Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 23 June 2013

Fiscal legacies and competence

I’m afraid this is more on Labour’s fiscal record, and the myth that this created a huge mess that current Labour leaders should apologise for. So if you have already been convinced that this is a myth, or if you will never be convinced that it is not, do not bother to read any further. However I will say something at the end about why this issue is so important, and therefore worth returning to.

The key thing to remember is that this debate is all about degree. I have argued (and repeat below) that UK fiscal policy was not tight enough in the years 2003-7, certainly in hindsight, but even given what we knew at the time. As I said before, some of the best myths are based on half-truths. The issue is how serious this fault was. The myth is that this was a mistake of the highest order, which had serious consequences and which therefore requires an apology [1].

Now the thing about myths of this kind based on half-truths is that those who perpetuate them have an ultimate fallback position. This is to switch back from myth to half-truth, and deny that they ever suggested the myth, or perhaps even to deny that the myth exists. Some of the comments on my earlier post have made this move, and Jeremy Warner in a response to my reply to his earlier post has done the same, although I have to add in a very courteous manner. I will return to this point after running through the facts.

One other point to bear in mind is the distinction between wisdom at the time and in hindsight. Any argument that is specific to the fact that we had a financial crisis and a huge recession in 2008 is likely to be in hindsight. So, for example, I have argued that Labour should have aimed for a declining rather than constant debt to GDP ratio, in part because it would have given itself a bit more room for manoeuvre once the recession hit. However I would never dream of labelling a past government irresponsible and reckless for not doing this, because few macroeconomists argued this before the Great Recession.

There are two types of argument put forward as to why the last Labour government’s fiscal record has been something that requires an apology. The first is that it left a serious economic mess that has been costly to clean up. Let’s call that the legacy argument. The second is that it demonstrates incompetence which, unless addressed, future Labour governments will suffer from.

Take the legacy argument first. The most obvious way in which a government can mess things up for the future is by an unwarranted increase in the level of government debt. This the last Labour government clearly did not do: before the recession hit the debt to GDP ratio was slightly lower than when they took office. Of course debt rose subsequently as a result of the recession, but I talked before about why that is irrelevant.

Looking at debt to GDP may be misleading for the obvious reason that it is a stock rather than a flow, and critics of Labour focus instead on the deficit. [2] However it is not so obvious that high deficits automatically represent a legacy problem. Those same critics usually add that Labour wasted money, and if this is the case then a new government can easily correct the problem by curtailing the wasteful expenditure. Everyone gains except those the money is being wasted on, and the new government gets the credit. The argument has to be that this ‘excessive spending’, once made, is costly to reverse. But let’s leave this point to one side, and just look at the figures.

Once again the data does not look promising for the critics. The current balance (which excludes investment spending) was -0.5% of GDP in 2006/7 and 2007/8, which is hardly a large number. Public sector net borrowing, which does include investment, was around 2.5% of GDP, which seems larger, but here zero is not the appropriate reference point. A sustainable deficit is one that leaves debt to GDP constant: to take some round numbers, if the debt to GDP ratio is to be sustained at 40%, and nominal GDP grows by 5%, we need net borrowing of 2% of GDP. So an actual deficit of 2.5% again does not seem that excessive.

But the critics say that is misleading, because the economy in 2007 was at the high point of a huge boom. (The phrase ‘credit fuelled’ usually gets added at this point.) They say, quite rightly, that such a boom will raise taxes, and it is wrong to follow that with higher spending. So was the UK economy in 2007 at the end of a huge boom? Here is the OBR’s assessment of the output gap.

The OBR’s output gap in 2007/8 was 2%, which could just count as a boom, although not huge by historical standards: the mid-70s, the end of the 1980s, and the end of the 1990s are all either larger or more sustained. [3] Here is the OBR’s series for net borrowing, both actual and cyclically adjusted.

Remember that 2% is a rough benchmark for a 40% debt to GDP ratio to be sustainable. The deficits from 2003/4 to 2007/8 were too high, as my paper clearly argues. But are they of a scale that leaves a really difficult legacy for subsequent governments? The obvious comparison is with the mid 1990s. Here we had a cyclically adjusted deficit that reached 6% of GDP, but it was brought down quickly by the then Conservative government. The idea that the deficits just before the recession were so large that they would inevitably create serious difficulties for a subsequent government does not stand up. [4]

So what about the economic competence charge? Here I have no interest in comparing Labour and Conservative governments in general - that is a completely different kind of exercise. What I am interested in, and have written about, is what we can learn from Labour’s record about macro fiscal management.

The first point is that the fiscal rules brought in by the Labour government in 1998 were progressive, both in terms of previous fiscal rules and compared to what was being done elsewhere. These included a ceiling of 40% for the debt to GDP ratio, which at the time few criticised for being too high or constant over time. Against this measure, fiscal policy was too tight in the early years of the administration. The subsequent relaxation can be seen as an attempt to correct that error, which it largely did. Debt was 36.4% of GDP in 2007/8, so correction was not complete: hence, Labour could argue, the fact that the deficit was above sustainable levels. The record shows that the Labour government did respond to fiscal outturns in the right direction. The budgets of 2006, 2007 and 2008 did involve fiscal tightening. [5] So at face value the main mistake the government made, relative to its own rules, was to run too tight a policy in its early years, but it successfully corrected that mistake in later years.

Looking at the actual record more closely, however, and you can see that there were two additional systematic mistakes that were made, which did not require hindsight and which we have learnt from. I go into detail in my paper, but they involve forecasts and cyclical correction. On forecasting, it really was a game of two halves: persistently too pessimistic, and then persistently too optimistic. On its own that is not crucial. What is important is that, towards the end of this period, Treasury forecasts were more optimistic than those of other forecasters, like the IFS or NIESR. One of the documented causes of deficit bias is overoptimistic forecasts by finance ministries, and this looks like a case in point. The second lesson is that looking at numbers ‘over the economic cycle’, as Labour’s rules did, is a problematic method of cyclical correction, for reasons I outline in my paper. Two mistakes, but neither merits a charge of incompetence.

Furthermore, both these mistakes have already been dealt with by the current coalition. As I have said many times, the Conservative party deserves praise for setting up the OBR. I am pleased to have played a very minor role in helping convince them it was a good idea, and it is a great pity I could not persuade the Labour government at the same time. The coalition’s remaining fiscal rule looks at a cyclically adjusted deficit, rather than at deficits ‘over the cycle’. So unless any future Labour administration scraps the OBR, or goes back to ‘over the cycle’ rules (both extremely unlikely), then Labour has nothing left to correct!

With hindsight there are additional lessons we can learn, and the one I have stressed is that we should have a declining rather than a constant debt to GDP target. But you cannot label politicians incompetent for not realising this at the time, for much the same reason as you cannot damn them for not foreseeing the financial crisis. By such standards we are nearly all incompetent. [6]

So neither the legacy nor the incompetence versions of the myth stand up, either with a simple look at the data, or after more in depth scrutiny. But why am I so bothered about this. Why should I care if the Prime Minister says things like:

“This deficit didn’t suddenly appear purely as a result of the global financial crisis. It was driven by persistent, reckless and completely unaffordable government spending and borrowing over many years.”

and that the media does not challenge him on this? After all, this is just the kind of thing politicians do - distort the truth by as much as they can get away with for political ends. (With this particular speech, the distortion in one respect went too far, as the PM found to his cost: see here.)

Well, this blog is about presenting the macroeconomic facts as I see them, so when they do not fit a widely promoted political (of whatever colour) line, I should say so. However there is a much more important reason in this case, which is that myths influence policy. This myth is part of a pattern, particularly evident in Europe, of seeing our current problems as being to a significant extent about fiscal excess, and of setting current policy accordingly. So in Europe everything is seen as if it was Greece. (Talking of which, if you want to see what reckless borrowing really looks like, see the chart below.)

OECD Economic Outlook: General Government Financial Balances

Explaining our current problems as being in significant part as a result of fiscal excess helps buttress the policy of austerity, which in a ‘zero lower bound’ recession is completely the wrong policy to pursue.

Myths may also distort policy in the longer term too. I have asked many times why the current coalition embarked on their austerity programme when it was obviously such a risky thing to do. (It was risky because it either relied on the recovery being strong enough to take this deflationary shock, which we all know it was not, or it relied on unconventional and untested monetary policy being able to put things right.) Part of the answer - and I suspect it is a small part - is that some politicians looked back to a previous episode where a Conservative government ignored academic advice, and that was the monetarist experiment of Margaret Thatcher. In this post I looked in particularly at the affair of the letter from 364 economists. The myth on the political right is that events proved Mrs Thatcher right and the academics wrong. The reality is that the verdict on Mrs Thatcher’s economic policy is much more mixed, as I discuss here. If this myth played any part in emboldening the Conservative party to ignore the warnings from economists this time around, then current events show how dangerous macroeconomic myths can be.

[1] As suggested by Janan Ganesh here, for example.

[2] The Labour government, like its predecessor, to some extent used PFI to artificially reduce public borrowing. However the OBR calculate that “If all investment undertaken through PFI had been undertaken through conventional debt finance, PSND would be around 2.1 per cent of GDP higher than currently measured”. So not good, but not that big an issue in macro terms.

[3] As I note in my paper, if you look at the output gap series as currently calculated by the OECD and IMF, you get much larger figures for the size of the 2006/7 boom, and hence for the cyclically adjusted deficit. However, these numbers take a particular view of the productivity loss that emerged after the recession. (In simple terms, the UK’s measured productivity performance shows a sharp deterioration from the recession onwards, and the methodology these bodies use assumes underlying productivity does not change abruptly, so therefore underlying productivity must have been growing more slowly than anyone - including these same institutions - thought at the time in 2006/7.) The same numbers calculated in 2006/7 are much lower. Whether their current view is right or not, it is an argument entirely in hindsight.

[4] Remember the argument is all about scale, and whether deficits of this size created a serious problem for a future government that they keep having to remind us about. To give these numbers some kind of meaning, the increase in VAT from 17.5% to 20% raised taxes by about three quarters of a percent of GDP. Now you could say, quite rightly, that deficits were more difficult to deal with this time around because we hit the ZLB, but again that is an argument in hindsight, and one which is particularly inappropriate for the current government to use.

[5] The 2008 budget did not tighten in that fiscal year, which given the signs of the financial crisis already apparent showed foresight.

[6] Of course Gordon Brown was foolish from a political point of view to first talk up his prudential credentials, and then through a series of minor manoeuvres (see my paper for details) undermine that image. But that is politics, and here I focus on the numbers.  


  1. At the end of the day what created the mess we are now in is the crisis. The rest of the stuff is relatively peanuts.

    A crisis that clearly shows all the unbalances in economies that were allowed much too long to persist.
    These unbalances are also partly different from country to country.
    The UK is relatively hit hard (compared to similar countries not to the bunga-bunga belt of course) because of the large banking sector (and the unbalances in that sector) so the rescue operations were more costly.
    Germany was lucky for the by far largest part. It had to do something with its economy earlier because of the reunification and it is strong in manufacturing. But these are not really clever strategic choices. 90% historically determined. If the crisis would have been several years earlier and in manufacturing The roles would have been changed, between these 2 countries.

    Anyway this has made one thing clear, if you have structural unbalances you better do something about it or otherwise things might correct 'themselves' and with force, like now.
    With in several countries unbalances that need policies that bite each other.

    These unbalances were ignored basically all over the place. Governments(left and right); CBs; Markets for a long time.
    Some were unclear. It was basically trying to find out where the cliff is. But why not a bit more careful with those?
    Some where pretty certain there. A lot of countries had clearly a (R)RE bubble. Including the UK. probably the greatest achievement post crisis has been basically solving that (looks even better than the US, while in France and several other all the air is still in it, waiting for the next phase in the crisis).

    As said it happened all over the place. So why did say a guy like Brown (opposition is hardly interesting imho) who is clearly not a complete idiot miss that. And why did CBs missed the mortgage bubble and how could Icesave be missed.
    Just to give you some of my experiences. Icelandic bankers looked after a few minutes I spoke to some of them simply complete jokes. Ask somebody with experience in international RE about say the Irish RE market in say 2005 or even earlier and he will say it is completely idiotic.
    I knew as a nearly complete outsider that Greece
    had been cooking the books, why were they allowed to get away with that.

    This is for me the main question why was this missed?
    If this is the level things are managed, you need a much simpler system as this will run into the wall time and time again.

    Looks like Brown with the no boom and bust stuff clearly overestimated the influence policies can have.
    Overrelying on official data. While these clearly smell. Something, look at the EZ, is simply clearly continuing. Spanish GDP and bad loans for instance.

  2. On myths.

    It is simply like with brandvalues for cars or soap. Compare it with those and you got 90% of the picture.
    This is a thing that is simply associated with the Left. And is time and time again confirmed by acts/statement of the left. They are generally the ones with new programms.
    That that is not necessarily the whole picture is another thing. That is simply way too complicated for John and Mary Average to oversee. Even if they would take the time (which nearly always they donot).
    Fiats rust and Mercedes is quality and it takes at least a decade to change that (and much more to restore than ruin it).

    Especially strange and or funny stuff attached to that makes the confirmation much stronger.
    Leaving a note with something like: 'the Money is finished' attracts a lot of attention and remains in people's mind. Funny but longer term a PR disaster.
    Or Krugman's 1 Tn coin. Makes things in the perception of the majority look like a complete joke. There is a huge difference in say this and just printing 1 Tn extra (which is basically the same in most ways but the the 'look' of it). Next to legally rather dodgy and basically allowing a government to do more than wherefor companies are blamed (tax evasion issue), which is to other groups also no great PR.

    A big part of the political game is attacking the other sides brandvalues. Simple as that. Which looks with the present Labour leadership not very difficult btw. It is simply very weak.
    They are moving all over the place with their policies. Next to a leader who is hardly more appealing to voters than Brown.

    In other words you will may be from an academic pov clear the issue.
    But who in politics cares. This is mass media politics and a few 1000s that read this blog and are notoriously hard to convince anyway are simply irrelevant in this game.

  3. If you remember, both Coalition leaders cited Canada in the early 1990s as their model for (V-shaped) recovery, which allowed the Liberals not to use the early 1980s UK as its historical precedent, while the Tories could secretly wallow in the latter.

    This was the 'little Canadian slump' which, like the UK early 1980s was a political psychodrama that had considerable electoral success.

    No one in the run-up to the May 2010 election talked about austerity, as it lost them points in the polls, and if you look at the 2005 to 2010 results, there was no movement of the middle class from Labour and into the Tories, rather it was social classes C and D that swapped.

    So our economic 'debate' is calibrated to those social classes C and D, the floating voters.

    And to quote my email from the BBC, "The job of our economics team is to make sense of hugely complicated areas such as these for general audiences, and for that reason they would often choose not to deploy such difficult jargonistic terms as liquidity trap – especially in a short bulletins piece - if they felt such a term would not add to audience understanding."

    1. 'So our economic 'debate' is calibrated to those social classes C and D, the floating voters.'

      You miss the rise of the UKip. Cameron & Co basically (after Blair) moved to the political centre (a European trend). But they missed the other main European trend: 'The rise of the so called Populists'. The Conservatives simply left their right flank completely open and UKip jumped into that assisted by the Euro-crisis.

      Labour could be facing a similar faith. There is a clear and large conflict of interest in its main voterbase between people more or less surviving on entitlements and its more traditional voters bluecollar worker (especially the part that has 'middleclassed' by increase of skills- and educationlevels). Split we have seen in say Germany and Holland. Holland clearer than in Germany where it is also caused by the East-West legacy.

      Anyway parties have to reposition because of that and in the UK the Conservatives are in the middle of that process. Mainly meaning a move to the right. As a consequence labour is moving to the right. Which looks a bit unnatural under this leader btw.
      Anyway politics moves away from the far left. There is a clear feeling that now not only growth has to divided but it has to be cuts this time. Simply a reason for less solidarity all over the place.
      In a nutshell bacause of the rise of UKip a new equilibrium has to be formed. Be as we are clearly not there yet.

      In the early stages of the rise of the populists the voters come from everywhere. However at the end of the day usually they end up with the same sort of voter (the social economic and entitlement conservatives). But this proces is a bit difficult to oversee in the UK. As Farage is hardly to appeal to left wing protest voters. Looks the UKip gets more or less directly the voterbase it would end up with lateron.
      Look at the programm of IP and you basically feel that they want to keep entitlements (only they are totally unclear how that should be financed).

      On Communication.
      They are not only trying to keep things simple. They also have not clearly communicated by far that entitlements will have to be reduced. And only doing that at other people's expense is an illusion. A majority sees the necessity of cuts but also a majority still thinks that the bill for that can be dropped with others. Osborne did an attempt, but he simply was sent back into his cage by the current political climate and electoral sentiment. Looks btw also for a large part a political game how to distribute the burden of nett cuts.
      And especially the BBC is not very helpful in that process. It simply keeps out sending the message that little will be changed and that the division of the bill and cuts is simply a political choice. While a large majority of politicians think clearly otherwise.

  4. Simon Reynolds24 June 2013 at 10:37

    Great post. This is an issue definitely worth returning to. This is a point that needs to be made again and again.

    Why should we care if the Prime Minister says things like:

    “This deficit didn’t suddenly appear purely as a result of the global financial crisis. It was driven by persistent, reckless and completely unaffordable government spending and borrowing over many years.”

    a) The prime minister – the person who is in the ultimate control of our macroeconomic direction – shows that he does not understand macroeconomics.

    b) The prime minister appointed his friend George Osborne to be Chancellor – someone who in September 2007 promised to match Labour's spending for the next three years.

    Osborne said then: "The result of adopting these spending totals is that under a Conservative government there will be real increases in spending on public services, year after year.

    c) Cameron and Osborne are making untrue macroeconomic statements purely with a view to getting re-elected in 2015 rather than with a view to doing what is best for the economy of the UK.

  5. Ref : "c) Cameron and Osborne are making untrue macroeconomic statements purely with a view to getting re-elected in 2015 rather than with a view to doing what is best for the economy of the UK."

    I think this isn't their aim. I think their aim is simply the stated aim (pre-crisis) of reducing the size of the state. Everything they are trying to do seems to be with this aim. What they say of course, is different (We are making difficult choices! - What is difficult about choosing to do what you said you wanted to do?). Austerity and the Financial Crisis simply gives them an excuse to blame for them having to do what they already wanted to do. If the PR works out, they'll have succeeded in their aim whilst not making themselves unelectable in the future.

    1. Maybe true, but as someone who generally agrees with that objective I think they are going about it in a rather stupid way. The desire for a smaller state stems from wanting the government to focus on those things it does better than the private sector, so cutting defence spending whilst "ringfencing" the NHS and overseas aid is completely wrong-headed. Also, they must realize that if the economy doesn't recover before the election they are unlikely to be elected, so they must believe that austerity is consistent with recovery.

  6. I have just located your excellent blog on this very important subject and wanted to reply, so sorry for the lateness of my post.

    The answer to your question, "I have asked many times why the current coalition embarked on their austerity programme when it was obviously such a risky thing to do", is political and not economic.

    The coalition can be admired for one thing, and in my view one thing only, and that is sticking to their guns with a political propaganda technique, known as 'The Big Lie'. To use Big Lie, Pick on an enemy or opponent, put out a lie about them or their record, and then say it again, again, again, again, and again. When people get sick and tired of hearing you say it, don't stop but up the tempo. Only then do they start to believe the porky and the bigger the porky the better. It really has worked very well for them.

    The response from Labour, in my view, seems a bit like that of a rabbit in the headlights. They do not seem to see the seriousness for them of the success of Big Lie and its effects at the 2015 General Election. The myth has now been accepted, not by inherent Labour supporters of course, or many economists, but it is taken as Gospel by many, or perhaps enough, voters especially in critical seats, i.e. those with a small Tory majority. The Tories would not have done this otherwise. Lord knows why the Lib Dems joined in with Big Lie. It is after all, being used against the sorts of policy stances that they, I believe, would also follow if they could. That aspect of this matter has been an act of political not economic incompetence.

    I share your anger about the effects of austerity when administered at the wrong time. Using the myth created by Big Lie to blame some else makes something of a crime out of it as well. Politically, Cameron and Osborne are further to the right than many appreciate. In that role they have successfully used the after effects of the GFC on the UK economy, and in turn the reduced Government income versus increased outgoings arising, to cover a dogma-driven dismantlement of the state.

    It's political Simon. The coalition doesn't really care about the economics of austerity that much.


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