Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 14 August 2014

The risks to the UK recovery are fiscal not monetary

So this is how it is going to go. As the UK recovery proceeds, and rapid employment growth continues, at some point firms will begin to find it difficult to fill jobs. There are few signs (pdf, section 3) of that yet, but it is likely to happen sometime in 2015 or 2016. At that point, real wages will start to rise. Labour scarcity, and the recovery in investment that has already begun, will mean that at some point in the next year or two UK productivity growth will also recover to more normal levels.

What happens to interest rates will depend crucially on the relative timing of these two changes. If productivity increases when real wage growth resumes, wise heads on the MPC will note that cost pressures remain weak. If there are no other inflationary pressures, the case for raising interest rates also remains weak. However if real wages start rising before productivity growth picks up, such that unit labour costs rise, then the MPC will raise rates.

Which will happen is I think anyone’s guess, given the uncertainties associated with the UK productivity puzzle. It may come down to measurement errors in the data. However I also suspect it will not matter a great deal either way. This is because I take the MPC seriously when they say rate increases, when they come, will be small and gradual.

We can speculate about the impact of one or two quarter point increases in interest rates, but I think this would be ignoring the elephant in the room. That is fiscal policy, where its 2010 all over again. We have two austerity programmes: for simplicity call them Labour and Conservative. One is tough, the other is - well let’s just say very tough. Here is a picture.

Alternative Austerity Paths for cyclically adjusted net borrowing (excluding Royal Mail and APF transfers): source OBR and my estimates for Labour

We see the sharp fiscal contraction in 2010 and 2011. Thereafter it eases off. (If we look at the primary balance, which excludes interest payments, the easing off is even more noticeable - see here). Under the current government’s plans, fiscal tightening resumes again in earnest after the election. My guesses for what would happen under Labour are based on their (somewhat vague) statements so far.

In the past I have been a bit dismissive of these government plans, saying they represent a political gambit by Osborne to make Labour look relatively profligate. However that may have been politically naive. After all if the Conservatives win the 2015 election (or are part of a new governing coalition) this will have been achieved having followed a strategy of frontloading austerity. So why change a winning strategy? They might therefore keep to these plans, cut spending and welfare sharply in the first two or three years (more hits on the poor and disabled), and then again ease off, perhaps with tax cuts in the second half of the five year term.

Maybe the UK economy will be luckier than it was after 2010. Perhaps the recovery will be strong enough to shrug off this fiscal contraction, as the US economy has been able to. (Although many will correctly claim that the US recovery has been slower than it might have been as a result.) But the key similarity with 2010 is that UK interest rates will be at or close to their lower bound, so there is no insurance policy if things do go wrong. Just as in 2010, the government will be taking a huge gamble by embarking on a sharp fiscal contraction. The one difference from 2010 is that this time there is no pretext to take such a risk.  


  1. What makes a Tory 2015 victory or their being part of another coalition unlikely (assuming Scotland votes 'No!') is that the Tories have spent a generation shifting the focus from unemployment to 'aspiration'.

    'Labour's Not Working' of Saatchi and Saatchi 1979 and one million unemployed being a totem was obliterated, and C1s and C2s - the Tory Party has the least well educated voters of the three established parties - were told to stuff thy neighbour and get ahead of the pack.

    And now in 2015 after five years of wages under the Coalition not growing as fast as inflation, well, this is not in the aspirational class pact. And the Tories will pay for it, compounded by the self-inflicted scuppering the boundary changes.

  2. (i) The Tory plans are completely implausible, unless they are planning on abandoning State Education or some such. There entire purpose is to paint Labour into a corner, and provide the Tories with a stick with which to beat them. In this they have succeeded.

    (ii) The Labour proposals are so open textured as to be worthless.

    (iii) The Lib Dems plans are not the same as the Tories, are less 'tough', and so reference to "the current government's plans" is inaccurate. There is a coalition.

    (iv) There will be a fiscal tightening in the early years of the government whoever wins. That is politics. It is easy to cut the pet projects of the other side (Sure Start in 2010, Free Schools in 2015), and tax rises have to be frontloaded in order to be forgotten. The only way this may not happen in 2015 is if there is a hung Parliament, and Labour form a minority which they intend to be temporary (think Wilson 1974). On current betting/polling that is not implausible.

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  4. I’m not sure about the Simon’s first paragraph. If real wages rise, that can only be at the expense of profits, all else equal, in particular if terms of trade remain constant (i.e. the value of the pound relative to other currencies remain constant).

    But suppose the shortage of labour is matched by a shortage of entrepreneurs (a not unreasonable assumption) then profits will rise at the same rate as wages. And that equals inflation, pure and simple: i.e. there is no growth in real wages (for employees or entrepreneurs).

    Now where have I gone wrong?


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