Was yesterday’s announcement austerity redux?

 

Rachel Reeves yesterday wanted to establish in the public mind the extent of the fiscal mess that the last government had left behind. She was absolutely right to do so. As I wrote at the beginning of this year, the last government by giving incredible numbers to the OBR had made fiscal policy a joke. Sunak and Hunt did this because they wanted to cut taxes, when what was needed were higher taxes and higher public spending. As I also said, the previous government’s asylum policy was not sustainable, implying growing costs. As the OBR has now said, last week they were made aware of “one of the largest year-ahead overspends” outside the pandemic.

In the year after the Coalition government was elected in 2010, its ministers relentlessly pushed the line that the austerity they were imposing was necessary because of Labour’s recklessness with the public finances. This was a double lie. First the large budget deficit was the result of a huge recession created by the Global Financial Crisis, and second basic macroeconomics told us that austerity was the wrong response to that deficit in a recession. That austerity not only crippled the recovery but it probably did nothing to improve the public finances. But thanks to our media that double lie was believed by a large percentage of voters. When governments really are irresponsible with the public finances, as the last government was, voters need to be told.

The economic environment today is very different from 2010. Rather than being in the middle of the deepest recession since WWII with interest rates at their floor, we are instead in a situation where interest rates remain high because of domestic inflationary pressures. Service price inflation remains well above the Bank’s target. (We will see if the Bank begins cutting rates this week.) For this reason alone, to say that Reeves has begun repeating 2010 austerity is just silly.

Part of the adverse reaction before her announcement came from briefing focused on cuts to public investment. As the FT reported on Saturday (with similar reports from the BBC)

“Rachel Reeves is set to officially delay a raft of “unfunded” road and hospital schemes as the chancellor seeks to fill an estimated £20bn fiscal hole she claims was bequeathed by the last Conservative government.”

Cutting public investment [1], which is by definition investment in the public’s future, to fill short term holes in the public finances is often called ‘Treasury Brain’, because it happens so often. But this is a little unfair to the Treasury. It happens so often in part because politicians know that the short term political costs of cutting public investment are generally less than cutting current spending or raising taxes.

To say that public investment projects are unfunded is nonsense, because public investment, unlike current public spending, should be matched by borrowing, not tax increases. There are two reasons why investment is very different from current spending in this respect. First, investment in a project is by definition temporary, so it makes sense to match variations in public investment with variations in borrowing so taxes remain relatively constant. Second, investment benefits future rather than current taxpayers, so it would be unfair for current taxpayers to pay for it.

For these reasons to appear to focus on cutting public investment to plug immediate gaps in the public finances, particularly from a Chancellor who has stressed the importance of public investment in encouraging economic growth, seemed very odd. As a BBC economics correspondent put it just before her speech, this government wanted to be known as builders not blockers, but now it may become known as scrappers.

Although some road and rail projects will be cut, in her speech Reeves added a more significant cut on current spending, involving ending the winter fuel payment for all but the poorest pensioners. As part of the overspend involves the cost of settling the junior doctors dispute and following the pay review bodies recommendations for other public sector workers, then some cut in current spending would at some stage probably be required to partially offset this increase in current spending. (Some will also be offset by departmental savings i.e. cuts.)

It would have been far better for Reeves yesterday to confine herself to talking about why current spending was higher than previously thought, giving the news on public sector pay, making the announcement on winter fuel allowance, and then say that she would of course make further adjustments to taxes and spending to ensure her fiscal rules were met in October. Why bother with the additional announcements, particularly those that involved cutting public investment?

A clue may come from Sam Coates at Sky News, who wrote

“Ms Reeves has been advised that "we couldn't leave a shortfall that big without immediate action" - presumably on account of market reaction - so the overspend gap will be narrowed (but not closed) by "very very painful" immediate savings to the 2024/5 budget.”

Reeves actually mentioned the Truss mini-budget at the start of her statement when justifying the need to take immediate action. Perhaps she and/or the Treasury felt the markets might get spooked by the news on public sector pay and they needed a whole list of cuts to stop that. If this was the case it shows awful naivety about how markets work.

Does yesterday’s announcement show that Reeves prefers cutting spending to raising taxes? Not at all. The main announcement about future policy was higher pay for public sector workers, paid for by most pensioners and some cuts to services. While higher public sector pay was essential, many might have liked to see that combined with higher taxes [3] rather than cuts to benefits and spending, but it is right to wait until the October budget for that.

Unfortunately I do think that yesterday’s statement did present two hostages to fortune as far as public investment is concerned. The first involves the pre-announcement briefing, which suggested that cutting public investment was a sensible response to current shortfalls in the public finances. It is not. The second involves language. Saying “if we cannot afford it we cannot do it” repeatedly plays to the idea that the government is like a cash constrained household, when it clearly is not. In particular, it is never true that we cannot have public investment because we cannot afford it. What binds governments are their own fiscal rules, not the kind of budget constraint faced by a cash-constrained household.

Are these academic quibbles? No, because as we saw in 2010 such confusion can lead to the promotion of terrible policy. More to the point such language can come back and bite those who use it even when the user knows better. A government, unlike an opposition without its own media, is in a position to increase the quality of macroeconomic discussion, rather than fall back on mediamacro type language because it’s to their short term political advantage. If the current Labour government is ever hit by a global recession, don’t be surprised if its political enemies say ‘if we cannot afford it we cannot do it’. [4]

One final thought. I still fear that Labour are underestimating the extent of money they are going to need to spend to restore public services. Promises they made during the election also limit the amount of taxes they can raise. Yesterday was the ideal opportunity to say that those promises had been made on the basis of false information. It was now clear that cuts to national insurance contributions over the last year were unaffordable, and that they would be reversed by Labour. That opportunity has been missed.   

[1] To argue that these are not really cuts but rather past government announcements that were never in departmental budgets is, I’m afraid, never going to wash with the media for good reason. If you cut a project the previous government announced would happen, you are cutting something the public expected to happen, and so the media is quite right to treat it as a spending cut.

[2] Scrapping public investment because it was bad value for money (or even harmful) is fine, but that is not the justification Reeves made. Scrapping public investment to fill a gap in the public finances is just terrible macroeconomic policy.

[3] Why cannot public sector pay be increased without higher taxes or spending cuts? That would represent an expansionary fiscal policy, putting upward pressure on interest rates. As I want to see large increases in public investment, which will do the same, I would rather see higher current spending matched by higher taxes.

[4] Keynes was more correct in saying "anything we can actually do, we can afford”, although the truth is a little more complicated than that. 

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