Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 26 November 2014

Understanding George Osborne

Yesterday I spoke at the Resolution Foundation’s launch of their analysis of the UK political parties’ fiscal plans post 2015. I believe this analysis shows two things very clearly. First, there is potentially a large gap between the amount of austerity planned by the two major parties. Second, George Osborne’s plans are scarcely credible. They represent a shrinking of the UK state that is unprecedented and which in my view virtually no one wants.  

I would add one other charge - Osborne's plans are illiterate in macroeconomic terms. The UK economy desperately needs more growth. There remains plenty of slack in the labour market, and real wages are continuing to fall. This and the inflation numbers tell us that the problem comes from the demand side. Yet monetary policy can do very little about this lack of demand, because interest rates are at their lower bound and - judging the Bank’s actions - the power of QE is largely spent. This is not a short term problem that is sure to disappear in a year. The risks that world developments will make the problem worse are real - as David Cameron has recently warned.

In this situation a Chancellor should not plan to reduce growth further. I have yet to come across a single macroeconomist who argues that Osborne’s plans for renewed austerity will not in themselves reduce aggregate demand. So doing this when the recovery could go much further but is still fragile is just plain dumb. It is even dumber if you have done this once before, in a very similar situation, and the risks I outlined above have indeed materialised.

So why is the Chancellor proposing to make the same mistake twice? My problem is that I cannot come up with a coherent macroeconomic explanation that fits his words and deeds. So let me list three possible justifications and why each fails.

1)    Debt must be reduced because the markets will punish us otherwise

This is a plausible excuse for austerity in 2010, because of what was happening in the Eurozone, but as an IMF evaluation has recently acknowledged, the Eurozone was a false alarm which shifted policy in the wrong direction. There never was a ‘clear and present danger’ that the UK might become like Greece, and there certainly is not that danger now.

The Chancellor must know full well that a more modest pace of debt reduction from 2015 will not lead to any market panic. It might lead to higher long term interest rates, but that will only be because the markets expect additional growth from less fiscal contraction (and therefore an earlier tightening of monetary policy), and that would be a good thing. There is no way markets will react to a more modest pace of debt reduction by starting to think the UK will default! He should know this because he allowed a more modest pace of debt reduction from 2012 (see below), and the markets did not blink an eyelid.

Some say we must reduce debt before the next major crisis. I agree, but the time to reduce debt is when monetary policy can offset the impact of fiscal contraction on demand. It would be a far greater disaster if the next crisis came with interest rates still near their lower bound, and when the recovery was incomplete, so the number one priority is growth, whatever risks you want to avoid.

2)    If debt reduction reduces growth, the Bank of England will do whatever is necessary to put things right.

Once again, this argument had some supporters in 2010, partly because the Bank appeared much too optimistic about the extent to which QE could become a substitute for lower interest rates. Today most are a little wiser. In theory, it might (and I stress might) be possible to replace lower rates by QE this way, but QE is now a riskier policy, because we know so little about its impact. So even if the Bank and Fed were still expanding QE, they cannot know what effect it might have compared to cutting interest rates. However neither central bank is expanding QE, even though inflation is well below target and likely to remain so for some time. That suggests they believe the impact of this policy is largely spent, or that additional expansion might do more harm than good. Monetary policy has its limits, and it is a shame that more central bankers do not admit the fiscal policy implications of this. But what is clear is that no Chancellor today would assume that monetary policy is not constrained by interest rates at their lower bound.

3)    Fiscal contraction is actually expansionary

Hardly any macroeconomist believes this - the OBR for example think austerity reduced growth by 1% in both 2010 and 2011 - but perhaps the Chancellor thinks otherwise. If this was true, then his plans for more austerity would make perfect sense. However I have two problems with this rationalisation for his actions. First, I cannot find in his speeches a clear articulation of this view. Second, it seems inconsistent with his actions (or rather lack of actions) in 2012/3. Here is the OBR’s assessment of the cyclically adjusted deficit both in the past and expected until 2015, taken from my presentation to the Resolution Foundation meeting. [1]

UK Cyclically Adjusted Net Borrowing (OBR estimates)
The pace of austerity clearly changed in 2012. It does not matter in this context why this happened. If the Chancellor thought getting debt down quickly was all important to promoting growth, he should have changed policy to bring deficit reduction back on track in 2012. To most economists it is obvious why he did not do that - because additional austerity would have hurt growth. But if the Chancellor believed fiscal contraction was expansionary, the opposite logic would apply.


So I cannot think of any way to rationalise what the Chancellor is planning in macroeconomic terms. But perhaps I’m looking for something that does not exist. Perhaps he does not have a coherent economic framework. Instead he has a clear political framework, which has so far been remarkably successful. The goal is to reduce the size of the state, and because (with his encouragement) mediamacro believes reducing the deficit is the number one priority, he is using deficit reduction as a means to that end. However another priority is to get re-elected, so deficit reduction has to take place at the start of any parliament, so its impact on growth has disappeared by the time of the next election. But this explanation would imply we have a Chancellor that quite cynically puts the welfare of the majority of the UK’s citizens at major risk for ideological and political ends, and I do not think I have ever experienced a UK Chancellor (with possibly one exception) who has done that. But as Sherlock Holmes famously said ...
 
[1] In this chart there are three horizontal lines. ‘Sustainability’ is the level of the deficit that is consistent with maintaining a 80% debt to GDP ratio, assuming nominal GDP growth of 4%. The Labour target line assumes public investment will be 1.5% of GDP. This chart probably underestimates the gap between the austerity implications of Labour and Conservative plans, because the former might be achieved later than the latter, and because the latter also involve substantial tax cuts. For a much more detailed and independent evaluation of the different parties' plans, read the Resolution Foundation's study. 

  

  

39 comments:

  1. Simon, is Robert Shiller right (“building houses not particularly advantageous”): https://audioboom.com/boos/2681721-economics-nobel-prize-winner-robert-shiller-on-future-of-british-economy ?

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  2. The Conservative Party throughout its recent history continually conflate political ideology with managing the economy. In the 80's they wanted to eradicate inflation whatever the costs now they want to eradicate the deficit whatever the costs.

    They seem incapable of circumspection when it comes to the economy which is surely a prerequisite of sound economics. You learn this on day 1 of GCSE!

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    1. Bingo.

      In addition in several speeches David Cameron has implied that they believe Government Finances = The Economy.

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  3. "Yet monetary policy can do very little about this lack of demand, because interest rates are at their lower bound and - judging the Bank’s actions - the power of QE is largely spent."

    Could you be a bit more clear on what you are saying here? The last clause in particular is very opaque. You obviously don't mean that the Bank is doing lots of QE, but it isn't having any more effect. In fact, the Bank in fact is saying very definitely that their next monetary policy is an interest rate INCREASE, and the only question regarding monetary policy that is on the table is when the interest rate increase occurs. So what do you mean?

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  4. Sorry, that was a bit pithy and unfair. In particular, your paragraph on this issue notes that the Bank doesn't plan on more QE. However, if they're not planning on QE, and proposing a rate rise, doesn't that suggest that they think the UK economy is burning too hot or close to burning too hot? If that's so, the monetary offset story is true: any expansionary fiscal policy will be reflected in tighter monetary policy.

    This is granting to you what hasn't been shown, which is that there's something special about expanding base money when Bank rate is near 0%.

    In general, you're not clear on whether you believe that monetary policy cannot offset the effect of austerity on demand because of either (a) QE is ineffective or (b) monetary policymakers think that the economy is nearing the point where they need to tighten. If it's (b), then it's a true point but also entails that fiscal policy (absent a change in the monetary policy regime) wouldn't be effective. If it's (a), then you're not just being agnostic about monetary policy effectiveness- you're making huge substantive claims about how monetary policy works, and claims that deviate from the standard economic consensus on monetary policy channels.

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  5. "the inflation numbers tell us that the problem comes from the demand side"

    Good joke, Simon.

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  6. One last note-

    "So I cannot think of any way to rationalise what the Chancellor is planning in macroeconomic terms."

    That's not true, since you don't doubt that your claim regarding monetary policy offset is controversial. You can't work out a justification for the Chancellor's policy GIVEN your premises, but that's just a sign you disagree with George Osborne, which is not a surprise nor a basis to get on a soapbox about ideology and (implicitly) callousness.

    Once you have eliminated the possibility that someone thinks what they think assuming they share your premises, the next step is... To wonder if they have different premises.

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    1. You underestimate your imagination, Simon!

      It's not that you can't imagine a Market Monetarist or similar perspective; it's that you disagree with it, or at least want to remain agnostic on how monetary policy works.

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    2. I think most MM would argue that we need to change the monetary target, but GO has not done that. If he really believed QE was a perfect substitute for lower interest rates, why did he slow down fiscal consolidation in 2012/3, when QE could have been expanded to offset any negative effects that renewed consolidation might have had?

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    3. You'd have to ask him, but I don't think that politicians need macroeconomic motivations for taxing less and spending more than they planned.

      I'm also not sure what 'perfect substitute' means here, in the absence of a broader monetary policy model.

      At the present time, inflation is below target, so the target isn't currently an inhibition on expansionary monetary policy. It's been the falling unemployment rate, not a high inflation rate, as well as a dubious idea of "normalising" interest rates, that seems to be the driving force behind current monetary policy.

      However, you are right on MM. I would say that the Coalition's single biggest failure was not to adopt an NGDP or nominal income target of some sorts. That would have both eased austerity (tight monetary policy is bad for the deficit, as is excess capacity in the economy) and would have safeguarded againt the Bank's underreactive monetary policy after the VAT rise.

      Incidentally, have you considered doing a post on unemployment rate targeting and the UK's current NAIRU? It seems like we're in danger of reversing the mistakes of the 1960s and 1970s, by systematically UNDERestimating the capacity for further expansion. I've seen suggestions online that the UK natural rate is now as low as 4%, maybe even lower, and could be dropped even further with the right policies for helping people back into work.

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  7. The idea that having inflation targets would end political manipulation of the economy for electoral purposes is not looking as good as those who promoted it thought that it would be.

    I think it's the same with Osborne as it is with Gove on education: you're looking for too much.

    This is the English berserk as statecraft.

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  8. Given that GDP growth seems to be decoupling from wage growth for lower and middle income workers, and given that the UK public has a massively disproportionate amount of its money (and debt) tied up in housing, it seems clear that the last thing the government want is a return to normal GDP growth (which will not filter down to middle income home owners) and a resumption of 5% interest rates (which will).

    Austerity is surely a bribe to the home owning middle classes. Sucking demand out of the economy keeps interest rates low. When people don't believe you can boost their incomes through growth, the next logical thing to do is convince them you can reduce their mortgage.

    The fact that this comes at the expense of the working poor, disabled and un/under-employed is immoral, but sadly predictable given that these people have no power... unlike the middle class home-owner constituency.

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  9. How much of the rationale for Osborne's policy is actually coming from the Treasury?

    It would not surprise me if the Bank of England didn't like unconventional MP and anything that compromises its independence, but the Treasury would be a different question. Does it see budget balance as important as counter-cyclical demand policies?

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  10. 1. Of course it makes no sense. That is because Osborne knows he will not be in any position to deliver this.

    The odds on a Tory victory are greater than 5/1 with any decent bookie. So the real world odds are much longer than that. Osborne knows this better than anyone.

    So there are two possible scenarios post-election.

    (i) Miliband is PM of either a Labour minority or a majority government. Labour has been embarrassingly opaque as to what the fiscal future holds, but we know it can't look like Osborne's 'plans'. Their purpose is to paint the future Chancellor (Balls?) into a corner and to give the future Tory opposition a stick with which to beat the government. "The deficit would have been eliminated by now if we had been in power".

    or (much less likely)

    (ii) A Tory-led government, in a coalition. In such a scenario Osborne (or whoever is Chancellor) can say they cannot deliver the fiscal tightening planned because their coalition partners are too weak to stomach it.

    It is just politics. The Tories' plans are not to be taken seriously in economic terms.

    The fiscal future in either (i) or (ii) will look nearly identical and the same as we had for this Parliament (ie a mild fiscal tightening in the first year or so followed by stability).

    2. The stuff about the employment numbers showing their is 'plenty of slack' and that low inflation 'shows the problem comes from the demand side' needs further justification I think.

    3. The end comments about how it is shocking and disgusting that fiscal policy is determined by the Parliamentary timetable and not demand management considerations is just a joke. Have you not been paying attention for how democracies operate for, say, the last 80 years?

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    1. On your (3), perhaps you would like to give me another example of a UK Chancellor who reduced GDP by 2% simply for ideological reasons.

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    2. How short your memory is. You gave examples of this yourself three days ago

      Geoffrey Howe: a lot more than 2%, indeed an actual sharp contraction as opposed to Osborne's mild slowdown.

      Indeed comparing, as you did, the impact of monetarism under early Thatcher with the mild fiscal tightening of Osborne is willful distortion. A lack of perspective.

      If you want Labour examples, Stafford Cripps and Philip Snowden.

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    3. My memory is not that bad - and do try and avoid these silly rhetorical flourishes. A recession was probably required in 1980/81 to reduce the inflation rate. It could have been done more efficiently, but the Tory government then really did believe in the monetarism they put forward. And I did say a Chancellor I had experienced - that does not include Cripps or Snowden.

      I think a better argument you could make would be as follows. GO did believe in one or all of the three positions I have set out in 2010/11. By 2012/13 he realised he was wrong, changed course, but did not admit it for political reasons (and because he thought he could get away with not doing so). Planning to do it again is - as you and others suggest - just a political ruse which, even if he remains Chancellor, he has no intention of carrying out. We may find out after the election, but you will not be surprised to know that I hope we do not.

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    4. Yeah, they really did believe in monetarism. It was an ideology.

      Not sure where in your question you stipulated that it had to be a Chancellor you had experienced.

      As for Osborne, expecting him or any Chancellor of any hue to fess up to mistakes is silly. No politician ever does that. 'Austerity' was all over by the end of 2011. We could expect Osborne to keep quiet about this. I wonder what excuse his critics have?

      What Osborne did, as opposed to what he said he would do, was almost identical to the Darling plan. Darling too planned "cuts worse than Thatcher".

      Now you may rightly say, that it was Osborne who actually cut investment spending not Labour. It is the person who actually does the thing who must take responsibility for it, not another person who would have behaved in the same way given the opportunity.

      I agree.

      Just so long as we apply the same line of reasoning to responsibility for the running of the UK economy prior to the crash. Failure to do so leaves one open to an accusation of applying different standards.

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    5. "'Austerity' was all over by the end of 2011."

      That is a joke, isn't it?

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    6. Depends what you mean.

      Specific cuts? No, they have carried on. Local government has taken a serious kicking.

      Overall fiscal tightening? No, that stopped years ago.

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    7. Quite. I'm just over-sensitive about using overall figures. There are enough people around who say "what austerity, the deficit is still so big", when you need to analyse the dis-aggregated data more carefully. An unexpected drop in tax receipts is not evidence of a lack of austerity.

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  11. Simon,

    First let me say it was lovely to meet you at last!

    I suspect the ideological stance is roughly the same as that which led Governments in the early 1920s to impose severe austerity in order to rejoin the gold standard at the pre-war parity. Geddes and Osborne are brothers under the skin.

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    1. This is nothing like the Geddes axe, which you must surely know was largely about demilitarisation after the first world war. This is about ongoing social spending, which unless the economy becomes substantially more productive is essentially unsustainable at current levels.

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    2. Your history is wrong, I'm afraid. The mandate Geddes was given was to eliminate "waste" in public spending in order to reduce public debt. In partnership with very tight monetary policy, this was expected to restore the value of the currency. And it involved massive cuts to what was already (by our standards) less than generous welfare provision. During the 1920s the UK ran fiscal surpluses of 7% of GDP despite high unemployment and poor growth. Worth reading the IMF's analysis of this - see pp. 109-110 here: http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/c3.pdf.

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  12. Simon

    I commented on this a few weeks ago. I don't think you are giving Osborne the credit he deserves for the magnitude of the mendacious trick he us pulling here.

    He KNOWS that the level of austerity he is proposing is entirely unrealistic (and would be deeply damaging if it were achieved). What he's doing is setting out a position against which he can claim that Labour has learned nothing and will destroy the recovery that we have enjoyed due to the Long Term Economic Plan.

    Osborne knows from experience that, once this tactic has worked and he's won the Election, he will not be held to account by the media (or Labour) for failing to meet the austerity targets. As in this Parliament, it will be the fault of snow, rain, sun, Royal Weddings, Royal Jubillees, Olympic Games, ISIS, Putin and the EU when the Long Term Economic Plan doesn't delivery what it is supposed to.

    Can't blame him really. After pulling off the stunt once, he's bound to try it all over again.

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    1. You may be right - see my response to SH just above. So perhaps he is just the most mendacious Chancellor in my experience.

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  13. Osborne has to deliver on his promise before the election that he would restore the finances after labour's "irresponsible" handling of the public purse. It is important to him because his other promise, that he would bring immigration rates "back down to sustainable levels" is not going to happen.

    So he his going to say he he managed to stabilise one of two areas which Labour let get out of control. It is important because a lot of people do not trust UKIP with the economy, even if they sympathise with their views on EU immigration.

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  14. For the most part people, perhaps more so important people, cannot adopt an idea and then rethink. Perhaps it is a great merit of democracy that, in contrast to other forms of government, democratic governments come and go more frequently. Thus, I suppose that while the stupid ideas of the previous government are withering and the stupid ideas of the new government have not yet flowered there is a brief opportunity for good ideas to flourish.

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  15. Simon

    You mention that people don't want to reduce the size of the state.

    Once we have properly recovered (how if ever you define that) what will the government of the days choices be in respect of the size of the state?

    To maintain the current size will we need to raise taxes? Presumably people don't want that as well.

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    1. Five times as many people want higher spending and taxes than lower spending and taxes - see the evidence quoted here:
      http://mainlymacro.blogspot.co.uk/2014/09/uk-attitudes-on-size-of-state.html

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    2. I think it depends on what type of spending.

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  16. It is purely political - he has an ideology that favours cuts, and he has realised that explaining the national economy as if it were your personal checking account or the parish fete petty cash tin is easy for voters to understand. His mooted balanced budget law shows his hand clearly.

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  17. Given that latest numbers on government spending (still going up a lot) I think we can take Osborne's numbers with a pinch of salt!! Lots of talk of austerity but very little in the way of cuts.
    http://getwd50.blogspot.co.uk/2014/10/cutting-taxes-and-axing-osborne.html

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    1. That's part of Osborne's breathtaking cheek. The whole Long Term Economic Plan mantra started just about the same time that the pace of deficit reduction was being slowed, and the economy started to pick up.

      Osborne has managed to spin the line that this is all part of the original Plan A that he has stuck to all the time. It is quite astonishing that a combination of quite pathetic media and opposition has allowed him to get away with this line. But that's UK politics in 2014.

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  18. SWL says he is trying to work out GO’s economic thinking by studying speeches and other tea leaves from HMT. The phone number of HMT is 020 7270 5000 why doesn’t he just ring up and talk to GO one to one. This should work; Prof of Econ at Oggsford here put me through to GO Ex Oggsford (Modern History). The trouble is SWL has been slagging GO off in this blog. Even so if SWL rang the HMT every day for a month he would probably eventually be allowed to talk to one of GOs underlings maybe even the one that writes his speeches. If I rang the HMT number every day for a month I would be in jail unless they needed some information on my own specialty the outdoor display advertising industry.

    Lets say it’s hopeless there is no way SWL can’t work out why our leaders do what they do and he can’t influence them in any way they are not open to reason what can he do? If all the apples are rotten in the barrel go to the tree. SWL is Prof of Econ at Oggsford. Some of the youngsters SWL rubs shoulders with in the canteen at the Oggsford college will be dead in 20 years. Some will be in dull jobs hanging on for a pension. A fair few of those youngsters at the Oggsford college will be in positions of power in 20 years. SWL needs to put himself about in Oggsford and try and make sure that in 20 years time our leaders will have more of clue than the current lot.

    From the internet I learn that less that 4,000 youngsters turn up at the Oggsford college every year, 48 work weeks in a year means he’s only got to talk to less than 100 youngsters a week to cover the whole field. He could even group them together in a big room so he does not have to get his ideas across one on one. He must cover the whole field. Thatcher studied Chemistry at the Oggsford college. She learned that if you put things under great pressure and heat them up dramatic changes are possible. Unfortunately this Chemical approach didn’t work for the UK economy. So SWL don’t miss out the Chemists or the Historians.

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  19. "that there is no necessary incompatibility between the microfoundations approach and Keynesian ideas. "

    Wrong. Keynes opposed classical micro-foundations and "submission to market idols". This is not a trivial matter. It involves fundamental assumptions about human behaviour and social interaction. New Keynesian economics might get Keynesian results, but it is not the view of the world that Keynes had. Very likely it is also not the view of the world many in a civilised society have.

    The micro-foundations project must be abandoned.

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  20. David Cameron got the reaction from the right wing press he wanted with the Daily Telegraph and Daily Mirror etc saying these like "At last the Government is serious about immigration."

    Of course, this was a red-herring. He merely toughened up on benefits, but as everybody knows, EU immigrants do not go on benefit.

    He has neutralised the issue until the next election. This allows the Conservatives to concentrate on how they have fixed up the economy. "Now trust us to fix immigration" is what they will say come the election.

    However, before the Referendum, people will see that immigration from the EU has continued to rise. It could very well force us out of the EU.

    High stakes.

    Some people say that England gets higher inflows of workers from Eastern Europe because its economy is performing better (and a useful thing for the Conservatives to flog). However the real reason is that GNP per capita in Britain is much higher than Eastern Europe which may never catch up. It is a magnet irrespective of whether the country is in recession.

    The main cause is that Britain does not change its idle (unemployed) work force so they do not go into well-paid employment even if the economy picks up. With a ready supply of cheap labour from the East, employers also do not have an incentive to train.

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  21. Why is it we have a pair of overgrown schoolboys like Osborne and Cameron, neither of whom display any particular ability, in positions of such influence and authority they could be said to be running the country? In a word, privilege. Privilege has put them in power and they're reinforcing that privilege by impoverishing the rest of us, all those outside their establishment circle. Expect more of the same.

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  22. I think if Osbourne and Cameron reversed their ways and went against their austerity doctrine and undertook the appropiate macro measures, it would end their political careers. Maybe that's why they will do it a second time round?

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