Budget Day Nonsense

For the last several budgets/autumn statements I have agreed to write an immediate response for some media outlet, and have therefore felt obliged to watch either the speech itself, or the media reports on the day. The good news is that no one has asked this year, and so I can ignore all budget coverage until tomorrow. This will leave me better off, because in macroeconomic terms most budget day coverage has over the last seven years been largely nonsense.

I can confidently forecast that today you will hear a great deal, at great length, about how the path of government borrowing has changed since the Autumn Statement. Journalists will ask endlessly whether he has done enough to reduce borrowing, or whether he had enough money to spend more. At the moment this is all utterly meaningless. In fact it is worse than that. It encourages people to think that government budgeting is just like household budgeting. It is, to be blunt, what gave us the disaster that was austerity.

What any macroeconomist should ask of this budget is has the Chancellor done enough to get UK interest rates off the zero lower bound: to get us out of what economists call a liquidity trap. When interest rates have gone as low as the Bank of England feels able to take them, then it has lost control of the economy. That is the situation right now. The only duty of the Chancellor in that situation is to give the Bank back control through a fiscal stimulus. [1] If he does do that the short term deficit and borrowing numbers that go with that stimulus are completely irrelevant. If he does not do that his budget has failed.

That is basic macroeconomics. But you will not hear any macroeconomics from the Chancellor, or most of the mainstream media. The idea that the Bank does macroeconomic stabilisation and the Chancellor does bookkeeping has become embedded in mediamacro, and even seven years in a liquidity trap has not been able to change this. Alas even the IFS, which is so brilliant at everything else, does not do macro and so reinforces the household budgeting metaphor.

Mediamacro will also spend hours talking about the OBR forecasts for this year and next. This too is pointless. I am sure the OBR will do what it normally does, which is put together a short term forecast that is not far from the average of other forecasters. To their great credit, they also forecast GDP per capita. It will be interesting to see who in the media picks that up. No doubt Brexiteers will go on about how great the economy has been in 2016 despite all the gloomy forecasts. There is a simple antidote to this, which any journalist can apply. Note that a great deal of the growth in GDP in 2016 was due to immigration, the same immigration that the Prime Minister has said was the cause of the Leave vote. [2]

What the better journalists focus on from the OBR is its forecast of where trend output is and how fast this trend will grow in the future. That is the only thing that will influence how much the Chancellor thinks he can borrow in future years. It is the only forecast that matters for future budgets, and as I have already noted it should have no influence on the current budget. Note particularly how the OBR has had to adjust its forecasts for future growth and tax receipts as a result of Brexit. (On this, see some good analysis by IPPR’s Catherine Colebrook.)

Of course the individual measures the Chancellor announces (either in his speech or elsewhere) are important. But even here a day’s reflection is useful, to deconstruct the spin and put the measures in context. (Once again, the OBR’s document can be very useful in that respect.) For pretty well anything the Chancellor does on the spending side, one important context is the extent to which he is just reversing the cuts his predecessor ordered. This is why the IFS wisely waits a day before presenting its post-budget analysis.

What I hate most about budget days nowadays is the constant repetition by government politicians, echoed by mediamacro, about not being able to afford improvements to public services. The reality, the detail of which Polly Toynbee sets out clearly, is that this government has managed to cut plenty of taxes which seem to have been affordable. But there is a deeper concern.

As I showed in this post, the performance of the economy since 2010 has been terrible. There has been no recovery, using the proper meaning of the word, from the Great Recession. All this time the Bank has been forced to keep interest rates at or near their floor, and use incredibly inefficient instruments like QE, because the government has kept on cutting spending. It is not normal to cut spending in what should be a recovery phase of the business cycle: at least not normal since the mistakes of the 1920s and 1930s.

In the years immediately following 2010 the government could claim its austerity policies were the international consensus, but no longer. In the Eurozone outside Greece austerity has come to an end and their recovery is gathering pace. In the US the central bank, for better or worse, is raising rates. Only in the UK does austerity continue and the economy continues to stagnate. Which is why I’m glad I do not have to watch lots of people completely ignoring all these points today.

[1] I’m not talking measures that might allow the Bank to raise interest rates by a quarter of 1%. I’m suggesting a stimulus such that members of the MPC say unequivocally rates will need to rise, and the only debate is by how much. Anything less than this just allows the economy to get blown back into a liquidity trap when something mildly bad happens.

[2] As background, GDP per capita increased by just over 1% in 2016, which does not sound so good. Average growth from 2010 to 2016 has been 1.2%, compared to 1997-2010 when the average was 1.4%, a period which included a global financial crisis and the worse recession since WWII. Having to get the deficit down is no excuse for this terrible performance, because fiscal consolidation need not reduce GDP if it is done outside a liquidity trap. This is the basic bit of macroeconomics that both this government and mediamacro fail to recognise.   

Household debt and house prices

In previous posts I have talked about why I am suspicious of (but not completely opposed to) the idea that the UK (or US) has a serious problem because there is too much personal debt. Too much popular discussion goes as follows: booms and busts are often caused by excess lending and borrowing, household debt to income ratios are currently high compared to a few decades ago, and so we must be on the verge of a new personal debt crisis. The first two points are true, but the third does not follow because of one thing: house prices.

I thought I would illustrate the key point with a graph, based on data from the OECD’s Economic Outlook.

The yellow line is house prices relative to income: the absolute level is arbitrary. The red line is mortgage debt as a ratio to personal income, and the blue line is the total debt to income ratio. The green line is the difference between the blue and red i.e. non-mortgage debt relative to income.

The key point is that most of total household debt is mortgage debt, and this follows house prices. That the two should track each other over the long term is not surprising, but the fact that mortgage debt seemed to fall exactly with house prices is. (If house prices fall, this changes the value of new mortgages, but not the value of existing mortgages.) The reason may be that in the short term the interaction is two way. A fall in the demand for house purchase (and hence mortgages) will impact on price. Non-mortgage debt is now a little lower relative to income than before the crisis.

The basic story is therefore very simple. The main reason people go into debt is to buy a house. The more expensive houses get, the more they have to borrow. If there is a problem, it is not that we have all gone on unaffordable spending sprees. It is that house prices have been rising. Rising house prices increase not only household debt but household wealth, which is a key reason why wealth was also rising rapidly before the financial crisis.

The picture for the US is similar, except that non-mortgage debt has returned to pre-crisis levels.

This suggests no near term risk of any private debt crisis. Indeed for the UK, as Chris Giles reminds us, 2008 itself was not a crisis about personal debt, but a crisis about UK banks overseas lending. As a result, talk about private debt nearing ‘2008 crisis levels’ in the future is highly misleading.

There are two reasons why house prices have been rising in the UK: not enough houses are being built and real interest rates have gradually declined (secular stagnation). As governments have relatively little control over long term real interest rates, you will only reduce mortgage debt by reducing house prices by building more houses. To put it very simply, the aggregate private debt problem in the UK is a reflection of our longstanding inability to build houses.

That is a serious problem, and not just because it prevents a lot of potential first time buyers from being able to afford to buy. It means that, if interest rates were to rise significantly, households with mortgages would be spending much more of their income paying off the mortgage, and they would be more vulnerable to shocks to income as a result. One of the problems with the recent relatively slow growth in nominal wages is that the real burden of a fixed nominal mortgage has not been falling much as the mortgage grows older.

Worse still, if real interest rates did start to recover (secular stagnation proved to be less permanent than many people currently think) this would in itself tend to reduce house prices. That could leave many relatively new home owners with a mortgage larger than their house was worth. In the UK people cannot walk away from this negative equity. Equally lenders could have loans that were no longer covered by the value of an asset. Deflation coupled with rising real interest rates is a toxic mix. But all of these problems reflect the fact that house prices are currently too high. [1]

I think the simple takeaway is this. Anyone who talks about the growing problem of total private household debt without also talking about what has and what will happen to house prices is missing the elephant in the room.

[1] It is tempting to write that high levels of private debt are a symptom rather than a cause of these problems. That is too strong: people choose to take out a mortgage to buy a house rather than rent. However as most people only own one house, it has an element of truth. It seems odd to argue that an irresponsible debt fuelled increase in the desire to own houses is pushing up house prices.