The austerity winds have changed

OK, back to the usual business. When a recent note to Labour's shadow cabinet on fiscal policy was leaked, the biggest negative reaction appeared to come from critics within Labour’s ranks. As a result I posted this, directly attacking what I called the left’s apologists for austerity. [1]

In that post I said the “rational case for imposing yet more austerity on the UK has all but disappeared”. Let me expand on that here. First, let’s look at other countries. The following table is from the IMF’s WEO database [2] and shows the projected deficit (as a percentage of GDP) for each of the G7.

	2014	2015	2016	2017	2018	2019	2020
Canada	-1.640	-1.664	-1.340	-0.960	-0.733	-0.615	-0.285
France	-3.975	-3.776	-3.370	-2.818	-2.129	-1.398	-0.747
Germany	0.306	0.511	0.301	0.354	0.561	1.036	1.036
Italy	-3.035	-2.686	-2.012	-1.249	-0.808	-0.447	-0.204
Japan	-7.295	-5.934	-4.549	-4.050	-3.751	-3.831	-4.143
UK	-5.672	-4.249	-2.830	-1.649	-0.755	-0.021	0.125
US	-4.108	-3.836	-3.590	-3.288	-3.373	-3.889	-4.165

We can see that the amount of projected fiscal tightening (the change in the deficit) is far greater in the UK than elsewhere. Only one country currently in deficit is aiming for a surplus, and that is the UK. If the UK followed a more sensible rule of aiming for current balance (which could avoid the welfare and additional spending cuts Osborne specified after the election), the 2020 figure would be minus the level of public investment, which under Osborne’s plans would be -1.8%.

It is very hard to find any respected institution or economist that will back going for overall surplus and keeping public investment low. The Economist is even talking about helicopter money (and quite right too), which is effectively a fiscal stimulus. It is just a matter of time before political commentators in the UK pick this up.

I suspect those who fear the electoral consequences of an anti-austerity line have in part begun to believe in Osborne’s political invincibility. In truth Osborne was always gambling by taking an austerity stance. He was out of tune with international opinion in 2009. He got lucky when the Greek crisis broke, but is now in great danger of overplaying his hand.

The Conservative response to McDonnell’s proposed plans tell us a lot. The spin is that Labour is planning to borrow forever. That spin is indeed consistent with Osborne aiming for surplus, but it is also incredibly weak and can be knocked down by a feather. Every company knows it makes sense to borrow to invest when interest rates are virtually zero. [3] If Osborne applied the same rule to companies as he proposes for the government, innovation and growth would grind to a halt. The 79-97 Conservative government borrowed on average over 3% of GDP each year. I could go on and on.

The austerity winds are changing once again, and Osborne has become isolated. In truth, any shadow chancellor worth his salt would exploit this by arguing against his new round of austerity. My only fear is that Labour will step back from doing so because the issue of austerity has become caught up in Labour’s civil war. This would be truly ironic, as no Labour MP who challenges Corbyn in an election on the grounds that Corbyn is anti-austerity has any hope of succeeding. Let us hope sense prevails, and Labour can at least unite in opposing Osborne's unnecessary cuts.

[1] Following this post, Hopi Sen noted that I had argued elsewhere that - in hindsight - it might have been better if Labour before the financial crisis had kept government debt close to the 30% of GDP they achieved around the turn of the century (rather than following their fiscal rule number of 40%) and asked if that would have been so different from current (or past) cuts? It is a helpful question, because it illustrates that I do not have a problem with fiscal consolidations per se, but just with the consolidations in 2010/11 and planned over the next five years.

The answer is that the two situations are very different. For a start we have a difference in scale. Keeping debt to GDP at 30% would have required reducing the annual deficit by 1-2%. The planned cuts in the deficit out to 2020 are much larger (see main text). In addition

1. from 2000 to 2007 we were not recovering from a recession, and interest rates were nowhere near their lower bound. So the overall macro risk of a tighter fiscal policy to keep the debt ratio at 30% was zero.
   
   
2. There is currently a strong macro case for additional public investment: very low borrowing costs, poor productivity performance, low real wages etc. Paying for that investment through higher taxes hits a generation ‘enjoying’ these low wages, so fails on intergenerational equity grounds. As the chart in the main text makes clear, the more reasonable aim of achieving current balance would still result in a sizeable consolidation if it was not offset by a large increase in public investment.
   
   
3. Stabilising the debt to GDP ratio at a new lower level after a windfall of unexpectedly high tax receipts in the early 2000s made sense from a tax/expenditure smoothing perspective. Trying to reduce debt rapidly, as current plans would do, does not.

[2] The database was compiled in October 2015, but despite what you may have read in the press, the Autumn statement did not fundamentally change this picture (see chart here).

[3] The UK recently sold a large amount of debt at a fixed nominal interest rate of only 2.5% for 50 years, and the sale was oversubscribed. With a 2% inflation target, that is a real interest rate of 0.5% guaranteed for half a century!

What if Labour’s pessimists are right

Want a blow by blow account of what happened at the first meeting of Labour’s Economic

Advisory Council? Before getting on to that, I thought it might be the right time to answer one comment that I have heard a lot since I accepted the invitation. Not the ‘it will damage your reputation’ line which I have talked about before, but this rather more practical one: as the new Labour leadership are almost bound to fail at the polls (see Hopi Sen for example), why waste your time?

There are two responses which I think are perfectly OK in themselves. First, election forecasting five years out is not a precise science. I do not underestimate the obstacles that the current leadership will have to overcome, but if defeat was certain would newspapers like the Sun be wasting front pages with character assassination? If general election defeat were certain under Corbyn they should be quietly hoping that the current leadership survives to fight it.

Second, with so much wrong with current government policy, it is important that the opposition has effective arguments. As we saw with cuts to tax credits, government policy can be changed. The better the arguments of the opposition, the more that might happen.

But neither of these are the best response to the ‘why bother’ question. Suppose the pessimists are right. What will happen next? There is a danger of lazy thinking here. The thinking goes that (1) the current Labour leadership will adopt a far left programme, (2) they will fail to deliver in the polls, and (3) the centrists will return in triumph and start afresh with policy. If we accept that (2) is right for the sake of argument, both (1) and (3) are way off.

Corbyn and McDonnell have to compromise with the parliamentary party. Compared to this, confrontation will only reduce what they see as progressive opportunities. Far better to play a longer game, where they seek to gradually shift policy to the left from the top but through consensus. If you think their primary objective involves cementing their position in the party by not compromising on policy, starting an open war with the rest of the parliamentary party and wholesale deselection of MPs then you still have not got over losing the election. (Of course this may not be true of all their supporters, and one of the tasks they have to deal with is in handling that.)

As a result, the platform they end up adopting will be one that nearly all Labour MPs can sign up to. Just as important, it will be one that most of those who voted for Corbyn can sign up to. The big divide will not be on the merits of the policies but on whether those policies and the leadership can win a general election. So suppose the pessimists are right and they fail at the polls, and Corbyn steps down. Who is more likely to win the subsequent election for leader of the party? Someone who accepts the majority of those policies, but appears to have more charisma and less history? Or someone who has opposed both the leadership and their policies over the previous few years, and wants to shift policy dramatically to the right?

I think the answer is pretty obvious. As Hopi Sen notes, public opposition to the current Labour leadership from within will not be forgiven by party members, so it is political suicide. The media will do their level best to hype any hint of division, but for the most part they will find it hard work. That was why the leadership election result was so dramatic a moment. It showed that you cannot lead the Labour party on a platform which is Conservative-lite when the Conservative programme is well to the right.

Which means, in turn, that a good deal of the policy positions and ideas that the current leadership develops over the next few months and years will survive, even if they personally do not. So for this reason as well, helping to contribute to that platform is not a waste of time, even if the poll pessimists are right.

As for that blow by blow account of the first meeting, you didn't really think you were going to get one did you?. But in case you feel really let down, here is a picture instead.

Labour and the deficit

A constant refrain from those who help make Labour party policy goes like this. I know what you economists say makes sense, but we tried that policy at the last election, and failed horribly. We have to listen to what the people are telling us.

So, for example, we cannot oppose George Osborne’s deficit plans, because we tried that at the last election and lost. We cannot talk about the problem of rent seeking by the 1%, because we tried that and it was seen by voters as anti-aspiration. We cannot argue for a higher minimum wage because that will be seen as anti-market and anti-business - oh wait.

I would draw exactly the opposite conclusion from the election result. On the deficit Labour tried to avoid discussion, and let the Conservatives spin the idea that austerity was the last Labour government’s fault. By failing to challenge both this nonsense [1], and the austerity policy enacted in 2010 and 2011, and the austerity policy proposed after 2015, in terms of perception it adopted the Conservative policy on the deficit. [2] That was why it lost heavily.

Some will say that come the next election the government will be running a budget surplus anyway, so why oppose the process of getting there? The answer to that is aptly illustrated by Labour’s decision not to oppose Budget plans to limit child tax credits to the first two children, or plans to reduce the benefit cap. Both are terrible policies, and it is incredulous that Labour is not opposing them. But once you concede the need for austerity, it becomes much more difficult to oppose the measures that come with it.  

Another argument is that Labour has to accept Osborne’s surplus target, because nothing else will stop Labour being accused of being fiscally spendthrift. (See Hopi Sen for example - HT Simon Cox ‏@s1moncox) This just sounds politically naive. George Osborne (as Chancellor or PM) will not suddenly drop the spendthrift argument just because Labour adopts his plans. Instead the argument will change to focus on credibility. He will say: Labour now admits that it was spendthrift in government, and in opposition it has changed its mind so often, you just cannot believe what they say – so any future Labour government will be as spendthrift as the last.

Others will respond to the above by saying how can you argue Labour lost because it was not left wing enough! But challenging austerity is not ‘left wing’, it is just good macroeconomics. The idea that opposing austerity, or advocating less inequality, is akin to what Labour did between 1979 and 1983 is absurd.

If there are examples to draw from, it is to see how your opponents succeeded where you failed. The Conservatives did not regain power in 2010 by moving their policies to the left. They did it by changing their image. Until a couple of years before 2010 they had promised to match Labour on spending. But when circumstances changed, they seized their chance to change policy and focus on the deficit. It was a smart move not because of the economics, but because of how it could be spun.

In 2015, the SNP saw that times had changed compared to 2010. The idea that we might become like Greece was no longer credible, and voter attitudes on the deficit were much more divided. So they campaigned against austerity, and partly as a result wiped Labour out. (Their actual policy proposals were not very different from Labour, but unfortunately few voters look at the numbers: it is perception that matters.)

The lesson is that when the external environment changes, you try to exploit this change in a way that enhances the principles you stand for and gains you votes. As the deficit falls, putting this at the centre of policy will seem less and less relevant. In contrast, the costs of austerity and rising poverty that are the result of ‘going for surplus’ will become more and more evident. Osborne, by going for an unnecessarily rapid reduction in debt by means of increasing poverty, has thrown a potential lifeline to Labour. Unfortunately, Labour appear to be swimming away from it.

   

[1] Chuka Umunna writes: “Some economists reject this [supporting going for surplus] approach as it would, in their view, necessarily entail simply capitulating at the feet of George Osborne. In their view all we need to do is – in ever more strident and louder terms – shout back at the electorate that it was not profligacy on the part of the last Labour government that caused the crash, but a banking crisis. And, in respect of borrowing, far from acknowledging that we understand the need to reduce national debt, we need to enthusiastically go about making complex arguments for different types of borrowing. Do this and the public will see the light.”

I guess I am one of those economists. I would respond that Labour in 2015 made no attempt to seriously debate this issue, let alone shout about it. The only people challenging the myth that Osborne and much of the media were telling were ‘some economists’. I do not think it is ‘complex’ to argue that you should borrow to investment when interest rates are low, and I think this argument can be effective - which is why Cameron called the people making it dangerous voices.

[2] The SNP saw that Labour were endorsing the importance of deficit reduction, and exploited this by arguing against austerity.

Bold macroeconomic policy changes for a new government

One of the features of the incoming 1997 Labour government was that it undertook significant and progressive changes in macroeconomic policy. Not only was it right to give independence to the Bank of England [1], but the institutional framework they created for this was innovative and effective. As I have written recently, the fiscal framework established a year later was also clear and progressive compared to past practice and what was being done elsewhere.

So could the government that gets elected in 2015 be equally bold? I think it could be. Furthermore, the suggestions I make below apply to many advanced economies. Yet why look two years ahead now, when recovery from recession is either far from complete, or for many countries has not begun? One reason is that the lags in policy making can be quite long. A new government will not have spent the year before an election working out its policies - it will have been too busy campaigning. Policies get decided much earlier. To have a chance in that decision making process, ideas need to be bounced around earlier still.

On monetary policy, the new government needs to acknowledge that the recession has indicated clear problems with the inflation targeting regime. Three things need to change. First, the medium term inflation objective should be accompanied by an objective of minimising the output gap - in other words the UK should have a dual mandate like the US. Second, nominal GDP should be adopted as an intermediate target, to guide the MPC as to how best achieve these two objectives. Third, the inflation target of 2% is too low, because it increases the risk that we will soon suffer another Zero Lower Bound (ZLB) recession. In the UK the government fixes this target (which is one reason why the 1997 decision was progressive), and it should raise it. All of these changes will assist the process of recovery as well as help in the longer term.

On fiscal policy, we have to distinguish between policies pre and post recovery. If the government inherits an economy where the interest rate set by the Monetary Policy Committee is still at 0.5%, then its priority should be fiscal policies that promote recovery. I agree 100% with Paul Krugman that governments around the world have needlessly confused long term issues involving debt with this short run priority: here is one of many posts I have written arguing this. Yet the incoming government should also have a fiscal strategy post recovery.

This should involve both rules and institutions. Whatever fiscal rule is adopted, it should make three things clear. First, it does not apply at the ZLB. [2] Second, it should focus on a long term objective of reducing the debt to GDP ratio. Third, deficits have to be flexible in response to shocks in the short term. Now how you square these three things is tricky, and I still have an open mind on this, but for the moment you should read this very interesting proposal from Tony Dolphin at the IPPR as to how it might be done. That proposal utilises an enhanced UK fiscal council (OBR), which is the institutional leg of the reform.

Before discussing that, however, I want to say a bit more about why the policy goal should be to gradually reduce debt to GDP. I would give four main reasons. First, it allows room for fiscal policy to support monetary policy if it again hits the ZLB, without worrying about the bond markets. Second, it reduces real interest rates, which should encourage private investment (although the more open the economy the smaller this effect will be). Third, it reduces future distortionary taxation. Finally, future generations will need all the resources we can give them to help cope with their inheritance of hugely disruptive climate change.[3]

In the context of similar proposals from Hopi Sen [4], Chris Dillow recently raised some doubts. Some of these relate to the short term position: yes, investment probably responds more to expected future growth than the cost of capital, but with an active monetary policy, reducing debt to GDP should not inhibit growth. A more serious concern is that reducing real interest rates might increase the risk of hitting the ZLB, which is one reason why I propose raising the inflation target. [5]

The current government should be credited with setting up the OBR, but it did so with a very restricted remit. The OBR is not allowed to crunch the numbers on alternative policies, so it cannot even produce the raw material on which others can propose advice. Perhaps this made sense to avoid throwing a new institution into the middle of a fierce political debate in 2010, but it does not make sense in the longer term. At the very least the OBR should be given the freedom to look at alternative fiscal policies, but its role could go further still, as the IPPR proposal suggests.

[1] I should confess that before 1997 I was very dubious about central bank independence. In retrospect that was because I did not have the imagination to see how that the institutional set-up could be crucial. Despite my recent criticisms, I think the MPC has done much better than elected governments would have done. However my fears were that we would get something more like the ECB, so they were not groundless. I also worried that an independent central bank might be too conservative in the Rogoff sense, and that concern has also been realised. 

[2] Or equivalently, there should be a rule that directs policy in very different ways at the ZLB.

[3] In an ideal world, we would be dealing with climate change now, and perhaps - as I discussed here - using higher government debt to help pay for it. However we are not, and it does not look like this is going to change any time soon.
Postscript 24/6/13: As well as leaving capacity for fiscal stimulus after a large negative demand shock, Obstfeld argues that we need low debt to leave capacity for a (partial) bail out of the financial sector.

[4] I obviously disagree with Hopi on how the Labour party should respond to the myth that their fiscal mismanagement was responsible for the UK’s current plight. If you want to get into the apology idea, then it seems reasonable that governments should only apologise for major errors rather than every particular thing they could have done better. As I have argued before, there is no comparison between Labour’s fiscal errors and the current government’s mistakes. Governments that commit errors that go against expert opinion at the time bear a particular responsibility. Few (myself included) raised objections to the constant 40% debt to GDP ratio when it was adopted in 1998.

[5] In the UK I suspect that the main short term impact of a tighter fiscal regime will be a depreciation in the exchange rate rather than lower interest rates. In the context of the last Labour government, I think that would have been helpful.