Below is a chart of UK net debt to GDP from the mid 1970s
until the onset of the Great Depression. This post is about the right hand third
of this chart, from 1998 to 2007, which was the period during which Gordon
Brown was Chancellor.
 |
| UK Net
Debt as a Percentage of GDP (financial years) – Source OBR
In general looking at figures for debt can give you a rather
misleading impression of what fiscal policy is doing, particularly over short
intervals. However, having finished trawling through budget reports and other
data for a paper I am writing, I can safely say that this chart tells a pretty
accurate story. (For those who cannot wait for the detail that will be in my
paper, there is an excellent account by Alan Budd here.) In the
first two years of his Chancellorship, Brown continued his predecessor’s policy
of tightening fiscal policy. The budget moved into small surplus, so that the
debt to GDP ratio fell to near 30% of GDP. Policy then shifted in the opposite
direction, with a peak deficit of over 3% of GDP, a period which included
substantial additional funding to the NHS. The remaining five budgets were
either broadly neutral or mildly contractionary in the way they moved policy,
but as this was starting from a significant deficit, the net result was a
continuing (if moderating) rise in debt.
Why was fiscal policy insufficiently tight over most of this
period? Despite what Gordon Brown said at the end of his term, I do not think
this had anything to do with the business cycle. In one sense there is nothing
unusual to explain: we are used to politicians being reluctant to raise taxes
by enough to cover their spending, which leads to just this kind of deficit
bias. However this should not have happened this time because policy was
being constrained by two fiscal rules designed to prevent this. So what went
wrong with the rules?
The first answer is in one sense rather mundane. The rules,
as all sensible fiscal rules should, tried to correct for the economic cycle.
However, rather than use cyclically adjusted deficit figures, Gordon Brown’s
rules looked at average deficits over the course of an economic cycle. That
allowed Brown to trade off excessively tight policy in the early years against
too loose policy towards the end, and still (just) meet his rule. As we can
roughly see from the chart, debt ends up about where it started under his
stewardship, which also roughly coincided with a full cycle.
Was this intended? The answer is to some extent not, which
brings us to the second reason policy was too loose, and that is forecast
error. One of the striking things about reading through the budget reports is
how persistent these errors were. Outturns seemed always more favourable than
expected over the first part of this period, until they became persistently
unfavourable in the second. The former encouraged forecasters to believe higher
than expected tax receipts represented a structural shift, and they were
reluctant to give up that view in the second period. Unlucky or an aspect of
wishful thinking that is often part
of deficit bias?
To their credit, the current Conservative led government
learnt from both these mistakes. Most notably, they set
up the independent Office for Budget Responsibility with the task of
producing forecasts without any wishful thinking. In addition their fiscal
mandate is also defined in terms of a cyclically adjusted deficit figure, which
does not have the backward looking bias inherent in averaging over the past
cycle. Their mistake
is in trying to meet that mandate when the recovery had only just begun.
What this chart does not show are the actions of a
spendthrift Chancellor who left the economy in a dire state just before the
Great Recession. He stopped being Chancellor with debt roughly where it was
when he started, and a deficit only moderately above the level required to keep
it there. The spin
that our current woes are the result of the awful mess Gordon Brown left the UK
economy in is a distortion based on a half-truth. The half truth is that it
would have been better if fiscal policy had been tighter, leaving debt at 30%
rather than 37% when the recession hit. The distortion is that the high deficit and
debt when labour left office in 2010 were a consequence of the recession, and
commendable attempts to limit its impact on output and employment.
|
It always seemed strange to me that the UK was running persisitent defecits during a period of unprecedented growth; thanks for giving this context.
ReplyDeleteThis comment has been removed by the author.
ReplyDelete"Their mistake is in trying to meet that mandate when the recovery had only just begun." There is another, closely related mistake made by the government over which the OBR has not helped at all: after a huge financial crisis, nobody has a clue what the cyclically-adjusted deficit actually is, because nobody knows the true state of the economy. Worse, the cyclically adjusted deficit is quite likely to be endogenous. If policymakers are sufficiently pessimistic about both the level of potential output and its trend rate of growth, they are likely to act in ways that prove them right. That is a truly disastrous outcome.
ReplyDeleteWhat Gordon Brown did preside over was a rise in the private debt to GDP ratio. This ratio according to the 2011 Budget report was about 200% when New Labour came in, and about 400% when Darling took over as Chancellor. It peaked at about 475% in 2009, and, as far as I can tell has, remained at about 450% of GDP since. Figures are difficult to get at in the ONS tables.
ReplyDeleteIt was this huge debt bubble that fuelled above trend growth throughout Brown's time as Chancellor and up till 2008. He called this bubble - "the end of boom & bust". In fact is was the largest boom in history, followed by the largest bust for the UK anyway. Brown was clearly influenced by the rhetoric of Greenspan et al who believed that they had reinvented the economy - an economy that would only ever grow. By ignoring private debt they managed a long period of growth. This belief that it would go on forever surely influenced the loosening of fiscal policy - any sensible government runs a surplus during a boom, unless they really do believe in the end of boom and bust.
The UK went from about 6% above quarterly GDP trend in 2008, to 12% below it in q4 2011. Before 1997 it took 35 quarters of GDP growth to create a 12% difference in quarterly GDP. We've lost about 9 years of growth because Chancellor Brown (amongst others) allowed banks free reign to pump up private debt.
If you want to see what it looks like on the ground then examine the case of Travelodge: a good profitable business (profits up 16% last year, and about 14% margin on revenue - a very profitable business) crippled by debt it acquired due to a highly leveraged buy-out by a foreign investment company during the height of the "boom" in 2006. Travelodge has just been handed to it's creditors who immediate wrote off 40% of the debt in order to give them some cash flow.
Debt that can't be paid back, won't be paid back. What we need to do now is decide how we're not going to pay it back.
So yes the current Treasury are perpetuating a big lie about the deficit. Brown's sin was not tax and spend, at least not in the way that he is portrayed. However they are also failing to tell the truth about the role of New Labour in allowing private debt to swamp our economy. Their policy was not too socialist, it was too liberal!
Most economists - and certainly the Treasury - still ignore the role of private debt. There is no policy to deal with private debt and very little public discussion about it (people don't listen to experts like Steve Keen or Ann Pettifor). But with debt so high we aren't going to return to normal any time soon. Deleveraging takes a long time.
Japan's example is instructive. Their debt bubble created recession began in 1990 and officially ended in 2005. But really they haven't had any substantial GDP growth for 22 years now. Japan got out of recession, after many false starts involving austerity, only by sustained fiscal stimulus over 3-4 years. But they ended up with public debts of 200% of GDP, and two years later the credit crunch began.
While private sector and consumer debt remain high, demand will stay low. As a result government revenues will be low (and borrowing high to compensate). Because out chief markets are going through a similar process we shouldn't see export-led growth either.
"Debt that can't be paid back, won't be paid back. What we need to do now is decide how we're not going to pay it back."
DeleteWill somebody please tell Angela Merkel this simple fact?
PS - the real reason governments ignore private debt is not because it doesn't matter but because there's not much you can do about it short of socialising the economy. Capitalism may be the most powerful engine ever devised for dragging us to a better future, but it is an engine that lacks a speed governor. It proceeds by lurches, and the pause between lurches crushes a lot of people.
@ Jayarava, I have sympathy with this view. But have you read this speech?
ReplyDeletehttp://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech553.pdf
Hi Martin,
DeleteThe speech goes over my head unfortunately.
I'm trying to learn about economics but struggling to get past the fact that no matter what I learn some other economist says it's not true. What I read in undergrad texts is obviously wrong - per Steve Keen's critique. But then what's in the texts is not how working economists think anyway. Everyone has a sincere and convincing argument that contradicts everyone else.
The one solid fact is that the mainstream did not see the crisis coming - and many of them claim they could not have seen it coming. Anyone who wasn't raising the alarm by 2006 is not on my reading list. Those who did raise the alarm did so on the basis of private debt levels. I haven't seen Broadbent's name listed as one of the prescient few. What was he saying in 2006-7 for instance?
Have you read Steve Keen's Debt Britannia?
I see that Mr Broadbent works (or worked) for Goldman Sachs in the lead up to the financial crisis... enough said.
DeleteA lazy ad hominem attack.
DeleteThe fact that Steve Keen predicted the crisis is neither here nor there. A stopped clock tells the right time twice a day. There will be always those who make grand predictions - but you only hear (after the event) about the ones whose predictions happened to be correct.
I wasn't lazy, I put a lot of effort into it. I know all about Goldman Sachs and their role in creating the Global Economic Crisis - I've read all about it and even watched some footage of the USA Senate Committee.
DeleteIt's all too easy to brush aside interesting and useful work that turns out to be right, by claiming it was an accident.
The corollary - that economists only did not predict the crisis by accident - suggests that success in predicting trends is entirely random. I doubt anyone would believe that. Not even economists.
Setting personalities aside if we are scientists we have to conclude that when a model fails to predict the greatest perturbation of the economy in recorded history then it is not very useful. And when a model does predict that same event then at the very least it merits further attention and study. Does it make other good predictions (such as another credit crunch soon?) As the current models continue to fail to accurately predict the state of the economy we should all be asking why? And looking for better models.
In other words it's not who predicted the crisis that matters, but which models did and which did not. (And BTW Steve calls his model Minsky, not the Keen Model. He's just put into mathematics the theories of Hyman Minsky.)
When it was discovered that Newton's Law of Gravitation did not predict the precession of the perihelion orbit of Mercury (in 1859), the race was on to replace it. Einstein won that race in 1905 by applying the mathematics of Laplace to Newton's equation and produced something new: Relativity. It was a great leap forward. That's what should be happening now in Economics. My sense is that this is not what is happening. My sense is that economists don't see this failure as requiring a paradigm change. Unfortunately the real world consequences of their failures and their tight grip on theory are and will continue to be quite devastating.
I agree that we should focus on models, rather than people who propose them. The same, of course goes for the backgrounds of those proposing them: the ideas advanced in the speech which Martin links to are either valid or not, irrespective of who has written about them.
DeleteThe criticism of the idea that gross levels of debt “matter” is very simple. One person’s debt is another’s asset. Rising levels of indebtedness by some necessarily mean rising levels of the assets of others. In the UK’s case, rising private indebtedness is the mirror image of rising private assets (chart 4, page 5). Now, there may be some reasons why asymmetries in the distribution of net liabilities and assets matter (changes in net worth can impact access to credit) but it is important to focus on what these reasons are. In the UK, the speech presents evidence that falling real interest rates led to higher property prices, which lead to higher mortgage debt (for those moving up the property market) but higher assets from house sales (from those moving down the property market).
The idea that debt levels are the driver of crisis is inconsistent with the following facts:
1. There is no correlation between the stock of debt in 2007 and subsequent GDP growth across a wide cross section of countries (Chart 15, p11)
2. The defaults in financial assets which precipitated the crisis occurred almost exclusively in the US. This is in spite of the fact that many other countries, the UK included, have much higher levels of gross debt than the US. UK banks were affected as they owned foreign (in particular US) assets. See argument on p4. starting second paragraph.
"The distortion is that the high deficit and debt when labour left office in 2010 were a consequence of the recession, and commendable attempts to limit its impact on output and employment"
ReplyDeleteObviously being a layman I'm missing something here but the logic of the concluding statement in the article eludes me.If GDP slumps and a government allows the automatic stabilisers to take effect, spending as a percentage of GDP is bound to shoot up.Surely the reduction in tax revenues that accompanied the slump and those stabilisers [benefits etc]generated by higher unemployment and part time working WERE a consequence of the deep recession which hit in 2008. As of 2007/8 revenues collapsed. Spending didn't. Hence...?
Are you sure the consequences of running a severely procyclical fiscal policy are quite as benign as all that? Consider:
ReplyDelete(i) the UK gvt was running a deficit of 3% of GDP at the peak of the boom. The cyclically-adjusted deficit must have been even larger.
(ii) *if* you agree that the government should try to close/largely close the structural deficit (5-6% of GDP) during this parliament, then by (i) the bulk of the cuts are deficit funded spending during the boom rather than a loss in permanent capacity due to the financial crisis.
Now, the premise (the ‘if’) in (ii) I know you take issue with. But there might be reasons why a large deficit going into a recession makes countercyclical fiscal policy less likely:
First, policy makers don’t know the ‘true’ model of the economy. Optimally, they will implicitly undertake some model averaging exercise. Some weight will be given to the arguments of yourself and Paul Krugman. But other weight will (+ should) be given to the arguments of Williamson, Marcet et al who argue variously that the UK is not immune to a sovereign debt crisis just because it has its own currency, that output may not be that far below the flexible price equilibrium as firms now have had the chance (a la Calvo pricing) to reset their prices and so depressed output may be due to other frictions that fiscal policy cannot help with etc. The concern over the deficit is likely to be convex in the size of the deficit (Marcet etc will probably worry more than twice as much about a 6% deficit than they do about a 3% deficit) so the starting point of the deficit does matter.
Second, even if you don’t buy this, certain political interest groups (here, net tax payers) may become nervous that their future liabilities are rising sharply: hence they put more pressure on the government today to rein in deficits. The Conservatives would have had much less of a political constituency in favour of reducing the deficit if the fiscal balance had gone from +2% to -5% of GDP rather than -3% to < -10%. So *even if* procyclical fiscal policy wasn’t bad from 2002 onwards at the time, it may have made countercyclical fiscal policy less likely.
Why was fiscal policy insufficiently tight over most of this period?
ReplyDeleteWhy you believe fiscal policy was insufficiently tight? If the debt/GDP ratio averaged, say, 35%, then why is that too high as opposed to too low? What do you think the ratio should have been?
Does this include money owed as part of PFIs and money "lent" to the banks? These figures clash: http://news.bbc.co.uk/1/hi/business/8415703.stm
ReplyDelete'The spin that our current woes are the result of the awful mess Gordon Brown left the UK economy in is a distortion based on a half-truth.'
ReplyDeleteSimon Wren-Lewis, August 2012
'It is at best a half-truth (and probably nowhere near that) to claim that the UK fiscal problem is primarily one of the government spending too much...'
Diarmid Weir, June 2010 - See http://www.futureeconomics.org/2010/06/camerons-deceitful-cuts-rhetoric
Just sayin'...!
Hi Prof,
ReplyDeleteCould you please clarify what you mean by net debt ? what do you exclude from the measurement? the intrest payments ?
Thanks
The reason why Brown was running a deficit in the boom years was to compensate for underinvestment by the previous Tory government. The Tories are not good investors, and Brown felt he had to remedy this.
ReplyDeleteThe actual cause of the debt pile jumping from 2008 onwards was due to the slump in tax revenue, plus the government's stimulus package to rescue the economy from a deflationary slump. The reason why UK GDP growth has flatlined since 2010 is down to cuts in government investment, particularly in construction.
If you check the details of each quarterly GDP estimate since 2010 Q4, you'll see construction has slumped. The government is responsible for this slump in construction due to swingeing cuts in investment, and the Euro Crisis is not a good excuse to cover this fact up. The double dip recession was created in Downing Street afterall.