The Big Picture for the forthcoming UK Budget that the media largely ignores

 

Budget coverage in the media is understandably all about the details. What taxes are going up or down? How do the OBR forecasts compare to last year or six months ago? Has the fiscal headroom gone up or down? In all this it is easy to lose the big picture. Yet when some media outlets do attempt to do big picture previews, they often get things very wrong. This post tries to correct that, and suggests why the Budget is unlikely to change that picture.

The big picture presented in much of the media is one of general gloom, if not crisis. This is not confined to right wing media, or cliches from Andy Haldane. Here is the director of the Institute for Government talking about “the gravity of the fiscal position”. From this vibe you might think that the deficit is increasing, whereas in fact the government’s current balance (the key measure for the sensible fiscal rule) fell from a deficit of 2.5% of GDP in 2024/5 to a deficit of 1.5% in 2025/6. As I show below, when you look at other countries this gloom is certainly not warranted.

I think a lot of the gloom comes from the media’s obsession with the bond markets, coupled with a general misinterpretation that the UK’s comparatively high interest rate on government debt is due to scepticism about Labour’s fiscal credibility. While scepticism about any politician’s fiscal plans is usually warranted, to suggest this is why UK long term interest rates are relatively high seems nonsense to me. A far more plausible explanation is market pessimism about UK inflation relative to other countries, as I set out here.

Here are three key points giving the big picture on current UK fiscal policy as I see it.

1. The UK is in the middle of a large fiscal contraction/consolidation that is far greater than any other G7 economy

Here is a chart from the October IMF forecasts, based on existing and projected policies in each country.

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The UK budget deficit fell last year, and is expected to fall further this year. If the IMF forecasts are right the UK will have the lowest budget deficit as a percentage of GDP of these four economies this year. Furthermore that consolidation is forecast to continue over the next few years. By 2029 the UK is expected to have the lowest budget deficit of all the G7.

All of which might come as a surprise to many who have absorbed the gloom vibe coming from the media. Even if you believe that the size of budget deficits influence interest rates independent of their impact on inflation (which I generally don’t), the chart shows why the idea that high UK rates relative to the other G7 is because of deficit concerns doesn’t hold water. While it is highly likely that there will be some slippage from this projected path for the UK, slippage by other countries faced with similar global pressures is also likely.

None of this, including any changes in the forthcoming budget, is likely to change the key message of this chart, which is that the UK is tightening fiscal policy to reduce the budget deficit, something that isn’t happening to the same extent (if at all) in other G7 economies. The direction of travel is what is critical here, rather than the speed at which goals are reached.

2. This fiscal consolidation is being achieved mainly through higher taxes rather than cuts in spending

The table below is from the pre-budget OBR fiscal database, with everything as a percentage of GDP.

	Receipts (taxes)	Current spending	Current balance deficit
2024/5	38.9	39.1	2.5
2025/6	40.1	39.3	1.5
2026/7	41.2	39.8	1.1
2027/8	42.0	39.6	0.1
2028/9	42.1	39.5	-0.1
2029/30	42.5	39.4	-0.7
2030/1	42,7	39.4	-0.8

The current budget deficit fell substantially last year because taxes increased. Over the next five years the current budget moves into a small surplus mainly because taxes continue to rise, from just over 40% of GDP last year to over 42.5% by 2030/1. In comparison, current spending is roughly constant as a share of GDP.

Once again these numbers will change following the budget and with the OBR’s revised forecast, but the overall balance is unlikely to: taxes are rising as a share of UK GDP not because spending is increasing, but because the UK government is reducing its deficit. For those who again dismiss this as just a forecast, this is exactly what happened over the previous financial year.

3. Keeping current spending flat as a share of GDP over the next five years does not seem realistic

For reasons that are well understood, health spending as a share of GDP has been rising in nearly all major economies over the last few decades. The UK is no exception. In the post-war decades this was offset in the UK by falling defence spending, but in the near future the opposite will be true, with the UK committed to increasing the share of defence spending in GDP.

Pretty well all the factors leading to a rising share of health spending in GDP are likely to remain with us over the next five years at least. Coupled with defence commitments, this means that spending as a share of GDP in other departments would have to fall to realise a constant share of spending overall. This seems implausible.

However I doubt that this will change in this budget, but instead will be addressed in forthcoming negotiations between the Treasury and departments. The Treasury would like to keep something close to the current picture as its initial bargaining position, faced with inevitable pressure to increase spending from individual departments. That the OBR’s fiscal forecasts are based on unrealistic spending plans is unfortunate, but the unrealism today is nothing compared to the plans set out at the end of the previous Conservative government. As the reasons for this reflect the clear incentives Chancellors and the Treasury face, the answer is not to bemoan governments but give the OBR the power not to follow government plans in their forecast when these are clearly unrealistic.

Given this big picture, it would be surprising if Chancellor Healey changes course in any major way. In addition, I suspect the next election is sufficiently close to prevent him announcing any major fiscal reform (like merging employees' NICs into income tax). When Burnham took over as Prime Minister I predicted that policy would focus on short term cost of living measures, and hoped instead that the ground would be set for more major reforms in the longer term. Burnham has certainly delivered on the latter, but I suspect to do the same on taxation policy would be seen as too great a political risk at this stage in the election cycle.

The Decline of Knowledge Based Policy and the Economics Nobel

 

I have structured this as a two-part post, where the second part is about one of the two winners of this year’s Nobel prize for economics. Both parts are directly connected, but I’ve split them because the second part is more of interest to those who know some economics.

The Decline of Knowledge Based Policy

I have written about this before, prompted by a post from Chris Dillow, who has returned to the theme more recently. Rereading all this I think we have a classic problem of overdetermination, by which I mean that we only have one observation - the decline in knowledge based policy over the last two decades - and far too many possible explanations for that observation. So here I want to counter that by putting forward just one story.

My proposition is that the decline in knowledge based policy in the UK is a result of something that happened long before the decline became evident: the adoption of neoliberal ideology by the Conservative party in the 1970s and 1980s. Not a consequence of neoliberalism, but neoliberalism being adopted by the UK’s dominant party of government. The distinction is crucial because in many ways the heyday of knowledge or evidence based policy, at least for social science, was the Labour government of 1997 onwards, and you can legitimately call that government neoliberal in many respects.

Of course neoliberalism was to an extent knowledge based, in that it used parts of economics to argue that markets were best at allocating resources, and certainly better than government. However I would argue that inpractice it was really an ideology of government that put the interests of business and corporations first, and used selected bits of knowledge to pretend that this was equivalent to maximising the interests of society.

Post war Conservative governments before this had of course always been attuned to the interests of business, but they also recognised other interests, and were prepared to overrule business interests if they thought society required that. Trade unions were tolerated, for example, as were the nationalised industries created by the Atlee government. That ended with the adoption by the Conservative party of neoliberal ideology.

In contrast, the New Labour government of Blair/Brown were much more prepared to modify that ideology in specific cases. The minimum wage is a clear example. That was why evidence based policy was able to flourish (comparatively) under that government. Of course not everything proposed by neoliberalism was necessarily wrong, so to many the initial Thatcher period might have seemed like it involved some knowledge based policy, even if some of the ideas they adopted turned out to be horribly wrong (e.g. monetarism).

The belief that steadily grew in the Conservative party under and after Thatcher that neoliberalism was all the knowledge that government needed meant that party lost what little interest it had in knowledge based policy. In particular, it stopped learning from its mistakes, and unlike Labour made no attempt to adjust after electoral defeat. This became very evident when they returned to power (in coalition with the Liberal Democrats) in 2010. Austerity was the opposite of knowledge based policy. It went against basic ideas in macroeconomics that were taught to both first year undergraduates and masters students in nearly all universities in the UK and the US.

In essence, the knowledge we had from both accepted economic theory and empirical evidence was that you don’t cut public spending in a recession, and in particular you don’t do so in a recession where interest rates had hit a lower bound and couldn’t be cut further. Doing so would either make the recession much worse or kill any recovery. The previous Labour government had understood that, which is why it adopted fiscal expansion in 2009. George Osborne and the Conservatives argued against that fiscal expansion, and when they gained power adopted a contractionary fiscal policy. The result was exactly what economic theory and evidence predicted. The recovery that started in 2010 stalled, and the economy didn’t start to show (albeit modest) signs of above trend growth again until 2013.

Osborne ignored macroeconomic knowledge because the neoliberalism his party had adopted argued for a small state and low taxes. The large budget deficits created by the biggest recession since WWII allowed him to scare voters into thinking that cuts in spending had to happen immediately to avoid the bond markets punishing the UK. The media largely cooperated in supporting this myth. They too had little time for knowledge based evidence for reasons that were not just political.

Austerity wasn’t the first time the Conservative party showed its disinterest in knowledge based policy, but austerity was the most obvious and it had a huge impact. Unfortunately this disinterest was rewarded when Cameron won the next election outright, and therefore his disregard for knowledge and evidence appeared validated. It was downhill from there and one year later economic knowledge was labelled ‘Project Fear’. Some on the Labour centre and right drew a similar lesson. (Not the left: John McDonnell as Shadow Chancellor was always interested in new ideas.) As Labour’s current disinterest in the economic viability of the university sector suggests, it’s a long road to get back to the heady days of evidence based policy under Brown and Blair. Conservative party policy making remains hopeless: Jill Rutter recently described their inheritance tax proposals as “myth-based”.

Michael Woodford jointly wins the 2026 Nobel

I’m not going to attempt to fully describe Michael Woodford’s contributions to macroeconomics, because others can do that much better than me. However I do want to correct an impression that some may have got from these tributes, and that is that Woodford’s work was all about monetary policy, and how central banks should operate. A great deal of his work was about this, but Woodford also wrote about fiscal policy, at exactly the time that this work was most needed - 2010.

First some background. In the 1980s and 1990s academic macroeconomics went through what is generally called the New Classical Counter Revolution. At the time the leaders of this revolution hoped to use some new theoretical ideas to end the dominance that Keynesian theory had over macroeconomic policy. Their ideas, and in particular rational expectations and an intertemporal model of consumption, were indeed adopted, but other economists also added simple models of price rigidity to rescue basic Keynesian ideas about the business cycle.

The result was generally called New Keynesian theory. I think it’s fair to say that in his 2003 book, Interest and Prices, Woodford wrote what was then the clearest exposition of the implications of the New Keynesian theory for macroeconomic policy, and the book became a bible for academics and central bank economists alike. For those overly sceptical of the New Keynesian model, I would suggest that the fact that the 2022/3 wage and price inflationary period was brought to an end without high unemployment is evidence in its favour over older Keynesian ideas. Blanchard has argued recently that the last few decades have seen a convergence within the mainstream around this New Keynesian perspective.

New Keynesian theory and Woodford’s book supported the idea that monetary rather than fiscal policy was the key tool that should be used to tame the business cycle. But as Woodford’s book made abundantly clear, monetary policy in this context meant interest rate policy. Monetary aggregates play no role in Woodford’s basic framework, and partly for this reason Woodford talked about his ideas coming from Wicksell rather than Keynes.

Which was fine, as long as interest rates were free to move. The recession of 2009 was so great that interest rates were quickly cut to almost zero, and for good or bad reasons central banks felt they couldn’t cut rates any further. The key tool of monetary policy was broken. Some central banks resorted to expanding the money supply (Quantitative Easing) and buying government debt, but Woodford was very sceptical about how effective that would be. Which left fiscal policy.

In 2010 Woodford published a paper called “Simple Analytics of the Government Expenditure Multiplier”. (It was published in 2011 in AER Macro.) He concluded:

“A multiplier well in excess of 1 is possible when monetary policy is constrained by the zero lower bound, and in this case welfare increases if government purchases expand to partially fill the output gap that arises from the inability to lower interest rates.”

In other words, increases in government spending could be very effective in helping to offset a recession when interest rates hit their lower bound, and should be used to do so. By the same token, austerity in that situation would make the recession worse. To pick up from the first section of this post, the Labour government in 2009 was right, and Osborne was dead wrong.

This result was hardly a surprise to those like myself who had been working on fiscal policy in New Keynesian models, or to those like Paul Krugman who had been looking at Japan, where interest rates had long been stuck at their lower bound. Anyone who bothered to talk to people using state of the art macromodels to analyse fiscal policy would have come away with the message that austerity when interest rates were stuck at their lower bound was very foolish. But the paper was typical Woodford in showing the formal result elegantly and why it was likely to be robust. It also showed why empirical evidence based on periods where interest rates were not constrained was a poor guide to multiplier size.

Woodford is probably this blog’s most frequently quoted living economist. I want to end by looking at another of his major contributions to macroeconomics. One consequence of the New Classical Counter Revolution is that macroeconomic models became much more focused on microeconomic theory, and less on matching empirical data. Whether this microfoundation was good for the discipline is something I used to write a lot about in this blog.

However before Woodford there was a major gap in this microfoundations programme. Although the behavioural equations of the model could be derived from the representative agent maximising utility, the objectives of policy makers were generally assumed to be ad hoc: some combination of minimising deviations of output from trend and inflation from target. What Woodford managed to do was to show what the objectives of a policy maker that wanted to maximise agent’s utility would look like.

Having subsequently worked through similar derivations myself in work with Tatiana Kirsanova and Campbell Leith, in my view this contribution from Woodford was a mathematical and intellectual tour de force. Its impact on academic macroeconomics could be measured in the fact that thereafter most theoretical papers in macroeconomics routinely used a version of Woodford’s derivation. Indeed given the length of this mathematical derivation, you could say his contribution to subsequent work could be literally weighed.

How useful this innovation was to actual policy in the short term was more doubtful, for reasons that I discuss here, but perhaps it might become so. But it would be quite wrong to suggest from this that Woodford was and is just a theorist aloof from practical policy concerns. Quite the opposite really. For example his work played a key role in the debate among central banks about how much to say about future policy (‘forward guidance’). He also wrote (see my summary here) about how much inflation targeting central banks should use interest rates to reduce the risk of financial crises, and the macroeconomic impact of the pandemic.

Michael Woodford has the ability to both do demanding and difficult economic theory, producing path breaking results, and also address current debates in macroeconomic policy that can influence what policymakers do. That is why most macroeconomics thought he was always going to win the Nobel prize. We just need politicians prepared to use some of those insights rather than ignore them.

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. [postscript below]

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 more 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.

Postscript 16/10/26. Among the G7, expected deficits are due to fall in the UK more than most. As IMF managing director Kristalina Georgiev said recently "The UK is actually one country where action to reduce debt and deficit has been taken decisively".

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.