Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 29 November 2022

How Scottish Independence has become entwined with Brexit



Brexit is the main reason the SNP give for wanting another referendum so soon after the last. While an independent Scotland as part of the EU would enjoy a larger single market than it enjoys as part of the UK, leaving the UK’s single market would impose short term costs almost certainly greater than the costs of Brexit. The government that enacted Brexit refuses to allow another independence referendum. A future Labour government might be less inclined to deny the Scottish people any say on independence, but that government could also start a process that would undo much of the harm caused by Brexit.

With Conservatives in power independence involves short term pain and long term gain

I cannot comment on the legal reasoning that lay behind the Supreme Court ruling that a referendum on Scottish Independence would be illegal without the cooperation of the UK government. (On that, see Dave Allen Green here and here.) However I cannot defend the decision of the UK government to refuse a referendum, or any law that says this is sufficient to prevent a referendum on independence.

The UK government’s reason to refuse another referendum is that it is too soon after the last one. But the reason that the SNP give as justification for pushing for it is Brexit. In a very important sense they are right. Not only did Scotland not vote for Brexit, and the economic damage it is doing, but Brexit gives the SNP’s claim that the economic future will be brighter after independence something beyond mere wishful thinking. The EU Single Market is a lot bigger than the UK’s Single Market.

I wrote about this four years ago here. There is no doubt that in the short term Scottish Independence will be very costly for the people of Scotland. In 2014 the only real economic compensation on offer was that different governance after Independence would bring a fairer but poorer society. So the economic trade-off independence offered was clear and certain short term pain set against the hope of possible long term benefit. But if Scotland was part of the EU’s Single Market and Customs union, it could eventually avoid the long term pain that Brexit will bring the rest of Great Britain.

But there is a counterpoint to that, which is that when Scotland does join the Single Market and Customs Union, they will have the considerable short term pain of creating a border with their largest market: the rest of the UK (rUK). That is in addition to the cost that dominated the 2014 referendum, which was the loss of the fiscal transfer from the rUK to Scotland. Scotland might still be better off in the long run, as its exports reorientate from rUK to the larger EU market, but that takes decades to happen.

So in terms of the economics, what was in 2014 a trade-off between certain and pretty large costs in the short run versus the hopeful possibility of benefits in the longer term becomes much larger and still certain short term costs against more tangible long term [1] benefits of being part of the EU. Adopting the Euro also carries clear risks as long as the Eurozone’s fiscal rules remain a mess.

However the prospect of a Labour government changes that trade-off in a critical way. To see why, it is useful to first talk about inevitable Brexit stasis under the Conservatives.

Over the next decade at least, only one party can reduce the costs of Brexit

In the last few weeks there have been two changes that represent a turning point for Brexit. The first was the humiliation of Prime Minister Truss, coupled with her successor being chosen by MPs alone. Truss was the candidate of the Conservative party’s European Research Group (ERG), who have consistently pushed for the most extreme form of Brexit. The second is that we are finally seeing across the broadcast media discussion of the costs of Brexit. With the UK economy being alone among the G7 in failing to regain output levels seen before the pandemic, and about to go into recession, it just wasn’t possible to avoid the subject any longer.

But last week it also became clear (if it was ever doubted) that the Conservative government cannot change the Brexit deal that Johnson agreed in 2020, because it is hopelessly divided. The ERG may have lost their leader with the downfall of Truss, but they are still powerful enough to stop any attempt to change that deal. Leaks suggesting the government were looking for a Switzerland type deal have been met by a chorus of denials from ministers and Sunak himself. Given the party’s terrible position in the polls, and a general election not that far away, Sunak cannot afford to risk the internal division that any attempt to rewrite Johnson’s deal would cause. The best we can hope for is that he is able to come to an agreement with the EU on the Irish protocol.

Nor would anything change if he was able to win that General Election. Not only has he to pacify the ERG, both the right wing press and his party members remain solidly pro-Brexit. Even if that was not enough deterrent, there is the ever present threat of Farage or someone similar threatening to take Tory votes and even some Tory MPs. All this means that for the next decade at least, no progress in reversing the economic and political harm caused by Brexit can be made while the Conservative party is in power.

So just as a Conservative government will not allow another independence referendum, it will also do nothing to alter the heavy costs of Brexit that the UK is experiencing.

However we now have the strong prospect of a Labour government. In opposition Labour have been extremely cautious. The last thing they want to do is unite a divided Conservative party and revitalise the right wing press in labelling Starmer a rejoiner. With polls like this, it is far safer for him to talk about improving relations with the EU, without being specific about how that would be done. With the Conservatives offering nothing, while Labour offer hope, only Remain voters who have learnt nothing from 2019 would refuse to vote tactically against the Conservatives.

Once in government, however, the trade-offs for a Labour government will change. It will become clear that the economic gains from a closer relationship with the EU while still outside its customs union and single market are pretty small. Labour will become responsible for the health of the economy, and just as the costs of leaving the EU are now becoming clear, so will the economic benefits become clear of rejoining the EU’s Custom Union and particularly their Single Market. The political risk of doing either noted above will still be there, but they will diminish in size over time. For both reasons, becoming part of the EU’s single market will become more attractive over time, and the pressure on Labour to move in that direction will only grow.

Brexit has encouraged independence, but could also mean it fails

Brexit was missold to the UK. Almost everything the Leave campaign said was a lie. Saying there would be no economic costs and only benefits was a lie. Saying there would be more money for the NHS was a lie. Saying UK trade would flourish under ‘global Britain’ was a lie. Saying we could negotiate trade deals more advantageous to the UK was a lie. Saying prices would fall was a lie. Saying immigration would be lower was a lie. The list is endless. Whenever evidence that these were lies was put into the public domain during the referendum campaign Leavers had a simple response: they called it Project Fear. Project Fear became synonymous with don’t worry about the facts, just believe the lies.

But the term Project Fear did not originate with Brexit, but in the first Scottish Independence referendum. The short term fiscal costs of independence were large and undeniable, yet the Yes side, like Leavers, preferred to use denial and misdirection rather than acknowledge this fact. As with the Brexit referendum, they could get away with this because what was being proposed had not been done before. [2]

However the similarities between Brexit and an independent Scotland joining the EU are too great and too recent to dismiss as Project Fear. Leaving the EU’s Single Market has caused the UK significant economic loss, and there is every reason to expect that Scotland leaving the UK single market would cause even more in the short term. In the long term firms in an independent Scotland that was part of the EU would have a larger market, but it takes considerable time to reorientate firms from one market to another, including the time and costs involved in persuading that new market that you have something worth selling. That time period will at best involve Scottish firms producing less and employing less people, and at worst it means these firms might no longer exist.

It will be very hard for the proponents of Scottish Independence to on the one hand give Brexit as a key reason for wanting independence, and on the other hand to deny the costs of leaving a large single market on which Scotland is currently so dependent.

If the independence referendum had taken place under a Conservative led UK, then the UK government would have been in a bind, because it would not want to point to Brexit as evidence of the short term costs of leaving a single market. [3] But we now know that will not happen, because a Conservative government will not allow another independence referendum.

A Labour government would be less inhibited, but could still face difficulties if it was trying to pretend it could make a success of Brexit. As long as it stayed doing that for fear of opposition from Leavers, it would find it hard to fight an independence referendum and would therefore be disinclined to grant one. However the moment a Labour government became committed to seriously undoing parts of Brexit (by joining the EU’s single market, for example), the case for a second Scottish independence referendum becomes much weaker.

It would become weaker because Brexit could no longer be used as a justification for another referendum. But it also becomes weaker because the long term gains of an independent Scotland as part of the EU having a larger single market also disappear, because these gains could be had by staying in the UK. Finally, using Project Fear to discount the short term fiscal costs of independence becomes weaker because Brexit has discredited that form of defence.

Brexit has given Scotland a reason for having another referendum, and has also given some credibility to the long term economic future being brighter after independence. Unfortunately for those advocating independence, those arguments only work if Brexit in its current hard form is permanent. That would be the case for at least a decade if the UK is led by the Conservatives, but the Conservatives will not allow a referendum. The UK under Labour might, but it would only be wise to do so if that Labour government could admit that any hard Brexit is bound to bring large economic costs. A Labour government that was seeking to rejoin parts of the EU would severely undermine the case for another independence referendum. Thus Scottish independence and Brexit have become inextricably intertwined.

[1] Here long term means a few decades at least before there is any chance of the benefits of EU membership exceeding the costs.

[2] Some have suggested that the short term fiscal costs of independence could be overcome if an independent Scotland had its own currency. Then, it is claimed, having a large budget deficit would not be a problem , because all the new Scottish central bank needs to do is create the money equivalent to the previous transfer from the rUK. Because there would be no greater claim on Scottish resources, it is argued there would be no inflationary pressure.

This ignores the fact that an end to the rUK transfer doesn’t just create a budget deficit, it also creates a current account deficit. At present Scotland is consuming more goods and services than it produces because of the transfer. The rUK is financing both a Scottish current account deficit and a budget deficit. There is every reason to believe that this Scottish current account deficit is not sustainable (the private sector would not replace the rUK transfer by capital inflows), and so the Scottish real exchange rate would depreciate on independence.

That depreciation would help Scottish exports and diminish its imports such that the current account became sustainable. However a depreciation means a reduction in the purchasing power of Scottish consumers, making everyone in Scotland poorer. Higher exports and lower imports also means a larger demand on Scottish resources, creating inflationary pressure.  

[3] In many ways we may see a repeat of 2016, where Cameron having set immigration targets and having failed to meet them, left himself wide open to claims that immigration can only be controlled by ending free movement. The obvious retort that immigration was good for the economy was not open to him. The Brexiters, having created a customs border between Great Britain and the EU, will find it hard to wax lyrical about the harm an English/Scottish border will do.

Tuesday 22 November 2022

The economics and politics of the three sides of aggregate fiscal policy


This post is prompted by the discussion around the Autumn Statement, but also in particular a post by Ian Mulheirn. Here is the key diagram from his post.

I think the diagram is useful because it distinguishes three aspects of aggregate fiscal policy that can easily become confused. However it is worth talking a bit about its limitations lest the diagram itself adds to confusion.

Each of the three circles above represents a non-central point on a spectrum. Take the ‘support short term growth’ for example. At one extreme (near to my own position [1]) you can believe that in a recession, or before an expected recession, or during the recovery from a recession, the need to stimulate the economy should take absolute priority over all other objectives. The other extreme would be to ignore the macroeconomic situation entirely, which Osborne/Cameron in 2010. There are plenty of intermediate positions between those two extremes, like Balls/Miliband over the same period.

The same is true for public services. I would go further and make a conceptual distinction between what you might call the ‘scope of the state’ and ‘how well the existing state is funded’. These both have to be continuums. My own view on the latter is that we are currently not even at an extreme point, but one which is not tenable.

What does fiscally conservative mean? I think the label here is misleading, because fiscal conservatism could equally be the label for the other circles. In my view the issue here is about the expected path of public debt, or public sector net wealth, over the long run. One extreme on this would be that public debt doesn’t matter at all. The other might be that debt should be reduced rapidly, and there are plenty of intermediate positions between these two extremes. Any good medium term current deficit fiscal rule will have to make a choice about where on this continuum it wants to go.

I would not include under this heading debates about the form of fiscal rules. This debate is more technical in nature, and involves whether it is better to target the current deficit or the total deficit, or whether some particular change in the debt/GDP ratio is a good target, and so on. Discussion often confuses the form of a target with the value it is set at. For example, a target for the medium term current deficit is a good rule in my view, but there is still a debate about what level the target should be at, and that will depend on how quickly public debt should fall or rise in the long run.

Making these distinctions help us see historical events in a clearer light. 2010 austerity, for example, combined two of these circles: a large contraction of public services, and ignoring the need for fiscal stimulus in a recession. It is also interesting to note that the level of taxes is influenced by at least two of these aspects of fiscal policy: higher public spending implies higher taxes, as does (for given public spending) a more conservative debt policy.  

The correct way to locate past Chancellors in all three dimensions of fiscal policy would be a three dimensional chart, with the three axes being ‘how high is public spending’, ‘the priority given to the macroeconomy during economic downturns’, and ‘how quickly should debt rise or fall over the long run’. But three dimensional diagrams are not easy to look at, which is why I suspect Ian uses the simpler formulation above. But that also creates problems.

While I have no problem with the classification of Osborne/Cameron, you could question whether Balls/Miliband were suggesting higher public spending or just less cuts than Osborne. Equally by putting Johnson/Sunak in the higher public spending circle, it’s clear that Ian is taking a conservative definition of ‘higher’. With Hunt/Sunak a budget that back loaded spending cuts and immediate energy subsidies could be spun as worrying about the economy in the short run, but they are still putting up taxes in a recession. I suspect the real reason that spending cuts have been delayed is not the coming recession but just that spending cannot be cut further, and the real reason for energy subsidies is political.

I think it’s clearer if we try and use one straight line and a 2D chart

The straight line just looks at the amount of government spending, and I’ve only included actual Chancellors, not PMs or shadows, and excluded Hammond and Javid for space. Brown is out in front for creating an NHS that worked, Sunak (under Johnson) increased spending as a share of GDP in a few public services but not others. Hunt gets to be to the right of Osborne mainly because his spending cuts have not happened yet. (I have put Darling in brackets because his period was dominated by the GFC.)

The second diagram plots the remaining two aspects of fiscal policy. Here I have only included four Chancellors, because Brown didn’t have a recession to deal with as Chancellor, and the GFC blew up his fiscal rules. Darling wins on stimulus in a recession because he did exactly that, while Sunak is next because of furlough. On debt reduction speed Osborne is clearly on top because of what he did once the deficit was brought down, and Darling is where he is because of plans he never got a chance to implement.

I think this is a more informative way to compare what Chancellors did, but it is a lot less pretty than Ian’s original.

I want to end by disagreeing with the main policy point that Ian makes, which is that Labour should aim for the intersection of his three circles. I have no problem with ‘higher government spending’ and ‘stimulus in recessions’. Indeed I think all good governments, from the starting point we are currently in, should increase public spending, and every government should follow basic macroeconomics. Where I differ is on a conservative policy towards public debt.

I understand that in opposition it may make political sense to match the government’s rolling target for falling debt to GDP. But I would hope, once in government, Labour would commission HMT (or the OBR) to do the kind of in depth analysis they did in 1998. This should show the drawbacks of that particular target that I outline here. The most pertinent from Labour’s point of view is that by focusing on debt rather than assets this target discourages the kind of Green investment that is a centrepiece of Labour’s economic policy offering. It is no good hoping these two things don’t conflict based on current forecasts, because at some point they almost certainly will.

Much more difficult is the judgement about the desirable path for net public sector wealth over the long run. Again a good analysis has to look at the costs of getting the judgement wrong. The costs of underfunding public services are today painfully clear. The cost of not reducing the current negative level of net public sector wealth is less clear, once you move beyond nonsense involving market pressure.

[1] I would not argue for immediate fiscal stimulus right now because it could be immediately offset by higher interest rates, but nor would I agree with tax increases. But I am probably at the extreme in believing fiscal stimulus should apply until the recovery from a recession is complete, which is why I think the Biden stimulus was a good idea.

Thursday 17 November 2022

A Conservative government raises taxes by a lot, again


This was not quite the Autumn Statement many people were expecting. Public spending on health and schools was increased a bit in the short term, welfare payments were indexed to inflation with some icing on top, and cuts to public spending were postponed to after the next election so may never happen. If we discount the latter, the fiscal tightening was all about raising taxes by not indexing allowances. By 2023/4, the ratio of taxes to GDP (national accounts definition) will be nearly 37'5%, compared to just over 33% in 2019/20.

Of course none of that means that most public services are not still in crisis, or that the government’s assumptions about public sector pay are any less painful (and strike creating), or that higher food and energy prices are not going to stretch many people’s budgets beyond their limits. The OBR’s forecast for falling average real disposable income last March was terrible (the worst since WWII), but their forecast yesterday (with less energy subsidy from the government) was a lot worse.

The coming recession

The OBR has predictably followed the Bank in forecasting a recession, which we have already started. What is most eye-catching about their short term forecast is what they expect to happen to inflation. The chart below looks complicated but focus on the black line, which is their forecast for inflation.

The OBR expects inflation is currently near its peak, but it will soon come crashing down. Indeed during 2024 it will fall to zero, and be negative during 2025/6, helped by modest falls in energy and food prices.

If you think that is implausible, here is the reason (bottom left quadrant).

The OBR are following their normal practice of taking their forecast of interest rates from market expectations. These expectations have Bank rate rising to 5% early next year, and then falling back to about 3.5% by 2028. There is no way this will happen if inflation follows the path the OBR are predicting. As the Bank themselves say they don’t believe these market expectations about what they will do, it is slightly surprising that the OBR have stayed with them. It makes the OBR’s forecast a bit weird, but I will try and rescue what I can in the comments below.

The OBR’s forecast for GDP is similar to the Bank’s latest forecast until about the middle of next year (their Chart 14), with both predicting falling GDP. Thereafter the OBR is much more optimistic, forecasting a recovery in output of 1.3% GDP growth in 2024 compared to a predicted further fall of 0.9% by the Bank. But the OBR are much more pessimistic about the path of GDP than they were in March (see Chart 1), which in the short term is because in March they were not forecasting a recession, and in the medium term because they now think energy prices will be permanently higher which will reduce potential GDP. This is one of the reasons for the need for fiscal consolidation in the Autumn Statement.

Another is higher debt interest payments caused by higher interest rates and higher debt. But here the implausibility of the path for short term rates assumed by the OBR matters. These rates will undoubtedly be lower, which will reduce borrowing costs particularly into the medium term. So some if not all of the cuts to government spending pencilled in for later years might not be necessary even if Sunak remains PM by then (see Table 3 and page 51).

Of course with cuts to personal income like those forecast, higher interest rates and rising taxes (excluding energy subsidies), the recession could easily be deeper than the OBR or Bank are forecasting. Is the OBR’s forecast for the recovery plausible? Well lower interest rates than they are assuming would help, but much depends on consumers. The OBR have the savings ratio falling to just under 5% next year and 2024, but then only recovering slightly to just over 5% thereafter. That is below the historic average, but may be reasonable given how much consumers saved during the pandemic.

The fiscal stance

The Chancellor has sensibly avoided calls from some of his MPs and others to cut spending in the short term, as such cuts would not have been credible. His income tax increases over the next few years will not help ease the coming recession and subsequent recovery, but their demand impact will be smaller than spending cuts, and they are probably necessary in the longer term. His failure to allow more for public sector pay will cause considerable disruption in the short term.

The government likes to say it is fiscally responsible. But one definition of fiscal responsibility is sticking to your own fiscal rules. It’s worth remembering that in 1998 Labour set out fiscal rules which guided policy for 10 years until the Global Financial Crisis. In contrast, since 2010 I have lost count of the number of times the government has broken and then changed its own fiscal rules, and today added to that count as we regress from a current deficit to a total deficit target so public investment could be cut a little (it falls from 2024 onwards).

So in the short term this Autumn Statement does very little to end the crisis in most public services, and we will have public sector strikes to look forward to. It also does nothing to moderate the forthcoming recession or help the subsequent recovery, although responsibility for the former has to be shared with the Bank. In the medium term, more sensible fiscal rules (see here) plus likely changes in the forecast will reduce or eliminate the need for public spending cuts after the election.

In political terms this Autumn Statement does nothing to enhance the Conservatives chances at the next election. Far from setting traps for Labour, promising spending cuts after the election is not a winning strategy when public services are already on their knees. If the OBR is right, and 2024 does bring a recovery in output along with falling inflation and interest rates, it gives the government something to talk about, but with real personal disposable income having fallen by 3% in each of the previous two years then voters’ memories will have to be very short to celebrate this.

One final point. The Chancellor presented a plan with far higher debt and deficits than previously, and with public spending cuts in the medium term that almost certainly will not happen. The markets didn't care. All those who implied that the markets are just waiting to punish any Chancellor that presented medium term plans that were not credible and tough have been proved wrong, just as they were wrong in 2010. What Kwarteng did was cause major short term uncertainty about the path of interest rates, which is why the markets reacted to his fiscal event. Yesterdays Autumn statement, and the lack of reaction to it, show once again that the markets are not some kind of policeman enforcing fiscal orthodoxy.    

Tuesday 15 November 2022

Missing a fiscal rule does not make a black hole, and a financial crisis after tax cuts does not mean markets want spending cuts


Although the Autumn Statement has been postponed until this week, talk about black holes in the public finances continues unabated. I have always hated this term, which now seems almost de rigueur among economic and political journalists. A black hole in the public finances is just the amount by which the government is forecast to miss some fiscal rule. Connections between a real black hole and a black hole in the public finances is an empty set.

Why do journalists talk about mythical ‘black holes in the public finances’, rather than ‘forecasts of how much fiscal rules will be missed’? I suspect a headline involving the term ‘fiscal rule’ will turn many readers off, whereas everyone knows what a hole in a budget means, and calling it a black hole makes it sound serious enough to demand the reader’s attention. But this attempt to make the public finances sound like household finances is the essence of what I call mediamacro. [1] Unlike real budget holes, public sector black holes are only as good as the fiscal rules that give rise to them. [2] In the last week, thanks to groups like PEF and some good journalism, this fact has at last been given some media coverage.

While fiscal rules have advanced beyond the crude and harmful balanced budget at all times idea, there has been for at least a decade a serious disconnect between what politicians do and what sensible macroeconomics suggests. I wrote a short post about all this two and a half years ago, and will not repeat that here, but instead focus on the problems involved with two fiscal rules that may be the origin of black hole headline numbers: targets for the current deficit, and for a falling debt to GDP ratio. But before doing either, I need to discuss the overall macroeconomic situation. One of the reasons black hole language is an example of mediamacro is that it makes fiscal policy a matter of accounting, when it should always be about the health of the macroeconomy.

The macroeconomic situation

The big mistake Osborne made in 2010 was to try and achieve a deficit target while the economy was in a recession and interest rates were at their lower bound. In that situation deficit or debt targets should be thrown out of the window, and fiscal policy needs to take the place of interest rates in helping to achieve a strong recovery. Labour’s idea at that time, of trying to go less ‘far or fast’ with fiscal consolidation, would have been better than Osborne’s policy but still missed the key point. In a recession you need fiscal stimulus, and only when the recovery is complete do you start worrying about deficits. As generally in life, you do the important thing first, and the less important thing later.

The situation today is more complex than it was in 2010. We seem to be heading for a serious recession, but interest rates are well above their lower bound because the Bank of England thinks that is necessary to make the labour market less tight. That means that any immediate fiscal stimulus (that will impact demand next year, say) would be in danger of being counteracted by higher interest rates. Does that mean that some immediate fiscal consolidation, in the form of tax increases rather than spending cuts for reasons given here, to make a start on achieving a medium term target for the current deficit would be sensible as long as the Bank responds, as it should, by having lower interest rates?

This is where the complexity comes in. The Bank’s own forecasts suggest inflation will be going below target in 2025 or earlier, implying the Bank will be cutting rates in 2024 or earlier. Of course the OBR may come to a different view, but I doubt this as the reasons for a recession (higher interest rates today combined with a large income cut caused by higher energy and food prices) are pretty compelling. There has to be a clear danger that we may in a year or so’s time find interest rates heading towards their lower bound once again, and the economy will need fiscal stimulus rather than fiscal consolidation.

The Chancellor could do fiscal consolidation now, but then reverse this with fiscal stimulus when rates are at or near their lower bound. However such fiscal fine-tuning rarely works as intended. For example, we may experience a much deeper recession next year than the Bank is predicting, and that will only be intensified by any fiscal consolidation now. From a macroeconomic point of view the safer rule is not to tighten in a recession and to only raise taxes when the economy is healthy again. [Postscript A]

An impending recession also creates difficulties for the OBR and any fiscal rules. A good fiscal rule aims to hit some target for the current deficit (see below) when the economy is at trend. Normally forecasts have the economy going to trend after five years, which is why policy should aim to achieve a target in five years time. Yet if the economy is still at the bottom of a recession in 2025, will the recovery really be complete by 2027? If the forecast suggests not, then trying to hit a 5 year target makes no sense. [3] It would be far better to extend the forecast by enough to ensure the economy is expected to be running at trend for a few years at the end of that forecast, and delay fiscal consolidation until those years.

The government will almost certainly ignore these macroeconomic fundamentals, as they have mostly done since 2010. Even then, it could square immediate tax increases with good macroeconomic policy in two ways. The first is to raise taxes where the immediate demand impact is negligible, such as taxes on companies (like those producing energy, obviously), on the rich or on wealth. The second is to combine tax increases with larger increases in public investment. If fiscal rules constrain worthwhile public investment then they are poor fiscal rules. [4] Higher public investment is an excellent way of stimulating the economy, and is also necessary to rapidly green the economy.

Current deficit targets

One of the things George Osborne (or more likely Rupert Harrison and the IFS) got right in 2010 was to have a fiscal rule that focused on the current deficit rather than the total deficit. The difference between the two is net public investment (the current deficit + net investment = the total deficit). The big danger with targets for the total deficit is that the easiest way to achieve them in political terms is to cut public investment, but that is an anti-growth measure and a classic case of increasing the burden on future generations.

Targets for the current deficit just one or two years out make no sense, and my own view is that the best target is to set policy so the forecast meets the target five years into the future, as long as there is little chance of a recession where interest rates hit their lower bound in the meantime (see above). But what should that target for the current deficit in five years time be?

In the past governments have suggested a target of zero for the current deficit. This has the superficial attraction that the government is only borrowing to invest. However economists talk about the need for the public finances to be sustainable in the medium to long run, by which they mean that the ratio of some stock like public debt (or public sector net worth - see below) to GDP should be constant. If the government only borrows to invest (a current deficit target of zero), then this ratio will tend to fall over time because of nominal GDP growth. The higher the value of public debt, the more rapidly the ratio will fall as nominal GDP grows.

This means that having a target for a zero current deficit is arbitrary. What the target should be is a matter of economic judgement. Critical to that judgement is the observation that negative shocks to the public finances, like the financial crisis and the pandemic, tend to be larger than positive shocks. That means it is not very prudent to aim for, say, a constant ratio of some stock to GDP ratio, because in practice that will mean the ratio gradually rises following unexpected shocks. On the other hand many have argued that the climate emergency is exactly the time when it makes sense to let government debt to GDP rise.

Whatever your view, there are sound theoretical reasons for not planning on changing the debt/GDP ratio (or similar) too rapidly. In the current context I think a current deficit target of 1-2% of GDP would still be fiscally prudent. Any ‘black hole’ calculation based on getting the current deficit to zero in five years time is therefore questionable, even if we ignore the macroeconomic outlook. If hitting that target becomes the basis for not increasing spending on public health, it means the Chancellor is prioritising fiscal prudence over saving lives and expanding the economy. Fiscal prudence is just much less important than either saving lives or expanding the economy.

Falling debt to GDP?

Of the fiscal rules we have seen over the last decade or so, targeting a falling level of debt to GDP is one of the worst. The first reason is that It refers to government liabilities but not its assets. If households had a fiscal rule that their debt should always be falling they would never take out a mortgage to buy a house. Equally it is absurd to stop a government investing in worthwhile public projects just because this pushes up its debt, and the lack of public investment in what was until recently an era of very low real interest rates is one more failure to lay at the door of this government.

As I have already noted above, this point is recognised when we talk about flows, which is why we have targets for the current deficit rather than the total deficit. But that logic should be applied to stocks as well as flows. Targeting government debt relative to GDP, or its change, is inconsistent with targeting the current deficit.

The stock measure that is essentially the counterpart to the government’s current deficit is not government debt but the public sector’s net worth, which is the difference between all government assets and liabilities. This is because net investment funded by borrowing adds equally to the government’s assets and liabilities. The OBR has a nice working paper about public sector net worth, and its figure 2.3 makes this correspondence clear.

In 2020 general government net worth was large and negative according to the ONS, because debt greatly exceeded assets. The OBR can forecast the future level of public sector net worth just as much as it can forecast future levels of public debt. So why is all the talk about government debt rather than government net worth? Not only does this make no economic sense [5], having targets for debt rather than net worth can constrain otherwise socially beneficial public investment.

Should we therefore have targets for both the government’s current balance as a share of GDP and a target for public net worth to GDP to be falling at some date? The answer is no, because the change in government net worth is the current balance! This is a second reason why having a target for falling net worth/GDP or debt/GDP makes no sense. At best we have two targets for the same thing, and at worst we have two contradictory targets. Why not just have a target for the current deficit, which can be informed by where we want public sector net worth to move to over the long run? In my own experience, governments that have multiple fiscal targets are governments that are trying to please lots of different people rather than thinking things through.

Any ‘black hole’ based on the need to have debt to GDP falling at some date is therefore not a good basis for government decisions on spending and taxes. [6]

What about the markets

One of the many unfortunate consequences of the Kwarteng ‘fiscal event’ and the market reaction to it is that journalists, commentators, and some politicians will once again suggest that we need to make bad fiscal policy because otherwise the markets will punish us. Comments of this kind fail to understand why the market reacted the way it did recently. Worse still, the Prime Minister and Chancellor are pretending that the markets will only stay calm if there are large public spending cuts. This repeat of one of the lies of 2010 onwards is the opposite of reality: the market reaction to Kwarteng's tax cuts was in part because cuts to public spending were not credible.

I set out in detail the reasons for the market reaction to unfunded tax cuts here. In short, announcing tax cuts without saying if and when they would be supported by spending cuts, together with the likelihood that announced spending cuts could not be delivered in practice, greatly increased the uncertainty surrounding the future path of UK interest rates, which made sterling assets less attractive to hold.

The lesson from this was not ‘don’t run deficits’! The UK government in 2009, while the economy was collapsing and the deficit was rising rapidly, engaged in a fiscal stimulus and we didn’t get the market reaction we saw after the Kwarteng tax cuts. As Ben Chu has pointed out, other major countries have larger deficits and debts than the UK. Indeed the Eurozone has suspended their fiscal rules, so why cannot the UK do the same? The lesson from Truss/Kwarteng is to have clear and credible plans for both taxes and spending, and announce both at the same time. If the markets know what all parts of fiscal policy are doing and those plans are credible, this reduces uncertainty about future UK interest rates and keeps UK assets attractive.


Headlines involving black holes in the public finances are misleading at best. The numbers involved are only as good as the fiscal rules used to generate them. A fiscal rule for the current deficit to be zero may be too restrictive, and a falling debt to GDP target has many serious problems and should be abolished.

However, fiscal rules of this kind should not be chased just before the economy is likely to experience a recession which could be severe [7]. Although interest rates are not at their lower bound right now, as we have seen in the past rates can fall rapidly. Attempts at fiscal fine tuning (fiscal consolidation now and stimulus when/if rates fall to zero) are unwise. Those that appeal to recent market turbulence to say we have to have fiscal consolidation now and spending cuts are at best misreading what caused that turbulence, or at worst making up stories to achieve political ends.

Postscript A

After the global financial crisis, current data suggests UK GDP started falling in 2008Q2. Interest rates at the time were at 5%. Was that a good time for fiscal consolidation? How about 2008Q4, when rates averaged about the same as they are now? The Labour government wisely announced various forms of fiscal stimulus. Supposing instead they had raised taxes and cut spending. Rather than recovery through 2009, we would have had an even deeper recession.

While we hope that the coming recession will not be as bad as 2008/9, we cannot know that it will not be. Delaying fiscal consolidation costs very little, but fiscal contraction just before a recession can cost a great deal.

[1] While knowledge about fiscal rules is scarce, everyone knows that a black hole has to be filled with either spending cuts or tax increases. But those spending cuts or tax rises are only as sensible as the fiscal rules that motivate them, so if you want to say something intelligent about the consequences of black holes you should really have some view on how good the government’s fiscal rules are. In contrast the black hole terminology in effect tries to translate household accounting concepts to the public finances, plus some allusions to frightening solidity or mass. The black hole language is not a useful shorthand, but is instead misleading journalism.

[2] While some economists have made this point, they often add ‘and only as good as the forecasts used to produce them’. While technically true, I think this observation has less practical significance. The whole point of having an independent body to produce forecasts is that the government should accept them, unless they have a compelling forecasting reason not to. Ignoring the forecasts because they are very imprecise is just a recipe for deficit bias.

[3] One way to avoid that issue would be to target ‘cyclically adjusted’ deficits five years out, but cyclical adjustment has its own problems.

[4] Having an arbitrary target for public investment as a share of GDP, as this government has done, is particularly daft.

[5] One argument for focusing on government debt rather than net worth is that a government’s assets often do not produce a financial return to the government, while public debt has to be financed. While a government that borrows in its own currency cannot be forced to default, there might be some level of taxes where it chooses to do so, as the higher is debt interest the higher taxes have to be. However as UK levels of taxation are well below those of many other European countries, this argument hardly applies to the UK in the foreseeable future.

[6] These are not the only problems with falling debt to GDP targets. In the past such targets have failed because they have applied to a specific date, and are therefore very vulnerable to shocks hitting the economy on or just before that date. In addition, as Rob Calvert Jump and Jo Michell have shown, the target is very sensitive to whether debt held by the Bank of England is included.

[7] It is generally recognised that macroeconomic forecasts tend to miss recessions. The fact that one is being forecast now may well mean its severity is being underestimated. The combination of a large cut in personal incomes, higher interest rates, fiscal tightening and a possible recession in major Euro area countries is a powerful combination of deflationary forces.

Tuesday 8 November 2022

Why is the Bank of England making the expected UK recession worse?

The Monetary Policy Committee of the Bank of England (hereafter ‘the Bank’), by raising interest rates over the last six months, intends to play its part in creating a prolonged UK recession. This is not speculation but a statement of fact. The Bank’s latest forecast, similar to the one in August that I highlighted in an earlier post, suggests negative growth in GDP in the third quarter of this year, forecasts a further fall in the fourth quarter, with further falls during the first half of next year.

Why does the Bank think it needs to help create a prolonged recession? It is not because energy and food prices are giving us around 10% inflation, because a UK recession will do almost nothing to bring energy and food prices down. Instead what has worried the Bank for some time is that the UK labour market appears pretty tight, with low unemployment and high vacancies, and that this tight labour market is leading to wage settlements that are inconsistent with the Bank’s inflation target. Here is the latest [1] earnings data by sector.

Earnings growth is around 7.5% in the wholesale, retail, hotels and restaurants sector, about around 6% in finance and business services and the private sector as a whole.

Of course these numbers still imply large falls in real wages for most. For many it seems odd to describe the UK labour market as overheated when real wages are falling. Perhaps the easiest way of thinking about it is to imagine what would happen if the labour market was slack rather than tight, and as a result firms had complete discretion over what wage increases it would pay. Domestic firms are under no obligation to compensate their employees for high energy and food prices, over which they have little control and which are not raising their profits. As a result, if firms were free to choose and there was abundant availability of labour, they would offer pay increases no higher than the increases we saw during 2019. The fact that in the real world firms feel they have to offer more is consistent with a tight labour market where many firms are finding it difficult filling vacancies.

Average private sector earnings running at around 6% are not a problem for the Bank because it is anti-labour, but because it believes wage growth at that level is inconsistent with its inflation target of 2%. It's not the kind of wage-price spiral we saw in the 1970s, but if earnings growth were to continue at 6% over the next few years then the Bank would almost certainly fail to meet its mandate. But earnings growth will slow as the UK recession bites. The big question for the Bank is whether they are overreacting to a tight labour market by creating a prolonged UK recession. Are they using a sledgehammer to crack a nut?

To try and answer this question, we can look at the Bank forecast based on no further increases in interest rates. The reason for looking at this forecast, rather than the ‘headline’ forecast based on market expectations of further rate increases, is that the Bank has been explicit in its scepticism about these market expectations. (Why the Bank cannot tell us how they expect rates to change in the future remains a mystery to many of us.)

The blue line is the Bank’s forecast for year on year consumer price inflation. It is expected to come back down rapidly, ending up close to target in mid 2024. The red line is GDP relative to the pre-Covid peak quarter in 2019. [3] It shows a recession hitting its bottom in around a year’s time, but then recovering at a snail’s pace subsequently, so that GDP by the end of 2025 is still below the 2019 peak! This prolonged recession implies steadily rising unemployment, increasing from current levels of about 3.5% to over 5% and rising by the end of 2025.

If we take this forecast seriously, and we presume the Bank does, then there is little need for rates to increase further than 3%, and we would expect the Bank to start cutting rates by 2024 at the latest. The reason to expect this is that inflation is undershooting its target by the end of 2025, suggesting unemployment of 5% is too high to achieve stable inflation. We will have gone from an overly tight labour market to one which is overly weak. Interest rates influence inflation with a significant lag, so to stop this undershooting and get a stronger recovery interest rates need to start falling by 2024 if not before.

This observation invites another. Rather than raising rates now, and creating a significant recession, only to have to cut them again after a year or two, wouldn’t it be more sensible to not to raise rates by so much right now? [2] That might mean inflation takes an additional year to go back to a target, but after a massive energy price shock that would be more than understandable. If the Bank thinks their remit requires them to get inflation down below 3% within two years, that remit looks far too ambitious after double digit inflation.

Is the Bank’s forecast of a recession an inevitable result of having 10% inflation today? The short answer is no. To repeat the point made at the start, the Bank cannot control energy and food prices which are the main cause of 10% inflation. The correct question is does a tight labour market now inevitably require a recession to correct it?

In the 60s and 70s macroeconomists used to think that an economic boom (in this case an over tight labour market) had to be followed by an economic downturn (or even recession), because that was the only way to get inflation back down. It was the logic behind the phrase ‘if it’s not hurting it isn’t working’. But nowadays macroeconomists believe it is possible to end a boom and bring inflation down without creating a downturn or recession, because once the boom is brought to an end a credible inflation target will ensure wage inflation and profit margins adapt to be consistent with that target.

The Bank might argue that this will only happen if interest rates are increased now, because otherwise the inflation target loses credibility. But as Olivier Blanchard observes here, the lags in the economic system mean a central bank should stop raising rates while inflation is still increasing. If a central bank believes it will lose credibility by doing this, and feels it has to continue raising rates until inflation starts falling, this will lead to substantial monetary policy overkill and an unnecessarily recession.

If that is why central banks in the UK and the Euro area keep raising interest rates as the economy enters a recession, then the truth is central banks are throwing away a key advantage of a credible inflation target. Credibility is not something you constantly have to affirm by being seen to do something, but something you can use to produce better outcomes. Furthermore central banks are more likely to lose rather than gain credibility by causing an unnecessary recession.

Of course raising interest rates to 3% is not enough on its own to cause a prolonged recession. Probably more important is the cut to real incomes generated by higher energy and food prices, which is enough on its own to generate a recession. On top of that we have a restrictive fiscal policy involving tax increases and failing public services (more on that next week). Both together should be more than enough to correct a tight labour market. To have higher interest rates adding to these already large deflationary pressures seems at best very risky, and at worst extremely foolish. The question we should be asking central banks is not why they are raising interest rates in response to higher inflation, but instead why they are going for inflation overkill by making an expected recession even worse.

[1] Data up until September should become available this week.

[2] A policy of raising rates when you can see a weak recovery and below target inflation in three years time, because you think you can deal with those problems later, is a good example of what macroeconomists call ‘fine tuning’. Fine tuning makes sense in a system where you have exact control and can forecast accurately, but makes much less sense for a macroeconomy where neither is true. The danger of trying to fine tune the macroeconomy is that errors in timing mean the economic cycle gets amplified.

[3] I chose this way to show GDP because it illustrates just how poor the economy has performed in recent years, reflecting a decline relative to most other G7 countries that began over a decade ago