Government spending is not limited by tax revenues or borrowing, but it isn’t limited by the productive capacity of the economy either.

 

When ministers, in response to demands for more public spending, declare there is no magic money tree they are in literal terms lying. One of the things that make governments that use their own national currency quite different from households is their unique ability to create money. This is no great economic revelation, as it has been taught to first year economics students for as long as there were first year economics students.

There is a very simple relationship between spending, taxation, borrowing and money creation. If we include paying the interest on its debt as part of government spending, then we can express that relationship in the form of an equation:

Government spending - taxes = new borrowing + new money creation

A great deal of confusion in popular writing about macroeconomics can be avoided if you just remember that equation. It is an identity, which means that no causation is involved. Governments are free to choose three of these four quantities, but not all four because the identity (the government’s budget identity) must hold. [1] 

When economists say that higher government spending is paid for (or funded by) higher taxes or more borrowing, they are simply talking about how this identity is satisfied. Equally when politicians say we cannot afford to spend more on the NHS, they mean they are not prepared to raise taxes, borrow more or create more money. 

Economists from the MMT school of economics are fond of pointing out that if the government chooses to increase spending but does nothing else, then this spending will be paid for by creating more money. However the practical relevance of this statement is zero, beyond confirming that the government can create money. This is because governments will generally respond to higher spending and that additional money creation by either increasing taxation or borrowing more.

Why is this? What stops UK governments making themselves very popular by increasing spending on the NHS, education and so on and paying for it by creating money? The short answer is that at some point this would become inflationary. Economists sometimes talk about this type of inflation being caused by too much money chasing too few goods. But my own view (and a monetarist might disagree) is that talking about too much money is again misleading. What causes the inflation is that the government has increased its demand for goods (produced domestically) or workers, the domestic private sector sees no reason to reduce their demand, and there is a limit on how many goods or workers can be provided (domestically). What really causes inflation in this case is not excess money creation but the aggregate demand for goods (or workers) exceeding the aggregate supply.

Why is this a better way of thinking about this type of inflation? [2] The most basic reason is that the problem would still arise if the government didn’t pay for the higher spending by creating money, but instead by borrowing from abroad. We would still at some point get excess aggregate demand for domestically produced goods or workers, and inflation would rise.

All this suggests that what limits aggregate government spending is the amount of goods the domestic economy is willing to supply, sometimes called productive capacity. [3] This is also a popular conclusion of the MMT school of thought. As Josh Ryan-Collins writes in the News Statesman: “The main constraint on public spending should be whether the economy has the productive resources and capacity to absorb such spending without it leading to excessive price rises.”

Thinking about things this way has its uses. It shows, for example, why in a recession there is every reason for governments to increase their spending, and finance this by raising borrowing or creating money. A recession is generally where there is an excess supply of goods and/or workers, so using those resources to produce stuff not only reduces unemployment (of machines and/or workers), but also makes everyone better off because they can benefit from higher government spending. Alternatively governments can keep spending unchanged but cut taxes in a recession, and this will not be inflationary.

This shows why deficit limits in a recession are a dangerous form of economic nonsense. Again this is no great economic revelation, but has been understood by economists for 80 odd years. If in the (very unlikely) event that governments cannot cover the extra spending or reduced taxation by borrowing, they can create money and this will not be inflationary, because there is an excess supply of goods and/or workers. That this basic macroeconomic truth was briefly ignored in many countries from 2010 onwards is a subject on which I once wrote a great deal.

Despite all this, it is not the case that productive resources and capacity are the main constraint on the amount government’s spend. Governments can spend more by persuading the private sector to spend less. In modern economies it can do this in two main ways. The first is by raising taxation. Suppose we start from a position where there is no excess aggregate supply or demand, so inflation is constant. The government can still spend more if it encourages the private sector to spend less by raising their taxes. [4]

The second way governments can reduce the private sector’s demand for goods is by raising interest rates. Higher interest rates encourage people to save more and spend less, making way for additional government spending without raising inflation. In countries with independent central banks targeting inflation this will happen because the central bank wants to keep inflation constant.

This second way of governments being able to raise spending (or cut taxes) raises a potential political problem in countries with independent central banks. Irresponsible governments may be tempted to raise their spending or cut taxes in popular ways (particularly before an election), pay for it by higher borrowing, and avoid the inflationary consequences because central banks raise interest rates. Higher interest rates might be unpopular with some (borrowers), but they will be popular with others (savers), and in any case it may be the central bank that gets the blame rather than the government.

Something along these lines seems to have happened in many countries from around the 1970s onwards, after the collapse of the Bretton Woods system of fixed exchange rates when interest rates began to be used routinely for controlling inflation. This is known as deficit bias, and is why some countries adopted either fiscal rules for the size of government deficits or debt, and or fiscal councils like the OBR. It is important to understand that these fiscal rules would be unnecessary if governments were responsible, and that the harm that deficit bias does is long term, minor (raising interest rates higher than they need be) and largely irrelevant in the current era of very low long term interest rates. The idea that deficit targets somehow limit the amount governments can spend or tax year to year is economic nonsense, but that doesn’t stop some governments and many in the media pretending otherwise.

This second way that governments might provide room for additional spending is hardly discussed by MMT economists, because they believe fiscal policy (or other measures) rather than interest rates should control inflation. If governments followed MMT and did this, then there would be no need for deficit targets. But nearly all governments nowadays do not do this, and have independent central banks controlling inflation (when they can) by varying interest rates. [5] As a result, as long as this is the case, appropriate deficit targets [6] have some place, but this place should never get in the way of fighting recessions or climate change.

In attacking the nonsense of analogies relating government finance to household budgets, MMT is on the side of the angels. But you do not need a new school of macroeconomics to do this, as the nonsense can, and was, easily exposed using either longstanding or more recent mainstream macroeconomic ideas and evidence.

In addition, when MMTers say that deficit targets are pointless, it is important to understand that this follows directly (and obviously) from their main departure from how most mainstream macroeconomists view demand management, which is a belief that fiscal policy rather than interest rate changes should manage aggregate demand in order to control inflation (outwith the lower bound for interest rates. At the interest rate lower bound, I think most mainstream macroeconomists would agree that fiscal policy has to take monetary policy’s place.)

Finally, MMT also favours combining fiscal stabilisation policy with keeping interest rates very low. If, as the evidence strongly suggests, higher interest rates reduce aggregate demand, then (outwith the lower bound) mainstream macroeconomic policy would allow more government spending for given levels of taxes or borrowing (or any other policy instruments) than an MMT policy would allow. This is because higher interest rates would reduce aggregate demand, making room for more government spending without increasing inflation. In this sense MMT’s choice of fiscal policy rather than interest rates for macroeconomic stabilisation lowers rather than increases the amount governments can spend.

[1] I now prefer to call this an ‘identity’ rather than a ‘constraint’ because it is not a constraint on spending, taxes or borrowing, precisely because governments can create money. Contrast this with a household’s budget constraint, where the money creation is not a legal option. But this is just language, not economics.

[2] Excess aggregate national demand is not the only reason national inflation can increase, of course. It can increase because of higher imported prices, such as the price of commodities like oil or gas.

[3] Productive capacity can also be a misleading term, because it suggests some kind of maximum for what the existing workforce and capital stock can produce. In reality most firms like to keep spare capacity in normal times to cope with unexpected but short term fluctuations in demand. The key measure is what firms are willing to supply at current rates of inflation.

[4] How much taxes need to rise depends on how permanent the tax increase is believed to be. If it is believed to be permanent, then taxes need to rise by about the same amount as the additional government spending. However if people believe the extra taxation is temporary, they may be tempted to pay some of the taxes from reduced savings. In this case the rise in taxation would have to be greater than the increase in spending to keep aggregate supply and demand in balance.

[5] For why most macroeconomists still think that, outwith the lower bound for interest rates, independent central banks using interest rate changes, rather than governments using fiscal policy, should control inflation see here.

[6] Unfortunately many deficit targets are badly formulated, and a bad fiscal rule can be worse than none at all. This is particularly true in the Eurozone, where national interest rates cannot control national inflation and so fiscal policy should, but this is made more difficult by deficit targets.

Rapidly Reducing carbon usage and Deficit Obsession don’t mix

 

Renewables are now the cheapest form of energy generation. If all energy use in the UK was based on electricity, and all electricity was generated by renewables, our current cost of living crisis would be far less severe, and of course we would not be adding to climate change. Furthermore, there is huge potential in the UK (and most other countries) for far more renewable energy production than we currently have. So why isn’t this happening faster?

That is the question addressed in a new book by Eric Lonergan and Corinne Sawers. In many ways it is a very optimistic book, because it suggests the problem of climate change is mainly solvable with known technology, and there are no insurmountable barriers for doing this with sufficient speed to enable us to avoid severe global warming. They suggest that the reason this is not happening is, in part, because we are thinking about it in the wrong way.

Much of the discussion around avoiding climate change is framed in terms of costs. Economists are partly to blame for this, as the debate was originally framed by economists in terms of what current costs are we prepared to pay to avoid future costs (global warming). The book suggests that a better way of thinking about it is as an industrial revolution, such as the invention of telecommunications. Because renewable energy is cheaper, we are better off developing it and phasing out fossil fuels even without the problem of future global warming. When electricity was first invented, no one talked about the costs of installing electricity generation compared to future benefits, because it was obviously a better technology for everyone concerned.

An economist might retort that there is always an opportunity cost of investing in green energy and electrification, because that investment could be used for something else. In this sense it is always right to talk about costs and benefits. However in today’s world we have very low long term interest rates, and yet in many countries private and/or public investment levels are if anything lower than the past. The trade-off in many cases may not be between green investment and some other form of investment, but between green investment and the spending power of those who own shares in companies.

Another strand of thinking suggests radical change, like individually consuming less or eating different foods, or for economies to stop growing, or fundamentally changing capitalism. Again this makes stopping climate change seem rather unattractive or risky, and this puts both people and policymakers off. Framing the problem as a green industrial revolution to obtain cheaper and more stable energy is much more appealing.

In terms of doing this faster, the book suggests looking at what has worked so far, that has brought us to the point where renewable energy is also the cheapest energy: a combination of large positive incentives and hard regulations. Central to their argument are the use of “extreme positive incentives for change”. These have led to the rapid reduction in the cost of solar power, and the widespread adoption of electric vehicles in parts of China, Scandinavia and the US.

Extreme positive incentives (like providing large subsidies for electric cars or well insulated houses for example) combine three important pieces of psychology, politics and economics that are often ignored by economists. The first is that extreme incentives are much more effective than marginal incentives, because of the psychological fixed costs of changing behaviour. The second is that positive incentives (giving people money to do things) are more effective than negative incentives (like taxing carbon), because the latter generates resistance and as a result are unlikely to be pursued strongly by policymakers.

The third is that people do not ‘internalise the government’s budget constraint’, which is the idea behind Ricardian Equivalence. If they did. people would recognise that incentives had to be paid for by them one way or another, so positive incentives and taxes would work in the same way. This doesn’t happen not because people are irrational, but because it is very uncertain how governments fund incentives, and many of those methods of funding would not fall on those receiving the incentive. So people who receive an incentive really are better off, and those who are taxed are worse off, in terms of expected income. It is only the fiction of the representative agent (and various additional assumptions) that leads to the idea of internalising the government’s budget constraint. [1]

We can see all this in action when we compare the success of solar power to the many difficulties governments have had in raising appropriate carbon taxes (or permits that act like taxes). Carbon taxes make sense in many ways, because they are the economists’ standard response to an externality (i.e. a cost imposed on others that isn’t paid for by the people generating that cost). Climate change is the biggest externality of our lifetime. Yet in the case of climate change, when the costs are generated by everyone and the harm they create is in the future, the psychological, political and economic factors noted above mean positive extreme incentives are much more effective than carbon taxes.

All of which brings me to the title of this post. If extreme positive incentives are what is needed to speed up electrification and the use of renewables to generate that electricity, that will cost governments money. Ideally that should be paid for by higher general taxes rather than borrowing, because it’s better if the polluter pays. (Equally richer countries, that have already deposited a large amount of carbon in the atmosphere, should help pay poorer countries to go green.) But this ideal may not be feasible in political terms, because policymakers will resist the idea of tax increases and therefore will not provide the incentives.

The way to avoid this problem is to fund green incentives through borrowing. As I have often said, future generations suffering the effects of substantial global warming will not think that’s OK because we reduced their ‘burden’ of paying taxes on government debt. Instead they will positively welcome the borrowing required to reduce climate change in the past. [2] This is particularly so when that borrowing currently costs so little.

Which is where debt and deficit targets get in the way. To see how ridiculous it would be if they did get in the way, just compare why we need debt and deficit targets, and compare that to why we need to mitigate climate change. Deficit targets are useful to prevent irresponsible governments from buying elections or rewarding donors by tax or spending breaks funded by borrowing. We need to reduce global warming because otherwise we will see, for example, large-scale global starvation and migration, with all the political chaos that this will cause. If you had to choose between reducing the fiscal behaviour of irresponsible governments and reducing climate change, which would you choose?

There may be ways of not choosing between the two. Perhaps we could create two separate sets of government accounts: a normal account and a green account. Deficit targets could apply to the former but not the latter. If Germany can do this for military spending following Putin’s invasion of Ukraine, why not do it for spending required to reduce climate change? [3] Of course there will be many practical political problems, and it may require a fiscal council with teeth to avoid governments cheating, but it’s clear we should be at least discussing this possibility.

If we don’t do something like this, then we may be faced with a simple choice. Do we speed up greening the economy to reduce the extent of global warming using the ideas proposed by Lonergan and Sawers, or do we do what this government and the media are doing now, and obsess about deficit and debt targets? The fate of the planet may depend on what people and governments choose.

[1] In a simple model with a representative agent, a subsidy would automatically imply an equal tax today or tomorrow, which will leave the representative agent no better off, so they would be indifferent between positive incentives (subsidies) and negative incentives (like carbon taxes). In reality the tax increases required by any subsidies may fall on different people from those receiving a specific tax cut or incentive. In addition tax cuts today may be paid for by cuts in government spending, which again may not fall on those receiving a specific incentive, and so on. In other words people see positive incentives for them as redistribution to them, and taxes on them as redistribution from them.

[2] The classic case for funding by borrowing is an investment that doesn’t just benefit people today, but also benefits people tomorrow. This is why no macro restrictions should be put on public investment. However many activities that are not classed as public investment have these characteristics. A war, for example, is often an investment in the future, which is why wars are so often accompanied by public borrowing. Greening the economy also has those characteristics.

[3] Does it make sense to treat higher military expenditure as different from other forms of spending? If it represents a one-off increase in spending, reflecting for example an unusually aggressive ruler in a nearby country then yes, it is. However if it is seen as a permanent increase in spending, it is not clear why that shouldn’t be paid for by the current generation through higher taxes.

When did things go wrong, 2010 or 1979?

 

A recent post was entitled “How Austerity created Brexit, and the economic and political decline of the UK”, and it tried to argue that the UK economy and politics had started going seriously awry in 2010 rather than in 2016. Some people responded that the real date from which things started going wrong was 1979 i.e, the advent of neoliberalism.

In a sense they are right, and I have made this argument myself when I have talked about neoliberal overreach. By ‘overreach’ I meant that the continuing pursuit of neoliberal goals would transform neoliberalism into a form of plutocratic authoritarian populism that we saw under Trump and we see in the UK under Johnson. (For why that represents a major change, see below.) In 2017, just after Jeremy Corbyn’s ‘glorious defeat’, I asked whether neoliberal overreach was inevitable, and in 2021 I tried to say more clearly why I thought it was.

However to say that the UK’s political and economic decline started in 1979 is both too simplistic and unconvincing. It is unconvincing because that decline was not evident to most for at least three decades after the onset of neoliberalism. In terms of GDP per capita, the UK at least matched growth in Germany and France in those 3+ decades. [1] It is only since the GFC, and I would argue in particular austerity and Brexit, that real wages have not grown at all over a 15 year period. It is simplistic because it treats neoliberalism in practice as a single entity, whereas in reality it comprises a number of separable aims.

The initial manifestation of neoliberalism under Thatcher and Reagan was not obviously doomed to failure in either economic or political terms. In the UK standards of living for most did not stagnate or decline, and political institutions continued largely unscathed. The power of trade unions declined, but so did inflation. UK poverty increased initially, but this was either arrested or partially reversed in the Blair/Brown years. North Sea Oil and the post-cold war peace dividend enabled Thatcher to cut taxes without drastically shrinking the state, and Blair/Brown raised taxes to increase the size of the state. Whatever you thought of the politics, neoliberalism didn’t at that stage appear doomed to end in authoritarian plutocracy.

While Thatcher and Reagan transformed what had begun before, in subsequent years it looked as if neoliberalism had become sustainable by being selective about what aspects were adopted and what aspects were not. In the UK unions remained less powerful and Thatcher’s privatisations were retained, but other neoliberal goals like a reduced state enabling lower taxation were ignored. Unemployment gradually declined compared to its high point under Thatcher.

There is a line of argument which says the economic success of the Blair/Brown years was an illusion built on deregulated banks that shattered in the Global Financial Crisis (GFC). I think the evidence for that is rather thin. Strong UK growth in earlier years was more broadly based than just financial services, and the UK banking sector survived the GFC with the help of the state. The reason the GFC seems to be such a breakpoint today is in large part because of austerity. Of course the GFC did illustrate the folly of the neoliberal goal of maximum deregulation, but the response of most governments was simply to increase those regulations (e.g. raising capital requirements).

Hypotheticals can be useful as another way of testing ideas. If I am right, then had Brown won a general election after the GFC, and if he had resisted pressure from the Treasury to embark on damaging austerity (which he probably would), then it seems clear to me that we would have seen a continuation of neoliberalism of the Blair/Brown type. That form of neoliberalism could have been sustained as long as the political right, that wanted to push neoliberalism further, did not gain power. But sustainability as long as the same party stays in power is not sustainability in anything but the short term.

I would also argue that the two main powers in Europe, France and Germany, are similar to Blair/Brown in adopting some aspects of neoliberalism but not others, and so have so far avoided neoliberal overreach. They both adopted austerity, of course, and this has increased the power of the far right in France, but they have retained a sufficiently robust welfare state to avoid the far right coming to power. (As I argue here, their voting system also helps. In addition, austerity didn’t have the same impact in Germany as in other European countries.)

So why do I think neoliberalism in the UK and US contained the seeds of its own demise? The first reason is that, for the believers on the right in both countries, the neoliberalism of Blair/Brown and Clinton represented an unfinished project. It was in their minds half-baked, and required more in terms of lower taxation and more deregulation.

The second reason, which reinforced the first, was inequality at the top. If you create a society where a small but significant minority gain incomes and wealth far beyond the majority, they will seek political power either to protect that wealth, or simply because money enables them to do so. The richer of the 1% could do this by funding political parties of the right directly (and thereby gaining influence on those parties), or by funding ‘think tanks’ that were really pressure groups, or by owning media companies not just for profit but to influence their editorial line and content.

Of course the authoritarian populist regimes of Trump and Johnson often pushed neoliberal ideas. The reason why they are a break from, rather than a continuation of, neoliberalism can be seen by thinking about the interests of capital. Arguably you could define neoliberalism in practice as simply being whatever is in the interests of corporations as a whole (see this post). What Trump did and Johnson is doing is not that. Trade barriers are not in the interest of traded capital, and capital also rather likes the ability to freely employ those from abroad. What you had with Trump and have with Johnson is government in the interest of friends and donors, which is why it comes closer to a plutocracy.

So to return to the question in the title, a neoliberalism that is pursued relentlessly in all its aspects does contain the seeds of its own destruction, and the evidence so far suggests what follows after neoliberalism is far more dangerous and can easily transform into undemocratic authoritarianism. In that sense 1979 is correct. However that transformation may take some time to emerge, and will only occur if welfare states are either limited to start with or are cut right back, which suggests for the UK 2010 is the correct date.

More generally it may also be quite possible for governments to adopt some elements of neoliberalism and not others, and avoid the same fate. If my analysis is right, what is critical is to keep the political power of extreme wealth in check (through taxation, media regulation, limits on election funding etc), for the political right to retain a sceptical view of the ideology and to cushion the impact of economic change on those who lose out from it. One big advantage that other countries now have is that there are two major economies where the consequences of not doing these things has become all too evident.

Inflation and a potential recession in 4 major economies

 

I think most people understand that the inflation we are seeing at the moment across the developed world has very little if any to do with excess demand (the famous too much money chasing too few goods) but is about external shocks to the price of commodities, and supply problems that emerged because of the pandemic and the recovery from it. In addition both types of inflationary shock are likely to be temporary: commodity prices are unlikely to continue to rise and most supply problems caused by the pandemic will be resolved.

If this is the case, why do central banks need to raise interest rates, particularly as higher commodity prices will reduce real incomes which is deflationary? Given the normal lags in monetary policy, higher rates will have little impact on current inflation, so why reduce demand and inflation in the future when inflation has largely disappeared? The answer is fear of a wage-price spiral. If wages rise to some extent as a result of price inflation, this will raise costs which will raise future prices. The received wisdom in central banks (from the mid-2000s as well as the 1970s) is that some reduction in demand is required to stop a wage-price spiral developing.

The likely level of excess or insufficient demand in 2022 should be crucial in this respect. If there is already insufficient demand, and lower real incomes will only make that worse, then central banks have little or nothing to do. In contrast if the labour market is currently tight and likely to stay tight the dangers of a wage-price spiral are much higher. It therefore makes sense to start any assessment by looking at output levels.

In terms of the major economies, we did get a V shaped recovery from the pandemic, but where the V stands for vaccines. As soon as vaccines became widely available, the economy expanded rapidly, as I showed here. Vaccines removed the need to lockdown the economy, and gradually gave consumers confidence to engage in areas of social consumption.

However the recovery was not equally strong in the major economies. Here is an updated chart of one I showed in that earlier post, looking at GDP per capita (2019=100) rather than GDP.

The US not only had a less severe COVID recession than the UK and France, but it has also had a much stronger recovery than the other three economies. (You can also see how the last ten years have been a decade of relative decline for the UK, matched only by France because of Eurozone austerity around 2013.)

Matching this is a clear hierarchy in inflation rates. If we look at Core inflation in each country, the US is the highest at 6.5% for March, while Germany is at 3.4% for the same month and France 2.5%. However UK core inflation is surprisingly high, at 5.7%, even though it has had a similar recovery to France and Germany. One of the reasons is Brexit, which we discuss below.

It is of course possible that the pandemic has caused a permanent reduction in the supply of goods, either through lower technical progress, capital or labour. I find it difficult to believe that the pandemic has had a permanent impact on technical progress, or that lower investment during the pandemic cannot be rectified by high investment later as part of a sustained recovery. The experience of the UK and elsewhere before the GFC was that recessions did not lead to a permanent reduction in productive potential.

The pandemic does seem to have had, so far at least, a negative impact on labour supply in the UK and US among older workers, in what has been called the Great Retirement. There are lots of possible reasons for this, including less need to work for some as a result of additional savings over the pandemic. However another potential explanation is Covid itself, and in particular Long Covid, as this Brookings study outlines, or the indirect effect of Covid because other health problems have not been fixed as quickly as they should. (For the equivalent for the UK, this briefing note is a good place to start.) France has avoided similar problems, in part because of early retirement.

This might suggest that US growth since 2019 may have exceeded the growth in supply, but elsewhere it is completely implausible to suggest these problems are big enough to give you zero growth in potential since 2019. This suggests the following:

1. In the US, relatively high inflation and strong growth combined with a reduction in labour supply could indicate an economy above its ‘constant inflation’ position (i.e. has excess demand).
   
   

2. France and Germany, with weaker inflation and projected output per capita in 2022 at around 2019, indicate economies probably below their constant inflation position, suggesting excess supply in these economies.

3. In the UK we have a special case due to Brexit.

Here are a few thoughts on each in turn.

United States

With high vacancies and wage growth at around 5% in 2022Q1, high inflation in the US has become more broadly based than it once was. An important reason for this, which is shared by the UK, is a drop in labour supply after the pandemic. The Federal Reserve Bank of Atlanta has hourly or weekly earnings at 6% in March.

The IMF’s projected growth for 2022 implies annual increases in underlying output since 2019 of around 1,4%, which does not at first sight seem unreasonable. However if the pandemic has reduced the supply of labour or some other element of potential in a significant way, this growth would indicate excess demand. This is the IMF’s view, which suggests excess output of over 1.5% in 2022. This judgement seems to be shared by the Federal Reserve, which recently increased interest rates by 0.5% on top of an earlier 0.25% increase. However, there are two major risks in the monetary tightening which is currently underway.

The first is that this contraction in labour supply may be temporary. The second is that the economy is heading for a significant downturn or even recession of its own accord, without the help of policy. As higher prices squeeze real wages, consumption growth may decline significantly which will drag down GDP. (The fall in GDP in the first quarter of 2022 may be erratic, or it may indicate this is already happening.) If either happens, raising interest rates rapidly could turn self-correction into a period of serious insufficient demand.

If neither risk occurs, I think it is wrong to conclude that Biden’s fiscal stimulus was ill-judged, for three reasons. The first is that very little of current high headline inflation would have been avoided if that stimulus had not occurred. The second is that a long period where interest rates are close to their lower bound indicates an inappropriate monetary/fiscal mix, and some correction such that a fiscal stimulus leads to moderately higher interest rates will allow monetary policy to more effectively respond to any future downturns. [1] Third, that stimulus was probably the only politically feasible way to reduce poverty quickly.

France and Germany

Whereas the IMF expects the US to have excess demand, it projects both France and Germany to have insufficient demand in 2022. It would be quite wrong, therefore, to argue that ECB interest rates should rise. Indeed, with interest rates at their lower bound, and higher energy and other prices likely to cut personal incomes, there is a strong case for a significant fiscal stimulus to raise GDP.

United Kingdom

Is the UK more like the US (current excess demand) or France/Germany (current deficient demand)? The level of core inflation, and the actions of the Bank of England in raising rates, suggest the UK is more like the US. Both also have tight labour markets and nominal wage inflation that is inconsistent with a 2% target. But I would argue that is where the similarities end.

The first obvious point is that projected growth in output per head in the UK has been much weaker from 2019 to 2022 than in the US. As I have already noted, the UK looks much more like France and Germany in this respect. A major reason for that is fiscal policy. Instead of sending a cheque to every person (as in the US), the Chancellor has announced a freezing of tax thresholds and higher NICs. [2]

So why is UK core inflation nearly as high as the US, and much higher than in France and Germany? One important reason is Brexit, which has raised UK inflation through various routes. We already know that the immediate sterling depreciation after the referendum result increased inflation in earlier years. In addition this study estimated that the Brexit trade agreement has directly increased UK food prices by 6%. This is because additional barriers at the border (checks, waiting times, paperwork) are costly. Importers can switch to non-EU sources, but that will also mean higher prices. More generally the Brexit trade barriers may lead to the creation of new, but less efficient, supply chains, pushing up prices. Finally these trade barriers mean reduced competition, allowing domestic producers to increase markups.

One additional possible inflationary consequence of Brexit that has been talked about a lot is due to labour shortages in low paid jobs because of the ending of free movement. While those shortages are real enough (vacancies for low paid jobs have grown much more rapidly), up to the end of 2021 this does not seem to have led to higher pay growth according to this IFS study (see chart 3.2 in particular). As a separate briefing note from the IFS points out, there is one sector that has shown rapid earnings growth recently: finance. (For a good discussion of the UK labour market, see here.) If we look at earnings growth in the first two months of this year, however, we see quite rapid growth in earnings in the wholesale, retail, hotels and restaurants sector. [3]

Yet all these inflationary impulses due to Brexit are temporary, reflecting the one-off nature of the trade barriers, reduced competition, labour shortages etc. While the increase in wages in the US is broadly based, that is not the case in the UK, suggesting a relative wage effect rather than general inflationary pressure. As a result, I think there is a serious danger that the MPC are seeing misleading parallels between the UK and US, whereas in reality the UK’s situation is much more like France and Germany with a short term Brexit inflationary twist. If I am right, then monetary tightening coupled with fiscal tightening and higher prices for energy and food could spell recession. [4]

My view on likely interest rate moves is not shared by the markets, which are expecting many more rate increases from the MPC. The Bank’s arcane practice of using these market expectations in their main forecast has confused a lot of people. If you want an idea of what the majority of the MPC currently think will happen, it is better to look at their forecast using current interest rates. That shows inflation falling to just over 2% by mid-2025, and annual GDP growth of between zero and just over 1% in every quarter of 2023, 2024 and 2025H1. That is not exactly an exciting prospect, but it is not a serious recession either. The problem, as I noted here, is that forecasts are poor at predicting recessions.

The MPC may be right or wrong, but the outcome in either case is pretty dire for the UK economy. If they are right to raise rates, then the best the UK can do after the pandemic is return GDP per capita to 2019 levels. That will mean that the pandemic in the UK, and the policy reaction to it, has lost at least three years worth of growth. If the MPC is wrong, raising rates will cut short a recovery in output and risk a recession which once again [5] risks policy induced deficient demand choking off long run supply, making everyone in the UK permanently poorer.

[1] Some might argue that in an ideal world fiscal policy should always respond to excess demand or supply, and therefore interest rates can stay very low. However the US is perhaps the country which has a political system where this kind of fiscal activism is least likely to occur without prior fundamental reform.

[2] In judging the impact of any fiscal stimulus, looking at measures of cyclically adjusted (or ‘structural’ or ‘underlying’) budget deficits can be very misleading. To take a clear example, if a country announces a five year programme of buying fighter planes from another country, its deficit increases but this provides zero stimulus to the domestic economy. The Biden stimulus was like helicopter money, except the rich got nothing. Furlough on the other hand gave people money in proportion to their salary. A stylised fact is that the wealthier people are, the less of any government transfer they will spend, and the more they will save. As a result, giving a fixed amount to the non-wealthy is much more effective at boosting demand than a furlough type scheme.

[3] The Bank of England say “underlying wage growth is projected to pick up further in the next few months”, so perhaps they are expecting a delayed reaction to high vacancies.

[4] It is easy to blame the MPC, but these issues are complex and its remit limits how much the MPC can ignore a sharp rise in inflation. I certainly do not think governments are better placed to make these economic judgements. What I think can be done is change the MPC’s remit to place more emphasis on output while making the inflation target more long term, as I suggested here.

[5] I say again because that has to be part of the story that explains the lack of recovery after the Global Financial Crisis, although the blame then lies with fiscal policy (austerity).

How Austerity created Brexit, and the economic and political decline of the UK

 

For many people things started going very wrong in the UK the moment the Brexit referendum result was announced. There can be no doubt that Brexit has been a disaster on almost every level. In economic terms this disaster is well established: if you have any remaining doubts, listen to Adam Posen giving the first presentation at the recent UK and a changing EU conference on Brexit. He shows how we have become a more insular country in terms of trade, FDI and migration: this has already led to lower UK growth while the implications of lower trade, FDI and migration for future productivity growth have yet to be felt. In addition, Brexit has led to higher food prices (see this conference presentation), adding to the cost of living crisis. In addition less trade leads to reduced competition, which allows price mark-ups to rise. For more detail on all this see Chris Grey’s latest blog.

However, just as important have been the political costs of Brexit. In 2019 we saw the election of the most incompetent, dishonest, corrupt and authoritarian UK government in living memory because it would get Brexit done, a government that has become either a joke or an embarrassment among other democratic countries. This was hardly a surprise, in that Boris Johnson - a serial liar - is at its head and he demanded unequivocal devotion to a hard Brexit as necessary to be in that government. As I have said before, demanding devotion to a hard Brexit is an excellent way of selecting either those MPs who have little clue about how the world works, or those MPs who are inveterate liars (or both). Johnson has institutionalised the influence of wealthy donors within government (the ‘leaders group’ and ‘advisory board’), turning the UK into a plutocracy where power is retained by trying to set one group of voters against another. This government has been so focused on retaining power and shutting down criticism that it has passed legislation to make demonstrations illegal, to end the independence of the Electoral Commission, to make it much harder to vote and more.

It would be wrong, however, to see the Brexit referendum result as some rogue event without which normal service could have continued. The political and economic decline in the UK began not in 2016 but in 2010 with austerity. Brexit and austerity are alike in one crucial respect, which is that they both reversed established approaches to economic policy. While Brexit reversed the idea that lower trade barriers were good for trade and therefore consumer welfare and growth, austerity reversed the idea that the aim of macroeconomic policy in a recession was to support the recovery by all available monetary and fiscal tools. [1]

In this sense austerity was the first central policy move that ignored the wisdom of experts. Brexit was the second, and government actions throughout the pandemic have been the third. But the links between austerity and Brexit may be rather more causal than that. This is the thesis of an AER paper by Warwick economist Theimo Fetzer, which is one of a series of Brexit studies that he discusses in the UK and a changing EU conference mentioned above.

It is well known that the less educated people were (in terms of formal educational qualifications), the more likely they were to vote Leave. But this correlation does not provide a causal mechanism for why Brexit was so successful in 2016. Fetzer also shows that this correlation was absent from UKIP support before 2010. It is also very well known that the gap between the earnings of skilled and unskilled workers has been growing. However under the Labour government this trend was moderated to some extent by the welfare state. This moderating effect ended, and was put into reverse, under austerity.

What Fetzer suggests and shows is that the impact of austerity was strongest on those with few qualifications, and as a result support for UKIP grew. In other words support for UKIP started to grow in areas with significant exposure to specific benefit cuts. It was the threat from UKIP that led Cameron to promise a future referendum. More importantly, as support for UKIP is closely correlated with support for the Leave side in the referendum, then Fetzer uses his estimates of the impact of austerity to suggest Remain would have won in the absence of austerity. (He also argues in his conference presentation that this austerity induced UKIP vote also helped the Conservatives win outright in 2015, which made a referendum inevitable.)

What this does not show is why cuts in welfare and other support led the less skilled to vote for UKIP, rather than some other opposition party. However that gap is not hard to sketch in. First, in many voters’ minds, Labour were at least equally to blame for austerity as the Coalition government, in large part because of the highly successful (and largely uncontested) lie put out by the Coalition government and their press that the Coalition were clearing up the mess that the Labour government had left. Second, the Coalition and its press used immigration as a scapegoat for much of the impact austerity was having, yet the Coalition also failed to bring immigration under control. For many, therefore, UKIP was an obvious choice.

This is an example of a more general, and often made, point about the critical role of the welfare state, that I alluded to here and which Fetzer mentions at the end of his conference talk. A dynamic economy is bound to create lower incomes and perhaps unemployment in sectors that become obsolete, or go out of fashion, or suffer from economic downturns. Globalisation is just like technical change in this respect. If the workers in those sectors are not protected and helped to a reasonable extent, then some in those sectors become fertile ground for right wing extremism.

How does this fit in with the strong correlation between support for Brexit and social conservatism? First, we have to distinguish between social conservatives who would have voted for Leave anyway (older voters in particular), and those at the margin that pushed support for Brexit over the line. Those inclined to believe that immigration is the reason why their pay, job prospects or access to public services have declined will be those who are newly attracted by right wing populists. In this sense the debate about the rise in right-wing populism between the those who emphasise the economic left behind on the one hand and those who look to the socially left behind (or, in the US, race) on the other hand as explanations may be misplaced, because the two factors may work together in the manner just described. [2]

This process is not unique to the UK. Austerity had a strong (perhaps stronger) effect on the Eurozone outside Germany, and happened in the US as well. Equally the rise of the populist extreme right occurred in many of these countries. It won 42% of the vote in the second round of the French presidential election. One big and obvious difference between the US and UK on the one hand, and France and Germany on the other, is the latter have stronger welfare states [3]. In my view another important difference is the voting system. In the UK and US this voting system meant it was very hard to displace the main party of the right [4], and so the way the more extreme right gained power in both countries was by taking over the established right wing party. Equally the voting systems meant it could subsequently win general elections without majority support. In France and Germany the extreme right could still imagine coming to power in its own name, but without cooperation from other parties this required majority support. [5]

Locating the origin of the UK’s economic and political decline in 2010 helps focus on how that decline can be brought to an end, or even reversed. A prerequisite has to be political change, and a government that does not involve the party and politicians that brought about this decline. But that alone will not be enough. Any new government has to abandon the obsession with government debt targets [6] that could both recreate austerity and foster populism, and end the demonisation of the EU that led to Brexit. International cooperation has to replace a desire for total sovereignty.

If these conditions are met, there is no reason why the UK could not recreate the economic success it enjoyed before 2010. The damage done by fifteen years of economic mismanagement is serious but not total. As the Resolution Foundation in a recent report sets out, the UK’s specialisation in many services (education and culture in particular) and some goods production reflects an international comparative advantage that will still be there in 2025. However those, and perhaps some new, specialisations will only thrive if we have better access than we do today to the huge market on our doorstep.

[1] That orthodoxy had only been challenged once since WWII, and that was very briefly by Mrs Thatcher in 1981. Unlike 2010 austerity, her experiment was quickly abandoned and substantially reversed two years later.

[2] Thus we get one element of what I have called neoliberal overreach. An attempt to do away with protection for the economic left behind with the aim of cutting taxes under Cameron and Osborne created the conditions for Brexit, and the end of neoliberal hegemony.

[3] In addition, Germany did not suffer as much from austerity as other Eurozone countries, in large part because of strong export growth.

[4] UKIP never gained an MP directly through an election.

[5] The differential impact of UK austerity on different parts of society also helps explain why many see 2016, rather than 2010, as the start of UK economic and political decline. Those most affected by austerity were also those with little voice in politics or the media, allowing politicians and the media to declare that austerity had not had much impact because it hadn't affected them.

[6] The key word here is obsession. There may be a role for trends in government net wealth (not government debt) to help inform deficit targets for current spending in good times, but these targets must not constrain direct or indirect measures to tackle climate change, government investment must be free of macro controls and no constraint should be placed on deficit spending in an economic downturn. In addition geographical levelling-up requires local areas to have financial power, and it is an obsession with debt that is part of the reason the Treasury keeps opposing that.