Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday 9 September 2020

In the UK Treasury cutting the deficit generally takes priority over the health of the economy

The UK Treasury bears some responsibility for the disaster of 2010 austerity, yet it has not accepted or understood the mistake it made. As a result it risks repeating the mistake, albeit in a milder form.

The problem is that fiscal prudence is basic to the way the Treasury operates, and with few exceptions other priorities, including the macroeconomic health of the nation, are not allowed to get in the way of that goal. Only the most determined Chancellor can change that. It is a longstanding problem. Back in the 1960s Harold Wilson tried to solve it by creating a separate ministry, but the Treasury maintained its power.

This was a key issue for the Kerslake review, of which I was a member. As we noted, the problem of prioritising the public finances over macroeconomic goals has got worse in recent decades, with outsourcing stabilisation policy to the Bank of England and fiscal forecasting to the OBR. This transfer of powers has weakened macroeconomics within the Treasury, because the idea was that macroeconomic stabilisation had been delegated to the Bank of England. The possibility that fiscal policy would need to be used for macro stabilisation when interest rates hit their lower bound was not on the raidar, and remains alien to Treasury thinking.

Of course politicians are ultimately in charge, but the Treasury can have a powerful influence on ministers' thinking. In 2009 the Labour government was, to its great credit, determined to combat the recession that followed the Global Financial Crisis (GFC) with fiscal stimulus, but the Treasury convinced Alistair Darling to publish forecasts that included substantial fiscal contraction during the recovery phase. If Labour had remained in power and the recovery had faltered as it did in reality (less likely because Labour's austerity was not front-loaded), it is unlikely that these austerity plans would have been enacted. However the key point is that it should not have been part of any fiscal plan for at least the first few years of the recovery. Its political impact was to give ammunition to deficit panic in the media.

In 2010 it was a briefing from the Treasury that helped convince the Liberal Democrats that the harsh austerity in the Cnservative programme was necessary, even though it wasn’t in the Liberal Democrat manifesto.

Despite all this, and many suggestions made to us, the Kerslake review did not recommend splitting off macroeconomic policy from the Treasury. Instead it recommended greatly enhancing its macroeconomic capability, as part of a general remit to look at major risks to the economy. The obvious risk at the moment, besides the resurgence in the pandemic itself, is that premature tax increases will stifle a full recovery from the pandemic (when the pandemic ends), and some of what should have been just a temporary fall in demand gets hard-baked into a permanent fall in the size of the economy. There is a strong case that this happened after the GFC as a result of austerity.

It is important to distinguish between two different questions, and mixing the two can lead to the kind of confusion I highlighted in my last post. The first question is whether taxes will have to rise at some point as a counterpart to politically essential higher levels of public spending. My guess is that it will to avoid interest rates going too high, but it’s a guess and I could be wrong.The second question is whether taxes need to rise anytime soon. The right answer to that question is no, because interest rates remain low as we are early in the recovery phase following the pandemic. Any increase in taxes before significant increases in interest rates will reduce the strength of the recovery.

In some respects the damage is already happening. Consumers that can will look forward when planning spending, such that expectations of future tax rises will have some impact on consumption today because of consumption smoothing. (An exception is expectations of a future VAT increase, which can stimulate consumption before the tax rise.) The Treasury and the Chancellor have let it be known that tax increases are coming since May (e.g. here, and more recently here), creating exactly those sort of unhelpful expectations.

In addition, the Chancellor is also showing little flexibility over the furlough scheme, in contrast to neighbouring countries. Once again the justification appears to be the financial cost (a larger deficit), which puts that above the cost of large increases in unemployment. As I have noted before, an obsession with re-opening the economy as fast as possible after the first COVID-19 peak is also counterproductive.

As Chris Giles has noted, there is an obvious motive for the Chancellor to raise taxes sooner rather than later, and that is the election in 2025. The Chancellor is among those who think taxes will need to rise eventually, and he would rather increase them sooner rather than a year before the election. As is often the case, the politics is not helping the economics. We have been here before of course. Osborne front loaded austerity for the same political reasons, which stopped the post-GFC recovery in its tracks.

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