The budget should create a balanced recovery, but instead it will be about the deficit

 

Some obvious points first. We are still in a pandemic, and so support measures for employees, the self-employed and businesses should continue. The chancellor should also, belatedly, increase sick pay substantially. The success of the government’s COVID strategy will depend on persuading those who otherwise cannot afford to isolate to do so.

The following remarks are based on the assumption that the government’s strategy works, and there is no return to NHS crises and lockdowns. Contrary to the perception you get from the media, encouraged by the government, it is far from certain that their strategy will work as planned. In addition, what I’m proposing here is what a Conservative Chancellor could conceivably do, rather than the budget I would enact if I was Chancellor. For reasons I will give later, it is not the budget I expect to see.

The overall macroeconomic context is for once fairly straightforward. Most academic economists, as well as the IMF and OECD, agree that you use fiscal stimulus (i.e. tax cuts or spending increases) to get you out of recessions, leaving monetary policy to control inflation outwith recessions. That means this budget should be all about ensuring a balanced recovery and not at all about fiscal consolidation. The last ‘recovery’ we had from a major recession was in 2010, when George Osborne thought the priority was to reduce the deficit. The result was a disaster, as this chart shows.

After the Global Financial Crisis the Treasury estimated trend GDP might fall by 5%. By 2010 GDP was 10% below the pre-austerity trend, and by 2013 that gap had increased to 14%. Of course austerity was not the only reason for this: productivity was gradually falling in most advanced economies and the UK was hit hard by the banking crisis. However it stretches credibility to believe that austerity was not a part of the reason why GDP and real wages fell by so much around that time, and failed to recover before Brexit hit. 

We need after this recession to focus on a recovery, but importantly on a balanced recovery. I think there is a good chance that most consumers will take the opportunity to spend some of the savings they have built up during the pandemic without any incentives from government. A lot depends on psychology and how COVID cases evolve. If cases this summer fall to levels that are similar to last summer, then with the additional protection of vaccination many will take the opportunity to do rather more of the things they would do normally but couldn’t do in the pandemic. We could call this ‘pent-up consumption’. However if cases start rising again in the autumn this may be short-lived.

In short, what will determine the consumption of most consumers will be the success or otherwise of the strategy to end the pandemic rather than any tax cuts. Because of the risk of cases increasing in the autumn another subsidy to eating out would be a bad idea. All this means that in terms of stimulus, tax cuts (either general or specific) should not be on the agenda. There is also no need to extend the stamp duty holiday, which moves house prices in the wrong direction. However tax increases, in the form of not uprating allowances, would be a bad idea because they focus on the deficit and not the recovery.

There is a very important exception to the bounce back in consumption, and that is the 20% of households in the lowest income quintile. They have seen savings fall rather than rise during the pandemic. This is no fault of their own, but a consequence of the jobs hit by the pandemic and the way the benefits system works. The Chancellor has agreed to the principle that people should be supported during the pandemic, yet those who need that support most have not received it.

If we want a balanced recovery, in which everyone participates, then the Chancellor should use the benefits system to help the lowest quintile. That means at the very least making the universal credit uplift permanent, and should include going further to reverse the real terms cut to benefits over the last decade. In addition it makes sense to provide incentives for people made redundant during the pandemic to get back into work as soon as possible. All this should be popular, because public opinion on welfare has shifted a lot, but the Chancellor will do a lot less because he is worrying about the deficit. 

All this applies just as much to sectors of the economy as it does to income quintiles. The cap on public sector pay is a bad idea during an economic recovery, and should be scrapped. There is an incredibly strong case for giving a thank-you payment to all the doctors and nurses that have worked so hard this year, and risked their lives in doing so.

A balanced recovery requires increases in investment as well as consumption. The impact of corporation tax on investment is very uncertain, but higher corporation tax will probably discourage investment and FDI to some extent. As a result, there seems no reason to announce any increases in corporation tax in this budget, particularly if the motivation for it is to reduce debt. (Expectations matter, so delaying increases by a year or two does not make much difference to their impact on investment.) Raising corporation tax makes sense when the recovery is complete, but there is a strong economic case not to anticipate or pre-announce this. [1]

A balanced recovery should also involve additional public spending as well as private spending. The demand for most public services does not go down in a recovery. There is a strong case against cutting overseas aid, and for additional funds to certain parts of the public sector including local authorities. A large increase in council tax is again not a good idea in a recovery, and it is up to central government to give local authorities funding to avoid this and more.

Last but not least, the 3% cap on public investment should be thrown out of the window. It is incredibly fortuitous that a desperate need for public investment to help green the economy takes place during a period of historically low real interest rates. It would be criminal if that opportunity was not exploited so that every potential investment that effectively reduced carbon use or protected us from things like flooding was undertaken. Keeping a lid on public investment that prevents projects with a high social return makes no sense at any time, least of all today.

How long should stimulating the economy through fiscal policy go on? The key here is not highly uncertain guesses about the output gap, but what is happening to short term interest rates and inflation. Fiscal policy makers should want to hand over macroeconomic stabilisation policy to central bankers (the MPC in the UK) when they are sure the economic recovery has gone as far as it can.

Looking at inflation alone is not adequate, because monetary policy is designed to keep inflation at target. Looking at interest rates alone is not adequate because we have very little idea of what a ‘neutral’ interest rate would be. So I suggest that stimulus continues until both forecast inflation is expected to be above 2% and the Bank’s base rate is above 2%. In other words, delay fiscal consolidation until both short interest rates and forecast inflation are above 2%.

Although a Conservative government could have a budget like the one I have set out, our current one will not. The reason is straightforward. Much of the public still associate fiscal consolidation with acting responsibly whatever the context. They haven’t learnt the folly of 2010 onwards because much of the media has not learnt it either. The big international economic institutions may have understood the need for fiscal activism during a recovery, but our media have not.

This is one of the reasons that a party that has done so much damage to the UK economy can be seen by the electorate as the more competent to run the economy. Since 1979 we have had high unemployment in the 1980s under Thatcher, botched (recession-inducing) ERM entry leading to Black Wednesday under Major, austerity under Cameron and Brexit under Johnson. Until a global financial crisis hit the UK, economic growth under Labour was strong, steady and accident free. The one big decision they had to take was Euro entry, which they managed very well and made the right call. On past evidence Labour are far better at running the economy than the Conservatives: stability and strong growth under Labour and chaos under the Conservatives.

Labour are right to call for no tax rises that could hurt the economy in this budget. The economic recovery may disappoint, and Labour need to point the finger at the Chancellor for this. Apart from this, Labour seem to have missed the one golden opportunity they had to try and dent the Tory lead on economic competence by not wanting to talk about Brexit. But the election is still a long way off, and in the meantime Labour can at least base their economic stance on the economic consensus rather than the mistaken beliefs of the media and voters.

Postscript (04/03/21)

In the post above I suggested the Chancellor could have produced a balanced recovery, but as expected his main focus was raising taxes (by freezing all allowances and raising corporation tax) in order to get public net debt falling in 5 years time. It is true that he has delayed tax increases until after the forecast recovery is over, but it seems unlikely that consumers and firms are going to ignore what he plans. As a result the recovery in consumption will not be as strong as it might have been, and the recovery in medium term investment will probably be lower than it could have been.

The rabbit out of the hat in the budget were the 130% investment allowances against corporation tax for the next two years. The danger of this measure is that it just brings forward investment, with little increase in investment over the next decade (see Chart 2.11 of OBR forecast, p63). In that case the main beneficiary is the balance sheet of large companies at the public's expense. With the recovery already forecast to be pretty rapid over the next two years, it isn't obvious why this bringing forward will be of much benefit.

What I was hoping for was a budget that created a balanced recovery, rather than a recovery driven mainly by better off consumers. There was absolutely nothing in the budget in this respect. We have public spending cuts (see page 8, some already announced but added to in this budget). Nothing to stop councils increasing council tax by 5% and repairing local services. The apparent cap of 3% public investment to GDP remains, despite the urgent need to help green the economy at a time of low interest rates. And nothing to help those from the lowest income quintile that have lost out in the pandemic. The increase in wealth inequality produced by the pandemic is not going to be reversed.

In the post above I say that fiscal consolidation should not start until both short interest rates and expected inflation are both above 2%. Neither is true in the OBR forecast. We have the crazy situation that fiscal retrenchment is happening while interest rates are forecast to remain at or below 0.5%. This makes no sense in economic terms. Macroeconomic policy is meant to stimulate a recovery, not to promise lots of higher taxes.

So we have an austerity budget. It may not be on the scale of George Osborne in 2010, but it remains about fiscal consolidation before we have begun to recover from a deep recession. The Conservatives have never come to terms with the gravity of their error from 2010 onwards, and remain attracted to playing on the media's false understanding of what responsible policy is. Next to what is happening in the United States, Sunak's policy seems totally perverse. What will suffer, just as under George Osborne, will be average prosperity in the UK.

[1] The left have criticised the Labour leadership a lot on this, with nonsense like this makes Labour to the right of the Tories. The position that you want to combine an increase in CT with additional stimulus (particularly anything helping investment) is perfectly respectable, but not transparent when the debate will be the economic consensus versus the mediamacro (we should worry about the deficit). When Sunak's economic stimulus falls short this Wednesday, the argument for raising CT becomes much harder to make.