In defence of the IFS, and why it cannot tell the whole story

Our own fiscal council, the OBR, is very restricted in what it is allowed to say by the party that created it. As a consequence, it is absolutely essential that we have widely respected bodies, principally the IFS but I would also include the Resolution Foundation and the National Institute (NIESR), that are able to provide good quality economic advice at all times, but particularly before General Elections.

A good example is the Conservative manifesto published last Sunday. Without the IFS, it is quite possible that it would have made extravagant promises on public expenditure and it would have also included some tax cuts. But because the media treats the IFS as authoritative and impartial, this year they will have judged that the political costs of a manifesto like that exceeded the benefits.

So the IFS or something like it is essential. But that does not, of course, mean that it is beyond criticism. Indeed it is essential that such criticisms are made (no one is perfect). There are two types of criticism. The first are specific criticisms: it got this piece of analysis or this particular statement wrong. The second is generic: it is often wrong because of a general failing of some kind. Let me take each in turn

A specific criticism I would make is that Paul Johnson’s initial reaction to Labour’s manifesto was ill-judged in the language he used. He used three words that you will not find in the IFS’s written assessment: colossal and not credible. On ‘colossal’, the written text uses the more neutral words ‘very substantial’. More seriously, he said claims that all the tax would be raised from companies and those earning over £80,000 were not credible.

That gave the media an easy headline. For example The Times wrote “Jeremy Corbyn’s plans to raise a “colossal” £83billion in extra taxes to fund an unprecedented public spending spree are “simply not credible”, the Institute for Fiscal Studies has warned.” The Mail wrote “Jeremy Corbyn's hard-Left spending splurge is 'simply not credible': IFS ridicules Labour leader's claim he can raise £83BILLION in extra tax to fund 'colossal' giveaways JUST from the rich - warning EVERYONE will have to pay”. The Guardian wrote “The Institute for Fiscal Studies, the non-partisan tax and spending thinktank, said that it does not believe Labour’s claim that it will be able to achieve everything it plans with 95% of taxpayers not having to pay any extra in tax”

There are two issues here. The first is about the direct incidence of tax which is how everyone, apart from those with some economics, understands by the question who pays tax. It is just not clear from their initial assessment whether the IFS are claiming that Labour’s numbers on revenues are wrong in any serious way. They don’t dispute the initial figures for corporation tax (I will talk about the longer run later), and welcome the measures for capital gains and dividends tax. Yet most people reading the phrase ‘not credible’ would think otherwise.

There is of course a legitimate question mark about the final incidence of corporate tax. As I note in my earlier post, the empirical evidence on this is all over the place. True, shareholders include pension funds. But none of this in my view justifies the phrase ‘just not credible’ to the tax plans in Labour’s manifesto, particularly as Labour pledge was about initial incidence. Now interviews, particularly in the age of 24 hour news and the resulting requirement for instant reactions, are hard to get right. But nevertheless I think it is fair to say that Paul Johnson, on this particular occasion, didn’t get it right.

Is there a generic problem that the IFS are biased towards the right, or against any kind of radical manifesto. Certainly many on the left think so, but then many on the right think the IFS is in the pay of the EU because it thinks Brexit will do what pretty well all economists think Brexit will do. How you feel also depends on your perspective. If a government in a situation you think is intolerable decides to do nothing, which is a fair characterisation of the current Tory manifesto, the IFS has little to say by way of headlines besides it being ‘remarkable’ (although, as with Labour, they should have mentioned Brexit). On the other hand, the IFS is almost bound to criticise some aspect of any radical plan of the type Labour are putting forward. This just illustrates that the IFS has a very limited remit, and cannot dela with everything that influences social welfare. 

Having said that, I should note some of the things that the IFS did not say about Labour’s plans. They made comparisons with the past when talking about the size of the state under Labour’s plans, but did not (as the Resolution Foundation did do) compare that to other countries. This matters, because the IFS will know more than anyone that with any country with a state run health service the size of the state is very likely to grow over time. In addition in discussing revenue raised from Labour’s tax plans, they failed to discuss the potential Remain bonus which they had already analysed for the LibDems.

Another generic criticism is that the IFS are just bean counters. This is nonsense. For example their point about the incidence of corporation tax is not bean counting. I think the problem is more about how others use the numbers the IFS produce. For example, if you listen to the presentation of both parties’ budgets from 2017 by Carl Emmerson, you will see that they think Labour’s tax projections are too optimistic, but they still meet their fiscal rule with room to spare. Guess which number the media talked about and which they ignored. You could respond that the IFS should take that into account, but how could they do that?

A more credible generic criticism of the IFS is that they do not do macroeconomics. I have in the past made this point. If you listened to the 2017 presentation I linked to above, you will see some discussion (13.02 minutes in) of the supply side of each party’s policies. Labour have a plus (more infrastructure spending) and according to the IFS negatives (higher minimum wage, higher corporation tax, more bank holidays), and the Conservatives have a negative (less immigration), so they assume both parties will have no long run impact on output! Now it is just possible the plus and minuses for Labour cancel out, but just one negative for the Conservatives cannot equate to zero. They also assumed the multiplier from a balanced budget fiscal expansion is zero. They clearly don’t want to do macro.

Does this matter? Yes for two reasons. First sometimes macro has a critical influence on their overall assessment of plans, and as my illustration in the previous paragraph suggests it is not good enough to wish them away. Another example is in their analysis of Labour’s 2019 manifesto, where higher public investment under Labour will almost certainly outweigh any impact of higher corporation tax on investment. It is better to be humble about ignorance than pretend to take it into account and then do nothing, and better still to do something more rigorous on macro. Second, as the media takes the IFS as definitive, it means macroeconomic aspects tend to be ignored, which - as with 2019 - is very unfortunate.

The IFS have a real problem here. Their basic funding is for microeconomic analysis of tax and spending changes, and not for macro. For the Green Budget this year they teamed up with Citi who did the macro analysis. In an ideal world they would team up with a respected think tank that is known for its macro analysis, like the National Institute (NIESR). In the meantime we need to look to the Resolution Foundation, that clearly has macro expertise.

In 2019, many of the key issues are macro, or are not addressed by the IFS analysis. To see that, read the letter in the Financial Times yesterday from scores of economists. Issues of stagnant productivity, lack of real wage growth, regional inequalities, the state of public services and the need for a green transformation of the economy are all key issues influencing peoples’ welfare, are addressed by Labour’s manifesto but are not part of the IFS’s analysis. That does not mean what the IFS does should be ignored - as I suggested at the start it is vital work they do - but just that what they do is not everything that matters to peoples’ wellbeing.

Postscript (28/11/19)

The IFS's full analysis of each party's plans, released today, avoids some of the criticisms I make above. One chart below illustrates exactly the key point I'm making, which is that there are many more important things about each party's plans than whether their tax plans match their spending plans. In this case its Brexit, and it is to the IFS's credit that they showed this.

The chart shows that even though Labour's large investment programme raises debt, as it should do, this is dwarfed by the impact of a possible/likely Conservative No Deal Brexit. 

Is Labour’s economic plan credible?

Labour have a huge set of spending proposals, many of which are unequivocally good like extra spending on the NHS, some are open to debate like abolishing student loans, and only one that I think is foolish (keeping the state pension age at 66). It would be good if all the debate was about these spending pledges. However the standard excuse for why you cannot have these things has always been about paying for them.

There are actually two issues here. The first concerns current spending, around £80 billion each year or about 4% of GDP, and public investment, expected to rise by about £50 billion a year or over 2% of GDP. Labour's current spending increase is financed £ for £ mainly by higher taxes on corporations, capital gains and high earners, while the investment is financed through borrowing. Let me take each in order,

The figure for the increase in current spending and taxes is large. I personally would not call it colossal but it is large. I would argue that reflects the extent of the squeeze we have seen on the public sector since 2010. But what about the argument that it makes the share of government current spending in GDP the highest since the 1970s? A much better comparison is to look at other countries, as the Resolution Foundation has done here.

What Labour’s plans do is to move the UK from the bottom of the league table in terms of the size of the state to somewhere around the middle.

I think this is a key part of the Corbyn project. Under Thatcher, but particularly since Cameron and Osborne, the UK has pretended it can have a state only a bit bigger than the US. But of course the US does not have a universal health service free at the point of delivery. So a key goal of this manifesto is to move us from the bottom to the average in terms of size of states. Another way of putting it is that the UK will become closer to the European average, and further away from the US/Canada level.

The reason why comparisons with the UK’s past are misleading can be summed up with three letters: the NHS. For reasons I have talked about in the past, spending on health has been increasing as a share of GDP since WWII. Every time the Conservatives try to halt this we get growing waiting times. That means that the share of the state in GDP is bound to rise over time, unless there is some offsetting component of public spending. In the 90s there was - lower military spending following the end of the Cold War - but now there is nothing. So the size of the state is bound to rise over time.

Who is going to pay for getting us to the average of European countries. Under Labour’s plans it is the rich and corporations. I think Paul Johnson in his initial TV comments on the manifesto confused two things, and as a result said some things which were very open to misinterpretation. (Initial reactions to complex documents are often hard to get right,) There is no ‘black hole’ in Labour’s costings. The IFS say the corporation tax numbers are realistic, and I know Labour have tried hard to make them so. Johnson’s point is that companies are not people, and some people will pay this tax. The question is who.

On this issue it has to be said that there is no settled view from the empirical evidence. At one end you have the studies presented in a recent IPPR report (p11). This suggests that most of corporation tax changes fall on shareholders. Now some of those shareholders will indeed be pension funds, but that might influence those who hold those funds rather than those who hold none. Other evidence suggests a 50/50 split between shareholders and workers, and some suggest workers end up paying an even greater share. The honest answer is we do not know what the incidence will be.

There also seems to be a legitimate difference of opinion over the longer term impact of higher corporation tax. The IFS say it will reduce investment and therefore profits. My own view is that corporation tax plays a pretty small roll in investment decisions. The most important factor for investment in non-traded goods is the future level of demand, and here Labour’s strategy is very positive. For exporting firms that are more mobile, factors like the skill base, ease of exporting and political stability play a big role, which is why leaving the EU is so costly.

I have no doubt that a few of the tax increases proposed by Labour will not yield as much as they hope. But most analysis misses the elephant in the room, and that is Brexit. I think it is highly likely Brexit will not happen under Labour, and even if it did it would be far less costly than either the Tories plans, or the effects embodied in the OBR base numbers that many people use. For this reason the LibDems have talked about a ‘Remain bonus’ (in the incredible event they could form a majority government). Labour will also get this bonus.

As to the investment part of the programme, the key issue is once again whether the investment is needed and well spent. We should not be talking about whether it is safe to borrow it. There is virtually no chance that this money will not be available at low long term real interest rates. No one should be scared of investing in the future of our economy and the planet, whether its by adding 2% or more to the deficit.

Much more interesting than the ‘do the numbers add up’ question is thinking about the macroeconomic impact of Labour’s plans. If you read some people there will be an immediate run on sterling as capital takes its money out of the UK. Of course if enough people believe this nonsense it might happen, for a day or two. But the one area where Labour are not radical is macroeconomic policy design. We will have Bank of England independence and a solid state of the art fiscal rule. As soon as that becomes clear any depreciation will be more than reversed, and I suspect there will be an appreciation from day 1. Sterling will appreciate on the expectations of an end to a hard Brexit and rising interest rates.

Why will interest rates rise? The large increase in public investment alone represents a large fiscal expansion. So does the increase in current spending, because a lot of the tax increases will come out of personal or corporate savings. A big injection of demand in the economy will require an increase in interest rates to prevent inflation rising, although the appreciation in sterling will provide some temporary cushioning.

An appreciation in sterling is likely to raise the real wage of every worker in this country. Is an increase in interest rates a problem? For some it may be, but of course for every borrower there is also a saver. From a macroeconomic point of view an increase in interest rates is long overdue. It is a sign that that after a wasted decade we are finally getting the economy moving. You thought the economy was already strong? Just more Conservatives lies. 2010 to 2018 has been the weakest period in terms of growth in GDP per head since the 1950s.  

In the unlikely event of a majority Labour government a stimulus of this scale might lead to shortages of skilled labour that would mean some plans may be delayed. More realistically that problem would be less severe in a minority government where some of the manifesto might be blocked by coalition partners. But either way, a Labour government implementing all or the major part of this manifesto will mean the economy as a whole will end a decade of low output and wage growth that has stifled UK innovation and productivity growth.

We should ignore the tired old discourse about whether we can pay for it, and focus on the benefits each individual spending increase or investment project might bring, and on the revitalisation of the economy that this manifesto will generate.

The differences between Labour and the Conservatives on fiscal policy

The Conservatives have learnt the lesson of 2017, and have ditched austerity in order to offer higher spending to the electorate.They hope voters decide that there isn't much difference between the two parties on this score. But voters would be wrong to do so. In Labour's case the extra spending is sustainable, whereas for the Tories it will not be. There are two reasons for this.

The first is that the Tories are not proposing large tax increases, while Labour almost certainly will - in the last election corporation taxes and taxes on high earners. (In 2017 the IFS suggested their match between extra current spending and higher taxes wasn’t perfect, but they agreed Labour would keep within its fiscal rule, which is what matters.) That means for a given fiscal stance Labour should have more money to spend on non-investment public spending than the Conservatives. And, assuming there is no collapse in demand ahead, their fiscal stance is now similar. (If there is a collapse, see below).

The second reason is Brexit. The Tories have negotiated a very hard Brexit, leaving the Customs Union and Single Market. I have argued that Brexit will not happen under Labour, but even if it did a much softer Brexit means less economic damage. Soft or no Brexit means higher incomes under Labour which in turn means higher taxes, and so higher spending.

What the Tories are counting on is that analysis by the IFS and others of the two party's programmes will ignore the second difference, and use a common baseline (as the Resolution Foundation does here). Once you factor in Brexit, the Tories extra spending is unlikely to be sustainable. They willl be forced to raise taxes or cut spending to keep to their current balance target. It will be even worse if Johnson throws in some last minute tax cuts in a desparate attempt to ensure he gets a majority. The OBR might have shown all this in its budget forecast, but the budget was conveniently postponed.

Not only will Labour spend more on day to day government expenditure, but they also plan a much more radical increase in public investment spending. Whether you think that is a good idea will depend on how seriously you take the need for a Green New Deal, how much you want to reduce regional inequalities and how much social housing you want the government to build, among other things. That will mean more borrowing under Labour, but public investment of this kind should be financed by borrowing. No one should argue we cannot invest to reduce climate change because it means borrowing more!

Those are the headlines from yesterday. The rest is only of interest to those who worry about fiscal rules. For the details of what each party's new rules are I'm relying on this account by the Resolution Foundation.

1) Both Conservaives and Labour are now targeting the current balance: the deficit minus net public investment. The Tories have given up Osborne's foolish move to target the total deficit, and like Labour's Fiscal Credibility rule will not constrain investment in the deficit part of the rule. There are two differences. Labour targets the current balance five years ahead using a rolling target, whereas the Tories will target it three years ahead with no rolling target. I argue in my paper with Jonathan Portes that in a mature economy with a fiscal council like the OBR a rolling 5 year target makes more sense, because it is more robust to shocks just at the end of the target period.

2) Labour's Fiscal Credibility Rule departed from the suggestions in that paper by having a target for debt. The big change in this election is that this is replaced by a target that includes government assets as well as liabilities, a suggestion that both the Resolution Foundation, INET and the IFS’s Green Budget have made. If you are going to have a stock target (see below) this type of target makes more sense. The Tories have a weak and conventional 'falling debt/GDP' target.

3) Both rules appartently include limits for debt interest in relation to taxes. I'm even less keen on these than debt targets, but they have been suggested by others.

4) Labour’s Fiscal Credibility Rule has a knockout that occurs when interest rates hit their lower bound. This was a key proposal in my paper with Jonathan Portes, and as a result Labour's rule was ahead of its time. When interest rates hit their lower bound, the fiscal rule would be temporarily suspended and fiscal policy would focus on an economic recovery. When John McDonnell launched his rule in 2016 one BBC reporter called the knockout a loophole, despite the fact that it would have created a much faster and quicker recovery and avoided austerity! Other than that mediamacro hardly discussed the knockout.

Since 2016, however, first the IPPR, then INET and then the Resolution Foundation have suggested very similar knockouts, reflecting a growing consensus that fiscal stimulus will be needed for the next recession. In another post I might discuss the small differences between these different knockouts, but the principle is the same and kind of obvious - if conventional monetary policy can no longer do its job fiscal policy should take over. But as we are not yet at this lower bound, Labour were quite right in 2017 not to base policy on the knockout happening, and I suspect they will do the same again in this election. As far as I know there is no knockout in what the Conservatives' propose.

The difference between the rule suggested in Portes and Wren-Lewis and the Fiscal Credibility Rule is that the latter initially contained a target for total debt, and now contains a target for public sector net wealth. While the latter is a definite improvement on the former, I personally think targets for any kind of stock in a fiscal rule are a bad idea. The reason to target the deficit rather than debt is basic to fiscal rules. Adjustment of taxes and spending should as far as possible be done slowly.

Suppose some temporary fiscal shock raises both the deficit and debt. Because the shock is temporary, there will be no impact on future deficits. At most debt interest payments may rise slightly, requiring some very tiny increase in taxes or cut in spending. Debt will gradually fall back to its pre-shock level. That is smooth adjustment. However with a debt target you need a much bigger adjustment in taxes or spending to get the debt stock down within the target period. Exactly the same logic applies to permanent fiscal shocks.

This is the basic logic of preferring deficit target to debt targets This is not to say that the debt ratio or some other stock measure are not important, but they should guide what deficit targets should be, and not be targets themselves. An analogy is a road trip where you are delayed by some congestion. A sensible person does not start taking risks by driving very fast to make up for lost time as quickly as possible, but instead think how they can make up the time gradually over the entire journey. As no one has any good idea of what the optimum level of debt is, the journey in this case is decades not 5 years.

There is a technical argument that you should target both if your deficit target is the current balance, which excludes investment. If that is so, and it should be so, then in theory without some form of debt target the government could increase debt without limit by keeping investment very high. My response is that, if this really is a worry (has it ever happened in the UK over the last 50+ years?), have a target or limit for the investment to GDP ratio, as the new Conservative fiscal rule does. In this one respect I think their rule is better than Labour's, if you ignore their silly change in debt target! An investment target would avoid the dangers of having a stock target.

It would be much more sensible in my view to have just a current balance deficit target, which is occasionally revised after suggestions by the OBR in light of movements in various measures of government debt and wealth. In their recent Green Budget the IFS are very pessimistic, suggesting fiscal rules will never last a long time. I think there is a simple reason for this, and that is that rules generally contain some form of debt target. But they seem very popular with politcians in all countries, and many of those that advise them, which alas may mean fiscal rules may not be as robust as they could be.

Postscript (12/11/19)

I saw it suggested yesterday that you could ignore the points I make here because I once advised the Labour party (that role ended in 2016). Over the last decade I have advised all three of the main parties on various issues. I believe it is an economist's duty to give politicians their expertise if asked, with very mild conditions set out here. Giving that advice on technical issues should never be mistaken for being partisan, just as economists should never let their own political views influence the advice they give on these issues. 

Health spending over time

There has been some comment on the fact that, with recent increases in spending on the NHS, the health budget is taking a growing proportion of UK state spending. I am missing Flip Chart Fairy Tales, so here is a chart heavy post to make one or two obvious points that regrettably are often missing from political reporting.

The first is that health has been taking up a growing slice of our total expenditure (i.e.GDP: expenditure on everything including investment) for a very long time. Here is a chart from a recent IFS publication which is a good source for more in depth analysis.

Note that real spending numbers can be misleading: although real spending has increased since 2010, as a share of GDP it has not, which is a reversal of previous trends. That alone does not inevitably explain recent problems in the NHS, but it certainly could do.

So why is it only recently that the growing share of public spending has been so obvious? Again the IFS have a handy chart that goes a long way to providing the answer.

In 1955/6, defence spending was over 20% of total spending, while by 2015/6 it had fallen to just 5%. This peace dividend (actually two: first a retreat from empire and then the end of the cold war) masked a steady rise in heath, which was only 7.5% of total spending in 1955/6 but was approaching 20% by 2015/6.

Many economists would simply describe this as reflecting that health was a luxury good, which means that spending as a share of income rises when income rises. Not all the evidence confirms this, e.g. the spending patterns of lottery winners. In reality I think there are various things going on. One may be that medical science has got better at prolonging life faster than it has held back the aging process. Another is that medical innovation is increasing the scope of what medicine can do. For example cancer is now increasingly survivable, but only with expensive care. While there is productivity growth in the NHS, it is below the national average and therefore fails to match increases in wages. In the document all the figures so far come from, the IFS expect these factors will require real health spending to increase by 3.3% each year over the next fifteen years.

Politicians, particularly those adverse to taxation, love to think that some kind of reorganisation will somehow change the inevitability of an increasing share of government spending and GDP. But this chart, taken from this source, suggests these trends are not some peculiarity of the way we organise things in the UK

In 1970 health spending was between 4-6% of GDP in these 5 countries, but by 2016 it was between 9-16% of GDP. (There is a definitional break in the UK series in 2013: there was no leap of spending in 2013 as earlier graphs show.) If there is any organisational lesson here, it is not to run a health service in the way they do in the US. It is indicative of the mess the world is currently in that politicians are busy trying to dismantle the positive recent reforms in the US and key politicians in the UK have once talked about making the UK health system more US like.

If the IFS is right, this inevitably means that taxes of some kind will have to rise significantly. Yet the Conservatives have repeatedly pledged not to raise any of the headline taxes, and Labour have felt compelled to match these pledges at least in part. That the budget included increases in the tax thresholds, and Labour’s internal spat over whether to vote for them, illustrates nothing has changed in this respect. This year this tax/spend dilemma was avoided by a tax windfall no one had forecast. But at some point in the near future something will have to give, and I really hope it is not once again the quality of our health services.

How UK deficit hysteria began

Laura Basu has a good book just out on UK media coverage of events from the Global Financial Crisis (GFC) until 2015, which I have reviewed for Open Democracy. Among other things, it tells the story of how what Mark Blyth calls the ‘biggest bait and switch in history’ happened in the UK. Laura argues that it can be dated almost exactly to the Budget of April 2009.

That the right wing press would start talking about the horrors of the rising UK deficit is no surprise. Osborne had decided in the previous year to oppose the Labour government’s stimulus measures because he saw in the rising deficit a way to beat Labour. The puzzle is why a broadcast media, ever conscious of balance, pushed the same line, even though it was clearly advantageous to one side politically.

The following story is mine, not Laura’s. Before the GFC, the way that the broadcast media covered budgets had become quite formulaic. Each budget would present estimates of the deficit over the next five years, and with the help of the IFS commentators broadcasters would discuss not only what tax changes had been announced, but also what might be implicit in the projections. No doubt this framework suited journalists well, because it allowed easy analogies with households. If the IFS felt that the projections were over optimistic and therefore fiscal rules might be broken, they said so and that became one of the budget talking points. The state of the economy was hardly ever discussed, because the Bank of England seemed to be doing a pretty good job of keeping things stable.

That all changed with the GFC, when monetary policy ran out of reliable levers to manage the economy. However journalists wouldn’t know that from the Bank of England, who tended to talk as if Quantitative Easing was a close substitute to interest rates as a monetary policy instrument. They would know it from academic macroeconomists, but journalists were generally too busy to make the effort to talk to them. For whatever reason, they did not fully appreciate how much the world had changed as a result of the GFC.

So when in the budget of April 2009 the Treasury showed the full extent of the deficits that the recession (and to a smaller extent the government’s stimulus measures) had created, journalists behaved exactly as they would have done before the GFC. Compared to deficits seen before the financial crisis, the numbers were indeed large. But crucially, because the Treasury estimated that the GFC had reduced the trend level of GDP, fiscal savings were necessary as a result. When these took the form of efficiency savings, the IFS were rightly skeptical.

So the coverage was all about higher taxes and lower spending, and whether they would be enough to close the record deficit. At no point in the subsequent discussion does anyone ask whether the current deficits are large enough to create a strong recovery. The growth forecasts are taken as given, and only their fiscal consequences are discussed, as if the former had nothing to do with the latter: an assumption that is only appropriate if monetary policy is in complete control of the economy. The government’s line that these deficits were necessary to ‘support’ the economy was almost entirely ignored.

Furthermore, the issue of whether the markets would purchase all this extra debt was already being raised. This is City speak, seeing a recession as involving more government debt and therefore perhaps higher rates, rather than understanding that the recession was caused by more saving and less borrowing so there would be plenty of new savings to buy the additional debt.

In other words the broadcasters had a framework for commenting on the budget which was appropriate before the financial crisis, but totally inappropriate after it. What they should have been asking is whether the Chancellor had done enough to ensure the recovery that was forecast, or whether perhaps larger deficits might be needed. In retrospect, that was exactly the right question to ask.

At the time, the reason for these deficits was clearly spelt out by the IFS as well as the Treasury. "The Treasury's assessment of the fiscal damage wrought by the current economic and financial crisis is breathtaking," said IFS director Robert Chote. "It will require two full parliaments of mounting austerity to repair." But in a telling indicator of things to come, the headline paragraph loses the bit about the GFC. As Laura’s book shows, it became so easy for a media prone to amnesia to forget about the financial crisis and blame everything on Labour profligacy, as after a time most voters began to believe. But the fundamental mistake was focusing on the deficit as a problem rather than as an instrument designed to produce a strong economy. The mistake came from the media’s inability to see how the GFC had changed the macroeconomic rules of the game.

How do you access unbiased expertise: follow the money?

Anyone can claim to be an expert nowadays. How do we tell real experts from fake experts, and what does that even mean? And even with real experts, how do we tell which are the ones we can trust and which are telling you what they are paid to tell you? These are big questions, but I want to look at what seems like an increasingly popular method of judging whether expertise is biased, and that is to look at who funds the experts.

There are clearly occasions when this method makes sense. A medic who promotes a drug who receives income from the company that produces the drug, for example. You would also be right to be suspicious about any think tank that is not transparent about the sources of its funding, such as Adam Smith Institute, Centre for Policy Studies, Centre for Social Justice, Civitas, Institute of Economic Affairs, Policy Exchange or the TaxPayers’ Alliance. It is not clear to me why the broadcast media gives a platform to think tanks that do not disclose who funds them.

However when various academics and research institutions produced analysis suggesting negative long term effects from Brexit, some suggested that we should treat this finding with suspicion because they received EU research funds. I have also seen the IFS described as tainted by the fact that it receives some corporate income. In fact the IFS can be accused of being in hoc to all kinds of vested interests. When it published a report estimating that Brexit could lead to a increased budget deficit of £20-40bn, Vote Leave dismissed the IFS as a “paid-up propaganda arm of the European commission” because it received funding from the European Research Council (ERC). But it actually receives more funds from the Economic and Social Research Council (ESRC), which is funded by the UK government, so by the same logic it is a ‘paid up propaganda arm’ of the UK government.

The IFS example shows the danger of taking a naive approach to linking funding to positions taken. The idea that funding from the ERC or ESRC should influence the position taken by the IFS is absurd. Government research funding is dispersed through organisations like the ESRC in part to ensure that money is given to researchers on their merits (as judged by other academics) rather than because researchers might please the current government. Because the IFS is essentially an academic research institute there is no way that who funds any research (directly or indirectly) would influence the outcome of that research. If that started happening, the IFS would begin to lose its academic reputation and therefore its core funding from the ESRC.

This point is also true of academia as a whole. However being part of academia or a professional body does not preclude a pecuniary influence on any particular academic or groups of academic’s opinions, as our example of a medic funded by a drug company illustrates. When it comes to economics an even greater problem than money may be ideological or political bias. That means, unfortunately, that you cannot rely on every academic economist to give you a reasonable idea of where the consensus or plurality of opinion lies. And you cannot rely on finding some monetary link to indicate how much you can trust a particular academic economist.

So how do the public tell when views from economists can be trusted as genuine results of expertise and research untainted by bias due to money or ideology? It is a question that is increasingly asked, but I remain surprised that more people do not point to an obvious answer.

The solution to this problem is to use polls of experts to find out if a consensus on an issue exists. There are already some regular polls of selected academic economists (interest declaration: I am part of the CFM surveys of macroeconomists). Here is the latest IGM poll showing that not a single one of the 40+ panel members think imposing new US tariffs on steel and aluminum will improve Americans’ welfare. These polls are one reason I can claim that most economists do not support austerity. (Guess who was the only IGM panel member that did not think the Obama stimulus reduced unemployment.)

Invaluable though these polls are, they are selective, and a journalist or member of the public cannot be sure that the selection method did not bias the result. I have argued in the past that it would be in the profession’s interest for professional national bodies like the Royal Economics Society (RES) or AEA (American Economics Association) to conduct polls of its own members themselves. The pre-referendum Brexit poll is an excellent example of what could be done, but it was commissioned by the Observer newspaper and not the RES. I remain unclear whether this thought has occurred to either institution, and if it has why it has not led to action. Until it is done, the absence of such polls as a resource means academics cannot really complain when individual overworked journalists take insufficient account of true expertise. [1]

[1] An important caveat here. The existence of such polls is a necessary but not sufficient condition for journalists to acknowledge expertise: see the BBC's treatment of Patrick Minford's Brexit analysis, and ignoring the polls that already exist on issues like austerity and Brexit.  

No spring in the UK air

I was not going to write anything about the non-event of Hammond’s Spring statement, in part because I confess I am tired of writing about the Conservative party’s hopeless macroeconomic policy. It is like being forced to second mark all the fails from a first year economics exam. There is a danger that if you keep on writing things like ‘the government is not like a household’ and ‘pro-cyclical policy is a mistake’ your writing becomes illegible or you start writing everything in capital letters. I can sense Chris Dillow is also running out of patience, 

So this time I will ignore macroeconomics and write instead about political economy and distribution. The political economy of modern Conservatism is extreme laissez faire in the following sense. The belief is that if you let businessmen (they are usually men) get on with things, and take away red tape, regulations, and reduce taxes, all will be well. There is no need to help with public sector investment and R&D initiatives, or worry about rent extraction: the private sector can always do things better itself. The public sector does not support the private sector, but just gets in the way. An obvious consequence is that the Chancellor is reduced to a glorified bookkeeper, and political success comes with balancing the books and shrinking the state

The results of this approach have been disastrous. This laissez faire experiment took place in the most favourable of circumstances: a recovery from a very deep recession which if history is any guide should have seen rapid growth. The result has been the slowest recovery for as long as anyone can remember. This chart from the Resolution Foundation shows this clearly.

The economic approach of those on the right of politics has therefore failed, and failed big. 

Perhaps it has been unlucky. Perhaps for some as yet unexplained reason the financial crisis has doomed the subsequent recovery. Perhaps the tepid recovery is a consequence of the particular mistakes of austerity and Brexit rather than a reflection of the overall laissez faire approach. That debate has begun in progressive circles, but in the mainstream media and among Conservative politicians we still hear talk of ‘strong and stable’. It is as if everyone is living in a postmodern world where the economy can be whatever government politicians wish it to be.

I have talked in the past about how this fiction of a strong economy can be sustained despite being obviously false. I argued that this deceit won the Conservatives the 2015 election. But I think there is another factor I have not mentioned before, and that is how the burden of austerity has been spread.

This chart from the IFS tells us all we need to know. On the horizontal axis are income deciles, with the richer to the right. On the vertical axis is the loss (or small gain) as a result of fiscal measures. The grey line shows what happened under the Coalition government. Austerity hit the poor most, but the richest also lost income. Austerity under a Conservative government, either already under way or (mostly) planned, hits the poor most and actually slightly benefits the ‘almost rich’.

We can say quite clearly, and without caveats, that the poor have born the brunt of austerity in terms of income gains or losses. In that sense we have not, and nor will we be, all in this together. Jonathan Portes estimates these changes will increase child poverty by 1.5 million over the next 5 years. Since Margaret Thatcher, Conservative governments have been and continue to be regressive (transferring money from the poor to the rich) and have increased poverty.

This chart also tells us how we can have political commentators talking about the end of austerity. Political commentators are secure in the upper half of the income distribution. For them, austerity has indeed come to an end. But for those who are working class, poor or left behind austerity is very far from over. No wonder they say “that’s your GDP, not ours” when real wages have been steadily falling yet political commentators let government politicians get away with talking about a strong economy.

Austerity has hit and will continue to hit those who can least bear it, but it has had very little impact on your average Conservative party member, or your average political commentator working for the BBC. This government has not just continued where Mrs Thatcher left off in dividing this country by class, but it has also divided it by age and divided it once again over Brexit. We may have just had the spring statement, but the country is still in the winter of its discontent.   

House prices and rents in the UK

I am not a housing expert, but it seems to me that the public debate is completely confused because it fails to make the distinction between house prices and rents. If we are talking about the supply and demand for housing, the price that equates those two things is rent, not house prices.

I discussed why here, but let me summarise the argument. Rent reflects the cost of being housed, of having a roof over your head. If there are less houses to go around, rents will be higher: higher enough to make some people share flats, live with parents or whatever. Because houses to buy can quickly change into houses to rent, there are not really separate markets for buying and renting, but just one big housing market.

The price of a house is the price of an asset. The asset in this case provides a roof over your head for as long as you own it. This means that house prices depend on current and future rents. Crucially, however, like any asset, the price is the discounted sum of future rents, where the discount rate is the real rate of interest. If real interest rates fall but future real rents stay unchanged, housing becomes a more attractive asset, and so wealthy people will buy more houses, pushing the price up.

Below is a chart of the ratio of house prices to rents in the UK and France, from OECD data.

There are large swings, but no major trend before around 2000. (That may surprise people, but it reflects what has happened to rents which we will come to.) In the early years of this millenium the house price to rent ratio increased substantially in both countries, and has stayed higher. I have included France with the UK to suggest that there may be some common factor influencing their similar behaviour. [1]

That common factor is real interest rates. You can define real interest rates many different ways: here I’m just going to be very lazy and pull data from the World Bank.

Again ignore the details (I have no idea about 1995) and focus on the trend. Around 2000, real interest rates started falling, and falling substantially. As real interest rates fall, house prices rise.

This will only be true if the housing market is liberalised so that this kind of arbitrage works, and that there are no taxes that stop the arbitrage happening. That was not the case in the UK before the 1980s (mortgages were rationed when I bought my first house), which is just one reason why you would not expect this relationship to hold over that period. But in the last two decades, lower returns on other assets has seen the rise of the middle class landlord as a way of saving for retirement.

This substantial fall in real interest rates is a worldwide phenomenon, and it goes by the name of secular stagnation. Why it has happened and to what extent it is permanent is still the subject of lively debate, which is beyond the scope of this post. The key test will be when nominal interest rates begin to rise over the next few years: to what extent do real interest rates rise with them. All I can say for sure is do not rely on those who say house prices always rise over time.

Thus the rise in house prices in the UK and France since 2000 has got little to do with a lack of house building, a point that Ian Mulheirn has stressed. But what about rents, which is where we should look for any imbalances in supply and demand. Here is some IFS data from a recent paper by Robert Joyce, Matthew Mitchell and Agnes Norris Keiller.

Outside London, there has not been a rise in the proportion of income spent on rent. Essentially, and I suspect this applies before the mid-90s, housing costs (rents) have risen with earnings rather than prices, and at constant real interest rates that would mean house prices rising with earnings. This represents a very reasonable return on any asset, and is why we think buying a house is a good investment. Now you could argue that we should build enough houses so that this proportion of income spent on housing falls, as it has for food for example. What you cannot argue is that building too few houses has anything to do with why houses have suddenly become unaffordable to young people.

The situation for rents has clearly been different in London in recent years, and London house prices have also risen much faster than elsewhere. David Miles and colleagues have written an interesting paper on how house prices in cities can rise as more people work in them but transport costs do not fall. In recent years UK governments have been trying to reduce the subsidy for train travel, and higher rents are a natural consequence. One way to reverse this is to invest in new and improved transport links into cities. However I think the main reason that house prices have recently risen in major cities in many countries is the decline in real interest rates noted above. (Here is the same debate in Vancouver.)

Does secular stagnation (low real interest rates) mean that a whole generation has to rent rather than buy? The main problem is the deposit that first time buyers have to find. Low real interest rates mean a mortgage is easier to service once you have one, although low rates of nominal earnings growth mean that it doesn't get so much easier over time as it used to. But rising prices means rising deposits, which if parents cannot help means saving for a long time. Banks do not want to take the risk of lower deposits, particularly if there is a real chance that house prices could fall. Help to Buy is about the state taking over the risk that Banks will not take, but is that something we collectively want to do? That is the debate we should be having in an age of secular stagnation. Building more houses may or may not be fine, but if real interest rates stay low it is not going to make houses affordable again for the generation that can no longer buy a home.

[1] It is fascinating to look at the countries that are similar to the UK and France, and those that are not (like the US and the Netherlands, but especially Germany). If anyone can tell me why these countries have not seen a permanent upward shift in house prices I would love to hear it.