Our new Prime Minister is abandoning austerity and going on a tax cutting spree (if you believe him)

These proposals are not designed to help the economy, but to keep Tory party backers happy amid the chaos of a No Deal Brexit

I was going to write something about some of the detailed fiscal plans of our next Prime Minister, and then I thought that would be pointless. Part of the remit of being a Tory Prime Minister nowadays is to lie all the time. So how do I, or Tory members for that matter, know if either of these two candidates for Prime Minister are going to do any of the things they have promised when they get into power? All they are doing right now is saying whatever they think Tory members want them to say.

However both campaigns do at least raise the possibility that our next Prime Minister will throw caution (and fiscal responsibility) to the wind and embark on some large tax cuts. It is critical to note that these tax cuts have not been carefully crafted to shield the economy against any demand shock that might follow from a No Deal exit from the EU. They are designed instead to make Tory voters happier with a government that enacts the biggest act of self harm in UK history.

How do I know that this is what the tax cuts are for, when I’m sure the future Prime Minister would say otherwise? Let’s just look at some of the big ticket items. Cutting income tax for higher rate taxpayers, cutting stamp duty on buying a house and cutting corporation tax. If you were looking for fiscal policies to provide a quick boost to demand, these would be a long way down the list. Much better would be to give money direct to poorer households, because they are likely to spend most of it, or to add to demand directly by increasing public spending, and in particular public investment. High up on my list would be to increase local authority funding to prevent some local authorities going bust. These kind of demand boosters are, however, not the kind of thing that would be attractive to Tory party members, which is why they are largely absent from the wish list of each prospective Prime Minister.

There is an equally important point about timing. Any demand shock following a No Deal exit is likely to be temporary, like a sudden stop in investment by business or in housing. The best measures to counteract that are ones that can easily be reversed. Again bringing forward public investment is an excellent example. In contrast, cutting taxes is politically difficult to reverse. None of the tax cuts proposed by either leadership candidate are explicitly temporary.

What we are seeing from both candidates is the fiscal policy of Donald Trump, and to be fair to Donald Trump also the policy of the Republican party since the second George Bush. Cut taxes under any pretext you can, and watch borrowing increase. After a suitable interval say that something must be done about borrowing, and propose a raft of cuts in public spending or welfare payments to stop the government debt to GDP ratio rising. It was the right’s preferred way of shrinking the state before the Global Financial Crisis and austerity came along.

There are two traps that the left can fall into by a Trump style give away to the rich. The first, which you may find among Lexiters, is to believe that fiscal stimulus is the means by which you stop permanent damage to the economy from any form of Brexit. The danger this leads to is to support the concept of a large permanent fiscal stimulus, even if you do not like the details. I am all for a large increase in public investment, of the kind that I hope a future Labour government will deliver, but that increase in investment should happen anyway, whatever the outcome on Brexit or aggregate demand. If the investment projects are beneficial, they should be undertaken whatever happens to Brexit.

Brexit’s main impact is to gradually hit the supply side of the economy by reducing UK trade with the EU and most of the countries the EU has trade agreements with. As we do less trade, the UK’s productivity falls. This causal linkage takes many forms, such as dynamic firms choosing to produce elsewhere or UK participation in supply chains ending, but the net result is that the UK produces stuff less productively than it would without Brexit. The empirical evidence for these effects is very strong, and we have already seen some of it happening.

You cannot counteract this long term loss of productivity by pumping up demand. All this will do is create inflationary pressure which will lead to higher interest rates designed to offset the fiscal stimulus. There is nothing the UK government can do to offset the negative impact of higher trade barriers on the UK. What the government can do is help offset any Brexit induced negative shock to demand, where demand falls more quickly than supply or falls temporarily, by using fiscal expansion alongside monetary policy.

This leads to a second trap, which is to think about the Johnson/Hunt proposals in terms of conventional fiscal stimulus to offset this temporary demand deficiency. Or in other words to think about them in macroeconomic terms. That is not their main intent. Their intent is to redistribute money from the poor to the rich, in order to keep the party’s backers (in terms of money or votes) happy despite all the chaos of No Deal. No doubt any actual proposals made after the winner becomes Prime Minister will include sweeteners (this could be a bad pun) designed to distract from this purpose, but reporting and comment should not be distracted.

Which brings us to the issue of how popular any package will be. Stephen Bush rightly points out that our future Prime Minister, if they stick to anything like their current fiscal plans, will blow the Conservatives' reputation for economic responsibility out of the water. The OBR will be quick to tell the next Chancellor that a No Deal Brexit will create one of those famous black holes in the public finances, yet rather than respond as Hammond would by fiscal retrenchment the new Prime Minister wants to shake the magic money tree for all it is worth.

In contrast Aditya Chakrabortty worries that this reputation loss will have little impact on voters, who will instead be dazzled by the goodies that are being thrown at them. If I had to choose I would agree with Chakrobortty on this. Labour are deemed irresponsible on the economy by the media even when they are not, so I suspect the reverse will be true: the Tories will be deemed responsible even when they are not. The IFS and the Financial Times will raise an eyebrow but their impact on most media comment will be regrettably small.

I fear we are returning to an age of deficit bias, which I have to remind younger readers was the tendency in many (not all) countries to gradually increase their debt to GDP ratio during the 30 years before the Global Financial Crisis. There is always the temptation for politicians to cut taxes or increase spending by increased borrowing to gain popularity. Austerity during the Global Financial crisis may be an exception to that rule, or more worryingly deficit bias may be how right wing politicians shrink the state in normal or good times and austerity (deficit deceit) is how they do it in bad times.

As a result, it is entirely legitimate for the left to criticise these plans on fiscal responsibility grounds as well as citicising their impact on the distribution of post-tax income, should these plans survive either candidate becoming Prime Minister. I make no apologies for saying this again: the Labour party is the only UK political party to have set out a fiscal framework that both prevents austerity and also prevents the kind of irresponsible fiscal giveaways that are being proposed by our future Prime Minister.

Forecast errors compared

And a coda defends experts against Aditya Chakrabortty

A recent conversation got me thinking about different types of macroeconomic forecast error, and what implications they might have for macroeconomics. I’ll take three, from a UK perspective although the implications go well beyond. The errors are the financial crisis, the lack of a downturn immediately after Brexit, and flat UK productivity.

The immediate cause of the Global Financial Crisis (GFC) was the US housing market crash, but that alone should have caused some kind of downturn in the US, with limited implications for the rest of the world. What caused the GFC was the lack of resilience of banks around the world to a shock of this kind.

Were there any indications of this lack of resilience? Here is an OECD series for banking sector leverage in the UK: the ratio of bank assets to capital. The higher the number, the more fragile banks are becoming.

UK Banking sector leverage: Source OECD

The first and perhaps most important problem with forecasting the financial crisis was that macro forecasters were not looking at data like this. For most it was not on their radar, because banks, let alone bank leverage, played no role in their models. It was a sin of omission, a big gap in our macro understanding. (Whether, if forecasters had been having to forecast this data, they would have predicted a crisis is improbable, but some would have at least noted it as an issue.)

Moving on to the second mistake, it is often said (correctly) that forecasters are very bad at predicting turning points or dramatic changes. But many did predict such a change immediately following the Brexit vote: a sharp and immediate slowdown in demand caused by the uncertainty of Brexit. It didn’t happen. The main reason was consumption, which held up by more than people were expecting, given the fall in real incomes that was likely to come from the Brexit depreciation. There are two and a half obvious explanations for this. First, because of Leave propaganda half the population thought Brexit would make them at least no worse off. Second, those who did anticipate the rise in import prices may have taken the opportunity to buy consumer durables made overseas to beat the prospective price increase. The half is that the Bank cut interest rates a bit.

None of these effects are very new. They may not have been incorporated into the forecasters’ models, but they could in principle have been incorporated using the forecaster’s judgement, although getting the quantification right would have been very difficult. In the end we got the slowdown, but delayed until the first half of this year, as Leavers began to face reality and the higher import prices came through, so it was an error of timing more than anything else (although it was apparently enough to make MP Liz Truss change her mind and support Brexit!). You could describe it as an unchallenging error, because it could easily be explained using existing ideas. It is the kind of error that forecasters make all the time, and which makes forecasting so inaccurate.

The third error was UK productivity, which I talked about at length here. Until the GFC, macro forecasters in the UK had not had to think about technical progress and how it became embodied in improvements in labour productivity, because the trend seemed remarkably stable. So when UK productivity growth appeared to come to a halt after the GFC, forecasters were largely in the dark. What many like the OBR did, which is to assume that previous trend growth would quickly resume, was not the extreme that some people suggest. It was instead a compromise between continuing no growth and reverting to the previous trend line, the second being what had happened in previous recessions.

My point of writing about this again is that I think this third error is much more like the GFC mistake than the post-Brexit vote mistake. In both cases something important that forecasters were used to taking for granted started behaving in a way that had not happened since WWII. Standard models were used to treating technical progress as an unpredictable random process. Now it is just possible that this is still the case, and the absence of technical progress in the UK and to a lesser extent elsewhere is just one of those things that will never be explained. But for the UK at least the coincidence with the GFC, austerity and now Brexit seems too great. As as I showed in the earlier post growth has not been exactly zero but has oscillated in a way that could be related to macro events.

If there is some connection, both in the UK and elsewhere, between the decline in economic productivity growth and macroeconomic developments, then this suggests an important missing element in macromodels. And like the financial sector, there is an existing body of research that economists can draw on, which is endogenous growth theory. There are examples of that happening already.

But I want to end with a plea. After the financial crisis too many people who should have know better said that failing to predict the financial crisis meant that all existing mainstream macroeconomics was flawed. It was rubbish, but such attitudes did not help when some of us were arguing against austerity on the basis of standard macroeconomic ideas and evidence. Now with UK productivity, we have Aditya Chakrabortty saying that experts at the OBR “are guilty of a similar un-realism and they have proven just as impervious to criticism” as people like Boris Johnson or Liam Fox. Not content with this nonsense, he says “This age of impossibilism is partly their creation”.

This is just wrong. Look at the elements of neoliberal overreach. Economists didn’t start calling for tight immigration controls and using immigrants as a scapegoat for almost everything. Most academic economists did not call for austerity. Almost all economists did not want to get rid of our trade agreements with the EU. Even if economists had warned about the financial crisis they would have been ignored because of the political power of finance. If all economists had thought productivity would continue flat we would have just had more austerity. [1] And in making this basic mistake, it is ironically Aditya Chakrabortty who has joined Michael Gove and other Brexiteers in having had enough of experts.

[1] Less expected productivity growth means lower future output which means lower future tax receipts which means, given the government’s austerity policy, more cuts in public spending.

Why it’s your bloody GDP, not ours

Why does the recovery mediamacro constantly talk about seem not to apply to most people? Aditya Chakrabortty tells the story behind my title better than I did here, and picks up the important regional angle. But there is more to it than that.

First, there is the abuse of language I talked about here. I make a strong case that recovery should only be used when GDP is catching up with a past trend. Instead mediamacro use it for any non-negligible increase in GDP. They are egged on, of course, by the politicians who are partly responsible for our failure to actually recover from the Great Recession.

Second is an old favourite. Mediamacro constantly uses GDP rather than GDP per capita. This makes a big difference when an economy experiences a large increase in immigration. This chart from an article in the FT recently attracted attention, showing that the UK was the only major economy over the period 2007 to 2015 to combine growth in GDP with a fall in real wages. (I assume below the chart means growth between 2007 and 2015, rather than between 2006 and 2015.)

If we use the latest ONS data, UK GDP did indeed grow by 7% between those years (0.85% average annual growth), but GDP per head increased by only 0.8% (0.1% annual growth). It is one of the great ironies of this period, and a largely untold mediamacro secret (because mediamacro hardly ever connects dots), that the government has relied on claims about GDP growth that were in large part a consequence of the immigration which they were at the same time complaining about.

GDP per capita is of course the relevant comparison for real wages. But the claim in the FT article remains true: the UK does combine growth in GDP/capita (albeit small) with falls in real wages. The chart below uses ONS data on average earnings deflated by the consumer expenditure deflator. [1] That is the relevant deflator to use, if you want to look at the purchasing power of wages. However if instead you use as a deflator the price of GDP as a whole, the GDP deflator, then you get a very different story. As the chart below shows, that measure of real wages has increased by a similar amount to GDP per capita between 2007 and 2015.

So what has caused the price of consumer goods to increase more rapidly than the price of total output? There are a number of factors, but I emphasised two in a similar analysis I did two years ago: the depreciation in sterling in 2008, and the increase in VAT in 2011. The impact of the later is clearly evident in the chart, but so is the depreciation if you recall that there was a temporary cut in VAT in 2010, which led to a short term fall in consumer prices. The depreciation raises after a lag the price of imported goods and therefore consumer prices, relative to the price of domestic output. [2]

The disparity between GDP growth and real wages is therefore due to a combination of three factors: immigration, which boosted GDP, a rise in indirect taxes and a depreciation which both raised consumer prices. If we focus on GDP per head, as we should, then very weak GDP growth caused by the global financial crisis and austerity was translated into negative real wage growth, because of the global financial crisis (the depreciation) and austerity (the rise in indirect taxes). We are not seeing a shift from wages to profits. [3]

If there is one overall message here, it is that since the global financial crisis overall GDP growth in the UK has been terrible, and austerity plus an exchange rate depreciation has made it even worse for real earnings. That the media have not presented it that way is an important reason why it seems like your GDP, not ours. 

This disconnect in mediamacro between GDP and real wages has been very evident more recently as well. On the one hand Brexiteers have made great play about the fact that GDP in 2016 has been much stronger than some had expected. The media has also noted how inflation is increasing, and earnings growth is flat, implying a squeeze on real wages. Yet the two facts are hardly ever brought together. If they were, they might note that the 1.8% growth that the Brexiteers are so proud of in 2016 falls to 1.1% if you take out population growth (immigration). And they might also note that any growth in GDP in 2017 is likely to seem like ‘your bloody GDP’ if real earnings fall because of the Brexit depreciation. (No wonder they are in such a hurry to start negotiations.) Another message of this discussion is that the media could try a little harder to relate GDP growth to average earnings, rather than treat them as disconnected events just because the statistics are published on different dates.

[1] The fall in real wages shown in this chart is a lot less than in the FT chart, but without knowing their exact source it is difficult to know why.

[2] If you are wondering how real wages managed to ride out the recession, there are two main factors involved. The recession reduced the share of profits in national income (as recessions generally do), and in addition there was a large increase in unemployment.

[3] The labour share (of GDP at market prices) did fall by over 1% over this period, but the profit share also fell. The share that increased was taxes, reflecting the VAT increase already noted.