Will Brexit make austerity worse?

There seems to be some confusion among some on the left about the impact of Brexit. Statements like ‘Brexit will make austerity worse’ by Remainers are imprecise, so let me spell this out. Because of the controversy this generates I’m afraid this is going to be a rather dry, analytical post. But if you think government spending can somehow reverse the negative economic impacts of Brexit, this post is for you.

Brexit will reduce UK trade relative to what it would be if we stayed in the EU. How much will depend on the type of Brexit. As I outlined here, it will not be possible to come near to replacing that trade through new trade deals. So less trade is a given.

Less trade reduces GDP mainly because it reduces productivity. Trade allows specialisation. Instead of Honda cars being produced in each EU country they can be made in just one, which allows (in part because of what economists call economies of scale) the cars to be produced more efficiently. Trade also increases competition (you can buy many makes of car in the UK) which improves efficiency. Therefore if you restrict trade, you reduce productivity. Less productivity means less GDP. I discussed how much GDP could fall under May’s preferred trade arrangement here.

A reduction in productivity is a supply side decline in GDP. It is very different from a demand deficient recession of the kind we had after the GFC. In a demand deficit recession fiscal policy (more government spending or lower taxes) can be used to restore demand and therefore GDP, and must be used if interest rates are stuck at their lower bound. The tragedy of austerity from 2010 is that the opposite was done. The decline in GDP brought about by lower productivity following less trade cannot be tackled in that way.

When GDP falls, taxes fall. To keep the deficit constant, that requires a reduction in government spending. Brexit will reduce government spending compared to what it would be if we stayed in the EU. To that extent Brexit makes austerity worse. To say that those who point this out are advocating a continuation of the policy of 2010 austerity are wrong.

It is important to note that what I am doing here is comparing two states of the economy, and saying what the differences would be between those two states. This type of comparison confuses many people. I am not saying government spending is going to be lower than it is now - it almost certainly will not be. People say cannot we do something to mitigate the impact on GDP of Brexit? There are many things that can be done to improve GDP, like more public investment, but they could also be done if we stayed in the EU. If you think there is still spare capacity in the economy then GDP can be raised by fiscal or monetary policy, but that is equally true in or out of the EU.

Does government spending have to lower out of the EU compared to inside the EU? The answer is no, which is why statements like Brexit will make austerity worse are incomplete. You could keep government spending at the same level in and outside the EU. But that would raise the deficit, which requires higher taxes. So in that case Brexit would increase taxes. So a correct statement would be that Brexit either reduces government spending or raises taxes or some combination of the two.

At this point you get MMTers up in arms. The deficit does not matter for a country with its own currency and so on. Or even worse, that government spending determines taxes and not the other way around. This is a very good illustration of how misleading MMT rhetoric can be. To see why, go back to the case where government spending falls in proportion to GDP under Brexit, which means the deficit is unaffected by Brexit. Now suppose you increased government spending to the level it would have been without Brexit. That is an expansionary fiscal policy, which stimulates demand which raises inflation. The obvious way to reduce demand and inflation is to raise taxes so the deficit is back to its original level. It does not matter whether you need to keep the deficit unchanged because you have a fiscal rule, or you have fiscal policy stabilising the economy as MMT advocates, you get the same result.

Some MMT followers never admit they are wrong, so I got a lot of stuff about how you can use other measures to reduce inflation like credit controls. But you could use them if we stayed in the EU as well to allow higher government spending or less taxes. There is no obvious reason why leaving the EU makes such measure more effective.

The correct statement about the impact of Brexit on the public finances is that it means government spending will be lower or taxes higher or some combination of the two. Furthermore the overwhelming majority of economists think GDP will fall as a result of Brexit, and I have not come across an academic whose field is trade economics who thinks otherwise. If you think, as I do, that this government has reduced public spending way beyond the level that people want, and therefore you want to raise that spending, Brexit makes that more difficult. .

When the media is biased against the facts

When I write about what I call mediamacro, which includes bad reporting of macroeconomic issues by the media, I often receive comments suggesting that the importance of the media’s bias against Labour is exaggerated, and anyway there is nothing that can be done about it. Now of course the print media is biased against Labour, and what evidence we have also suggested a BBC bias against Labour under Miliband. But most of the time when I complain about BBC and other non-partisan media reporting on macroeconomic issues, it is not a bias against Labour that concerns me, but a bias against the facts.

Take the proposition that austerity was required because Labour borrowed too much. That proposition is simply false. The increase in the government’s deficit occurred in 2008/9 and 2009/10 as a result of the recession caused by the global financial crisis. As I noted most recently here, the Labour government before the recession was clearly not profligate in the normal meaning of that term. So when Conservatives constantly talk about having to clear up the mess Labour left, and this goes unchallenged in the media, that has the effect of legitimising a false statement.

What we have in this case is a variation on what they call in the US a ‘shape of the earth: views differ’ style of reporting. In that case one side claims the earth is flat and the other side says it is round, and the media in an effort not to appear politically biased report it as a disputed fact. If you think that example is too wild, think about climate change, or maybe wait until the US election where Trump is one of the two candidates. Was Obama a US citizen: views differ.

What we get as a result is a bias against the facts. In the case of Labour and the deficit, because Labour chose fatefully not to challenge the Conservatives on this, the media takes this as confirmation that it must be true rather than checking the facts themselves, or shy away from presenting the facts because that would be seen as ‘too political’. Myth then becomes a fact that even some Labour MPs start believing, and when someone actually stands up for the facts they are assumed to be dishonest or a slightly mad professor. So the BBC fails in its mission, which is to inform and educate as well as entertain.

I was going to advertise my talk in Bristol at this point, which will also explain how this failure played a major role in the 2015 election, but I see that it is now sold out. If there is sufficient demand I will write up what I say and publish it here. 

Time to rewrite a bit of oral history

I have written at great length about the myth that the Labour government created the need for austerity, or as George Osborne likes to put it, how he has had to clear up the mess that Labour created. Here he is again, in an exchange with Yvette Cooper yesterday. And I long for the day that after he, or any other Conservative, repeats this line, someone has the courage to reply: “that is total bollocks”. This bit of oral [1] history has survived for too long.

I will not go again through all the details (for that see these two posts), because a simple picture tells you all you need to know. Here is the UK government deficit, as a percentage of GDP, since 1970.

The deficit in the five years before the global financial crisis was around the average over this whole period. It shoots up in 2008/9 and 2009/10 for one simple reason: the UK, like most other countries, experienced the largest recession since WWII. Osborne has been clearing up the mess left by a major recession, which left UK GDP around 15% below its pre-recession trend. And the real irony is that he has done nothing to fix that very real problem, but instead obsesses about one of its symptoms.

Yet as long as this myth continues to go unchallenged, Osborne can portray Labour as unfit to run the national finances. As long as it goes unchallenged, a large section of voters will continue to believe that austerity was Labour’s fault. I think most people now agree that Labour made a huge tactical mistake when they failed to combat this narrative five years ago. But as this little exchange from yesterday shows, the damage to Labour the myth has done is not going to go away because the Conservatives will not stop repeating the myth.

I therefore have a suggestion. John McDonnell should send a copy of this chart to every Labour MP and tell them to always keep a copy with them. The next time the ‘clearing up the mess they left’ line is repeated, they should respond not by changing the subject or looking sheepish. They should produce the chart and say that it is just not true. The deficit went up because of the recession following a global financial crisis, and this chart proves it. [2]

[1] I know I'm abusing the meaning of 'oral history' here, but I do so because the written history is very different. The few scholarly papers on fiscal policy under the Labour government are consistent with the data and facts.

[2] I am also happy to suggest simple knock downs to possible responses. For example:

C: The recession was caused by inadequate financial regulation during Labour’s watch.

L: But you were constantly arguing for less regulation at the time.

C: IMF/OECD data show huge cyclically adjusted deficits in the pre-recession years

L: Extremely dubious (the OBR who use real data to cyclically adjust do not have this, and few signs of a huge boom at the time), and pure hindsight (both groups suggested otherwise at the time).

C: Everyone knows Gordon Brown bent the rules and missed his targets

L:  George Osborne has missed 3 of his own targets. Of course policy was not perfect under Labour, but that does not change the fact that the deficit more than tripled in size between 2007 and 2009, and that was all down to the recession.

C: Labour did nothing to tackle the deficit in their last two years in office, when George Osborne was saying they should.
L: You are right, and we make no apology for it. In 2009 the UK, along with the US, Germany and China, undertook a fiscal stimulus, which George Osborne argued against. Every serious economist agrees that helped prevent the recession being even worse than it was. Which means if Osborne had been Chancellor in 2009, UK unemployment would have risen by more and real wages would have fallen even more.

Lack of accountability

In 2007 the Pitt review told us that climate change was going to greatly increase the incidence of record breaking bursts of rainfall in the UK. The Labour government responded by substantially increasing their spending on flood defences in the spending review which ended in 2010/11.

The coalition government reversed those increases, leading to sharp falls in spending on flood prevention. Five years and many costly floods later, George Osborne has finally admitted he was wrong by announcing a substantial increase in money for flood defences. After being told by the government, one flood disaster after another, that they were doing everything that was possible, they have now decided that maybe it would be a good idea to spend more.

A bigger mea culpa you could not find. Yet if you google “austerity flooding”, it is still my blog post that comes top. When the floods hit around Christmas in 2013, no one seemed to want to connect the two. The government seemed immune to criticism, and successfully directed any culpability to the Environment Agency (who could not answer back). Even with the latest floods, outside the pages of the Guardian or Independent there was little criticism of earlier spending decisions. Yes Labour were slow out of the blocks in attacking the government, but are we really in a media world where if a senior politician does not talk about something it becomes a non-subject?

Chris Dillow asks why Osborne is not given the scorn and derision he deserves. As ever he gives many possible answers, but to many people one factor above all explains what is going on. It can be summarised by the following chart from the IFS, looking at who wins and who loses from this latest budget.

As I noted in my last post, Osborne felt he had to produce a budget like this for reasons that have only to do with who will be the next leader of the Conservative Party. Yet many will conclude that he (almost) gets away with it because it is in the interests of those who control the media to let him get away with it.

While there is undoubtedly some truth in this, I do not think this is quite the killer explanation that some suppose. Another important factor is that we have been living through a period in which the need to cut spending to reduce the deficit has entered the national consciousness as not only an undeniable truth, but an imperative that dominated all other concerns. So strong was that conviction that it helped win the Conservatives an election, despite the fact that they pledged to make the deficit worse by cutting taxes. Osborne had successfully characterised himself as the politician brave enough to ‘make the hard choices’ required to fulfil that imperative.

But as I have argued before, this belief that what George did and continues to do on cuts is an undeniable necessity is a product of the events of the recent past, rather than some immutable idea that the nation will forever hold. The most significant part of Iain Duncan Smith’s resignation letter is the following:

“I am unable to watch passively whilst certain policies are enacted in order to meet the fiscal self-imposed restraints that I believe are more and more perceived as distinctly political rather than in the national economic interest.”

So a plea to political journalists and commentators. Forget the spin that this resignation is all about the EU referendum (which, like all good spin, has an element of truth) and focus on this sentence. The idea that with his cuts George was and is only doing what had and has to be done is crumbling, and you do not want to be the last to notice. Start holding our government to account, not just for benefits cuts but also for the damage caused by flooding, and above all for the dire performance of the UK economy relative to the past.