voters, but I’m not sure this is the case (apart from those who opt out of the public system, of course). Indeed one group that you might expect to want much higher health spending because they use these services more are the old, who tend in the UK to vote for the right.

There are real political differences over what services the state should provide, and under Thatcher there was a big reduction in the scope of the state with privatisation. (Even there, however, I think economics has more interesting things to say than the platitudes of politicians.) One of the problems of austerity from 2010 onwards is that public spending was cut with hardly any reduction in the kind of services the state was meant to provide, so the effect was just poorer quality services, rising waiting times and so on. [2]

Which brings us back to the title of the post. Here a household analogy is useful (they can be sometimes). Imagine there was no state beyond an army, and a household’s mortgage payments had increased because of higher interest rates. They needed to find that money from somewhere. Would they cut back on the children’s education, not go to the doctor so often when they are ill, and maybe reduce their help to a disabled elderly relative, but otherwise keep their other spending, including meals out and entertainment, unchanged? I hope not. But that is exactly what anyone saying higher that public spending should be cut back as a result of higher interest rates is in effect suggesting.

A more reasonable approach for a household would be to cut back on all its items of expenditure evenly, or maybe cut spending on luxuries more than necessities. That is why I would suggest, in the first instance, raising taxes to cover the additional debt interest. Higher taxes will lead to lower consumption spending, mimicking what the household would do in the face of higher interest rates.

In effect that is what the government has been doing over the last few years, which is a key reason why taxes have been increasing and are expected to carry on rising. Now if consumption does fall [3], then by the same logic public spending should fall in proportion, but that is public spending falling in line with GDP, rather than taking all the burden of adjustment. Crucially higher debt interest payments should mean higher taxes in the first instance.

That is the economic logic behind my view that higher debt interest payments that are expected to be persistently high should be mostly covered by higher taxes rather than spending cuts. Those who suggest otherwise have to argue why only certain goods and services that consumers benefit from should bear all the burden of paying for the higher cost of debt.

The same logic makes me question the idea that economic growth somehow in itself reduces fiscal pressures, It appears to do so because spending plans are fixed over the next few years in nominal or real terms, but taxes rise when GDP increases. But to the extent this happens it reduces the share of public spending in GDP, which if the previous share was near optimal will lead to pressure to raise spending in due course (mainly be increasing public sector wages or employment). I think the real reason growth eases fiscal pressures is that it allows politicians to raise taxes while still allowing some growth in living standards..

[1] The same chart based on nominal spending shows a similar shape, but has a more upward trend, presumably because productivity gains have been lower for public services than for the goods and services that make up aggregate private consumption.

[2] The other way the Conservative government cut public spending was to reduce the relative pay of public sector workers, which unsurprisingly turned out to be unsustainable.

[3] Higher debt interest payments in themselves will tend to raise consumption, because consumers directly or indirectly hold government debt. However higher interest rates discourage consumption and encourage saving. These are what economists call income and substitution effects.

Racism and xenophobia are not 'legitimate concerns'.

 

During the 2010 election campaign, Prime Minister Gordon Brown was questioned by a member of the public about immigration. Shortly afterwards in his car Brown described her as “just a bigoted woman”. Unfortunately the microphones were still on, and his remarks became national news. He subsequently apologised, but of course it remained a very embarrassing moment in a campaign that Labour subsequently lost.

This, and similar incidents, are one reason why Labour politicians now go overboard to treat any public manifestation of antagonism or even hatred towards immigrants or asylum seekers as stemming from ‘legitimate concerns’. Another is of course the gradual tendency of working class constituencies (the ‘Red Wall’ in particular) to vote for the right rather than the left. A powerful Labour faction, Blue Labour, is all about trying to retain those voters by adopting right wing policies on social issues like immigration.

Labelling any concern about immigration as stemming from racism is certainly foolish. But equally suggesting that all expressions of hostility to asylum seekers must stem from legitimate concerns is just as foolish. Events over the last two weeks in the UK have illustrated where that mistaken tolerance can lead: hundreds of masked men dressed in black, some of whom have criminal records, blocking roads, harassing lifeboats bringing asylum seekers ashore and publishing the names and addresses of RNLI (Royal National Lifeboat Institution) volunteers who they call traitors. This is not the sign of a healthy society or of legitimate concerns about immigration or asylum. [1]

While it is never sensible to presume racism, it remains the case that a significant proportion of the UK population have racist beliefs. After a world war fought against fascist governments, politicians in many countries went out of their way to tackle overt racism and delegitimise politicians that openly attempted to attract racist or nationalist voters. We seem now to have turned that position on its head, where masked gangs involving former criminals are treated by sections of the media and politicians with kid gloves and in some cases sympathy.

In part this transition reflects the memory of WWII fading away, but it also reflects decisions taken by politicians and their media supporters on the right..When the political right encountered falling support for their newly embraced neoliberal economic policies, they switched to campaigning on social issues and that political firewall against far right political views began to dissolve. A charitable view would be that mainstream right wing parties didn’t realise what the consequences would be of their switch towards the politics of immigration and culture wars.

I have argued elsewhere that it is a mistake to see support for Reform and far right parties elsewhere as reflecting a rightward shift among the electorate. In the UK at least the population has become more socially liberal over time. Equally, while economic factors can both provide short term support for right wing populist parties and encourage hostility to minorities, I think economics cannot provide an explanation for the continuing core support for the far right. [2] Instead I think there has always been at least about a quarter of the population with pretty socially conservative views, but until the last few decades the political and media elite has either marginalised or disregarded this group.

What the mainstream right found was that once you start courting the racist and nationalist vote, that vote will demand more and political actors will meet that demand. In addition, those demands may be encouraged by parts of the media and wealthy political donors. The result in the UK has become a competition between the Conservatives, Reform and now Restore to attract the most socially conservative voters.

As David Aaronovitch points out, all three UK right wing parties with MPs in parliament are now committed to mass deportations if they gain power. All suggest we should join Russia and Belarus as the only European countries that are not part of the European Court of Human Rights, and violate international treaties like the 1951 UN Refugee Convention. This right wing competition for the racist vote will not end if either party, or a coalition between them, forms a government. A Conservative government in particular will be terrified of a repeat of 2024, and will therefore do all it can to court the racist and nationalist vote. The combined Conservative, Reform and Restore vote in some recent polls is around 47%.

With such competition, it was always foolish for Labour to think it should also try and appease this segment of the electorate by adopting far right policies and rhetoric on immigration and asylum. To do so sacrifices the basic humanity which is at the core of social liberalism. Talk of the legitimate concerns of some should always have been combined with condemnation of racism by others, together with appeals to recognise immigrants as fellow human beings who can contribute a great deal to society and viewing most asylum seekers as a particularly vulnerable group that deserves society's help. What we have now is one side generalising from individual criminal cases to suggest most asylum seekers are similar, and almost no one in the mainstream political class outlining the more realistic positive picture of successful integration. [3]

Unfortunately the consequences of that failure have become particularly apparent in the last two weeks. If some political parties continue to not only demonise particular groups of people, but also in their own interests dial up the supposed threat that those groups represent to the rest of society using words like ‘invasion’, then one consequence is to encourage intimidation and violence against those groups, and in some cases even those that show humanity towards these minorities (so called ‘traitors’). If you dehumanise groups, then you encourage others to treat them as less than human. [4]

Every time politicians and the media describe groups like those in black wearing masks as anti-migrant activists or protestors against asylum seekers, they are presuming the motive is legitimate concerns rather than racism or xenophobia. It doesn’t seem to bother the media that this is happening at a time when immigration numbers have fallen drastically and small boat numbers are also down. It is the equivalent of describing Mosley’s blackshirts in the 1930s as protesters with legitimate concerns about the government letting in too many Jewish refugees, when in reality the government refused entry to many more than it let in.

Not only is Labour’s passivity on recent developments morally wrong, it is also bad politics. The vast majority of voters in the UK dislike the idea of masked gangs blocking roads and intimidating the RNLI, and would credit any government that came down very hard against such gangs. Equally the spectacle of hecklers being beaten up at Reform’s party conference while audience members cheered and Farage laughed were horrific, and Labour politicians should be going out of their way to vilify Reform's Treasury spokesman Jenrick and others for their reaction to that. [5]

In a past post I talked about the dividing lines between right wing populism and fascism, and have suggested that violence is one sign that populism has become fascism. Reform are clearly right wing populists, as their intention to declare a state of emergency on gaining power together with their comments on the judiciary at their conference clearly show. The encouragement of violence against their opponents by their senior politicians suggests they have the potential to become a fascist party. Perhaps rather than call them populists we should call Reform proto-fascists. [6]

Reform certainly should be called far right rather than hard right. That the BBC fails to do so indicates they have lost their way in dealing with Reform. Part of that may be the result of Reform supporters or sympathisers within the organisation, or their well known paranoia towards the right wing press that has a very similar agenda to Reform. But part may be a misplaced fear of a Reform government. I say misplaced because the BBC would not survive under a Reform government, and probably not under a coalition involving Reform. Appeasement that cannot work is worse than useless.

What is required is that politicians and media in the political centre start to draw some lines, and when these lines are crossed to shout with all the power at its disposal. Stop calling organised gatherings of thugs in masks ‘protesters’ and start calling them ‘gangs’. Politicians need to demand that the right condemn the behaviour of these gangs [7] (and if the police don’t make arrests ask why [8]) Both politicians and the media need to attack Reform politicians when they make racist remarks or encourage violence.

As Stephen Bush says, believing that someone who is not white and is born abroad can never become a true citizen of a country or participate in our politics, or indeed that their children or grandchildren cannot become truly British, is not a legitimate concern about immigration. Nor is describing all immigrants as goat herders. Not only should senior Labour politicians and the media call those politicians making those statements out, they should demand the leaders of the party they represent do so too. Labour politicians and the media doing this would reflect public opinion, partly because many Reform and other right wing supporters share certain views and values with more liberal voters, like a dislike of violence and intimidation. Labour needs to both stop making it harder for immigrants to feel British, and to start acting more like an anti-fascist party.

[1] While this post is partly about the underlying reasons why this is happening now, the proximate cause may be funding from right wing groups in US, although of course that reflects similar underlying trends in that country.

[2] I also don’t think the scale of inward migration has that much explanatory power for various reasons. Areas of high immigration don’t show higher support for the far right, and many voters tend to say that immigration is a major national issue but not a concern in their area. Levels of immigration have fallen substantially over the last two years, yet it remains the issue that most concerns voters. The best predictor of concern about immigration is the newspaper people read (see also here).

[3] For example Sam Freedman points to the recent Pisa survey showing second generation immigrants outperforming their peers at school (see also here). But a mass deportation programme, together with continuing Conservative/Reform anti-Muslim rhetoric, is likely to reverse that positive record.

[4] There may be an analogy here between the tension between international or religious alliances and calling out ethnic cleansing.

[5] The Liberal Democrats to their credit called this out.

[6] Here proto-fascist would mean a group or party that shares many features of fascism and could therefore become a fascist party if they gained power. While populist is a widely used label I think it has two big disadvantages. The first is that even among academics its exact definition is disputed, particularly if the label is used to include left as well as right. The second is most people are unaware of these alternative academic definitions, and so the label is even less meaningful. What is pretty clear, however, is the similarity between right wing populists and past and current fascist governments. If Reform dislikes the label proto-fascist then they should stop trying to imitate everything the fascist government in the US is doing.

[7] The Conservative Police & Crime Commissioner for Hampshire appeared to justify the actions in Portsmouth. Reform’s Braverman expressed sympathy. Restore’s leader Lowe gave them his support. This in turn encourages sections of the media to describe the thugs as polite and motivated by a love of Britain rather than a hatred of foreigners, to describe the RNLI as becoming a taxi service for small boats, and to continue to spread lies about asylum seekers.

[8] As one person commented, it “seems the difference between ‘protestors’ and ‘terrorists’ is that protestors wear balaclavas while terrorists hold placards.”

Understanding long term interest rates movements over the austerity period and today

 

The first section explains some basic ideas, and those familiar with arbitrage and the natural real rate of interest can skip to the austerity section.

Basics

Longer term interest rates, rates on borrowing for a number of years, are what helps determine the cost of government debt, the cost of long term borrowing by firms and the cost of mortgages. A lot of popular discussion links these longer term rates to the short term interest rate set by central banks. The reason is arbitrage. Someone who buys a longer term asset with a fixed return over five years, say, could instead hold that money in a variable rate account, and arbitrage means that rates will move until lenders are indifferent between the two, so longer term rates and short rates are linked.

By that logic, interest rates on a 5 year bond, say, are just equal to expectations about how the central bank will set short term interest rates over the next five years. It’s not that simple because of liquidity and uncertainty. Having money in a variable rate account normally gives you instant access, while investing in a longer term asset will either tie your money up for a long time or to a potential loss by selling it before term, so lenders want some compensation for this. In addition, what is going to happen to short rates is very uncertain, so most lenders want compensation for taking the risk of betting on a particular forecast.

Guessing how independent central banks will set interest rates in the future is not easy, but the logic behind their actions are pretty clear. Most aim to hit an inflation target, so they will set interest rates at whatever level is required to either keep inflation at target, or get inflation back to target. In crude terms, interest rates act to control aggregate demand, and keeping inflation steady involves getting demand matched up with available supply.

A critical question is therefore what level of interest rates will stabilise inflation in a few years time. That depends on what will happen to aggregate demand, but it also depends on how demand is influenced by interest rates. Demand is mainly determined by real rather than nominal interest rates, where the real rate is the nominal rate less expected inflation, so we want to know what real interest rate will match aggregate demand to supply. That level is often called the natural real interest rate. Judging by historical data the natural real interest rate seems to vary a lot over time. [1]

Most measures of real interest rates fell steadily from 1980 until at least 2000. Above is an example based on US rates (source). While you could argue that rates were unusually high in the 1980s because central banks were squeezing demand to bring inflation down, that doesn’t explain the continuing fall in the 1990s.

We need two more conceptual ideas before going further. The first is the importance of the supply and demand for savings. If, say, a technological revolution produces a large increase in borrowing by firms, but there is no increase in the supply of savings to meet it, real interest rates will rise to encourage more saving and discourage some borrowing. While I tend to discount the idea that the supply of particular assets, like an individual government’s debt, is the critical factor determining the interest rate on that debt [2], at the aggregate level the supply and demand for assets does matter.

The second idea is the distinction between safe assets, where the person borrowing is almost certain to pay back the loan, and other investments where the loan may be only partially paid back. Equities are the main example of the latter, because not only do aggregate share prices move around but any individual company may, in the extreme, go bust. The difference between the two types, returns on safe assets and the return on equity or capital more generally, is called the ‘equity risk premium’, but that gap may not just be about risk. In particular the overall supply and demand for either type of asset can influence this risk premium.

The Financial Crisis and Austerity Period

For more detail on this and the next section I strongly recommend this fascinating discussion between Paul Krugman and Ricardo Caballero. Caballero argues that after 2000 there was a continued fall in the real interest rate on safe assets, much greater than anything happening to the return on capital, and he described this (at the time) as a shortage of safe assets. (This study suggests that the return on capital in the US actually started rising in the 90s.) In other words rather than there being too much government debt around (as many politicians and journalists claimed) there was actually too little.

Was this shortage one reason that the private sector tried to make its own safe assets with mortgage backed securities, the failure of which was the spark that led to the Global Financial Crisis (GFC)? Caballero suggests it was a factor. It would be horribly ironic if the GFC, the impact of which was often misattributed to excessive government borrowing, might itself have been partly caused by governments borrowing too little! But what Caballero’s argument certainly tells us is that attempts in most countries to cut government deficits from 2010 because government debt was dangerously high were especially wrong.

The original sin of austerity was of course to cut government spending in a recession, going against basic macroeconomic teaching understood since Keynes. We now know that policy, as well as delaying and probably diminishing the recovery from the financial crisis, also probably failed to even reduce the government debt to GDP ratio. The argument that economists like myself made was that fiscal consolidation, if required, should wait until the recovery from the recession was all but complete. However, if there was in fact a shortage of safe assets in the form of government debt before the financial crisis, it may well be that the large amount of debt issued as a result of that crisis was a necessary correction for that shortage. Even the excuse for austerity was wrong.

Because safe assets were in short supply, austerity meant that interest rates remained extremely low for a decade after 2010. Government debt was increasing, but this may have simply replaced the hole created by the demise of mortgage backed securities. (For a period a lot of European government debt also stopped being safe.) [3] What is unforgivable over that period is that governments kept public investment low, despite the fact that it was so cheap to borrow. [4] We are suffering the results of that colossal policy mistake in most countries today. The one country that didn’t make that mistake was China, which is the reason they have a state of the art railway network today.

Rising interest rates today

Those days of very low short and longer term interest rates seem to be over. The first point to note is that this is essentially an international phenomenon. Political journalists like to focus on domestic issues when talking about this, but you will not find an explanation for rising longer term interest rates across the globe in anything the UK government has or will do. [5].

One story that follows from the post-GFC discussion above is that we no longer have a shortage of safe assets, and indeed there may now be a glut. The Eurozone crisis ended as a result of the switch in policy by Dragi and the European Central Bank, so that supply is back. In addition the pandemic led to a step increase in the amount of government debt worldwide. Finally, in the US in particular, budget deficits have been large and (unlike in the UK) there are no plans to bring them down.

Another part of the explanation for higher longer term rates that is often discussed is inflationary pressure caused by the US attack on Iran. However what is noticeable about longer term interest rates is that they are higher at all durations. Why should higher oil prices today be adding to inflationary pressure in 20 years time? One answer to that is a point I have noted before, which is the rise of right wing populist and even fascist governments. [6]

Take the worst case scenario, which is that traditionally right wing parties are either being overshadowed by right wing populist parties or are morphing into such parties. (Of course we might get both, as we have in the UK.) That means that periods of right wing populist government become almost inevitable. It is unlikely but not impossible that such governments would actually default on their debt. What is more likely is that they would end, by one means or another, independent central banks and allow inflation to stay permanently and significantly above today’s target levels. For any given level of the real natural rate, that means higher nominal interest rates in the future.

A third factor that may generate more persistent inflationary pressure is the AI boom. Most people believe that the current AI revolution will greatly improve future productivity growth. [7] Prospective higher productivity in the medium term can lead to increases in aggregate demand in the shorter term through two routes. First firms will increase investment in AI. We are already seeing that in the US with the development of AI itself, but that will spread to investment in these models across many other sectors. Second, higher future productivity means higher expected future incomes, and people’s consumption today depends in part on expected future income. (In effect they will spend more today because of a strong stock market.) Just as with a future natural resource boom, demand will increase before supply does, putting additional pressure on inflation and therefore raising the natural rate of interest.

Finally the AI boom itself tends to increase the return on capital, which other things being equal will raise longer term interest rates across the board. Higher future productivity raises the long term natural rate of interest according to standard economic models. This is why we are seeing stock markets remaining strong despite rising interest rates. In addition the investment required to implement AI improvements requires additional corporate borrowing, pushing up longer term interest rates. [8] At the moment that borrowing is concentrated in the tech companies developing AI, but later it may spread more widely as firms adapt to integrate AI into their production methods.

All these stories, with the possible exception of higher oil prices, imply that higher longer term interest rates are here to stay, unless a financial crisis forces central banks to lower short term rates (see [6]). To the extent that this is the result of anticipated productivity gains, it can be viewed as a positive rather than negative development.

If that is the case, what should policymakers do about it? In terms of the distribution from borrowers to lenders not much directly. We may end up judging the era of cheap borrowing after the GFC, rather than conditions today, as an historical oddity. As far as fiscal policy is concerned, responsible governments will at the very least need to stop debt to GDP rising as a result of higher interest rates on government debt. As higher interest rates particularly benefit wealth holders, it makes sense to raise taxes on those who save rather than those who borrow. Cutting public spending makes much less sense as long as private consumption continues to increase..

[1] As aggregate demand varies around supply, then the natural real rate will be approximately the average of real interest rates over a number of years

[2] For the same reason that a sudden shortage of, say, VW cars is unlikely to lead to a large increase in their price.

[3] Another story to explain the low natural real rate of interest popular at the time was secular stagnation (low corporate borrowing because of limited investment opportunities) or a glut of savings associated with China in particular.

[4] Even Ken Rogoff, whose work helped justify austerity, said he didn’t agree with cuts to public investment, which in the UK were critical in stalling the economic recovery.

[5] For some time the rate on UK 10 year government debt has been at the top of the range among major economies. It’s hard to put much stress on domestic political/fiscal factors to explain this when the interest rate on 10 year government bonds in France is 1% below the UK. One possible explanation is the Bank of England unwinding Quantitative Easing. If you really want to relate relatively high rates to UK fiscal decisions, I think the best line to follow is the reduced scope of action created by both a (quite understandable) political unwillingness to cut spending and a commitment not to increase the major tax rates, which reduces the chance of fiscal policy helping to reduce demand thereby putting all the burden on interest rates.

[6] An additional longer term pressure on inflation is climate change. With significant global warming now inevitable, disruption to supplies of food in particular will become more frequent.

[7] Note that this doesn’t necessarily mean that the high equity price of the leading AI companies is justified. You can believe that AI will greatly improve future labour productivity but also believe that the companies producing the AI will find it difficult to capture much of that through monopoly profits. The likelihood of a future productivity boom and who gets the benefits of that boom are separable questions. One quite possible source of a financial crisis is a sudden realisation that AI will not lead to big increases in the profits of those doing the development of these models, making the debt of some of these companies vulnerable.

[8] As noted above, higher future income may encourage a reduction in current saving, whereas what may be required is a rise in current savings relative to income to finance additional investment.