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.

UK mediamacro myths: an introduction

I’ve written an article for the New Statesman entitled “Covering up the austerity mistake”. The first half is about the nature of the mistake, which readers of this blog will be familiar with. The second half is how this mistake was effectively ignored by most of the media. Given the size of the mistake - lost resources worth on average at least £4000 for each UK household - calling this a media cover-up is hardly an exaggeration.

Let’s be absolutely clear: this £4000 figure is not just the opinion of one economist. It is based on analysis by the OBR, which the media is happy to treat as authoritative on most occasions. The OBR say austerity reduced GDP growth by 1% in both financial years 2010-11 and 2011-12. With no significant growth in 2012, that means a total output cost of at least 5% of GDP, which is about £1,500 per person or £4,000 per household. The only serious challenges I have seen of this analysis are that the numbers are too small. My own estimate of the total cost of austerity would be considerably higher, but I tend to use the OBR based figure because the OBR rightly has authority.

This cover-up is only part of the story. What I call ‘mediamacro’ continues to portray the economy as the Coalition’s strong card, yet all the data suggests this has been the worst recovery on record, with an unprecedented failure of living standards to rise. The combination of supposed competence and terrible outturns can only be sustained through a series of interlinked macroeconomic myths. Mediamacro - and particularly the political commentators who either perpetuate or fail to challenge these myths - have created an alternative reality, where a return to average growth rates during what should be a recovery period is treated as a triumph, and where stagnant productivity is either ignored or celebrated (by praising rapid employment growth).

That the governing parties want to cover-up such a big mistake and create this alternative reality is understandable. They enjoy the privilege of having at least half of the print media available to create and promulgate the myths that allow the cover-up. But myths cannot be created out of thin air. To get the majority of the remaining media to perpetuate these stories requires that they have some link to reality - what I call a half-truth, but which is really a much smaller fraction of a truth.

As a result we have the bizarre situation that this last five years has been terrible for the average person’s living standards, but nevertheless a majority think the government is relatively competent at managing the economy. This paradox can only be explained by the widespread belief in a set of interlinked myths supported by the media. It should be the task of the non-partisan media to expose myths rather than sustain them, and failure to fulfil that task diminishes our democracy.

As this is so central to the election, I want in each of the next 8 days to discuss a particular macro myth: how it springs from a half-truth and interlinks with other myths, but why it is clearly not supported by the facts. (Apologies to non-UK readers whose interest may be less direct, but I hope you understand that occasionally I really should be parochial. Normal service will be resumed shortly after 7th May.) Each post will be short, with one diagram at most, and easily accessible to non-economists. It is really important that the facts they contain get across to as many as possible.

The mythical debt crisis

A constant refrain, from both the Conservative and LibDem party conferences, is how the current government saved the country from a crisis. Here is Osborne: “Four years ago, our economy was in crisis, our country was on the floor.” Or LibDem Danny Alexander: “We’ve seen the economy through its darkest hour ..” Now someone from outside the UK would immediately think Osborne and Alexander had got their counting wrong: the Great Recession was in 2009, which was five not four years ago. But of course they do not mean that little old crisis - they are talking about the Great Government Debt crisis. The only problem is that this debt crisis is as mythical as the unicorn.

The real crisis was the Great Recession. And if any politicians can claim to have saved the country from that crisis, it is Labour's Gordon Brown and Alistair Darling. They introduced stimulus measures (opposed by Conservatives) that helped arrest the decline in GDP. By 2010, which is when Osborne took over, the economy was growing by nearly 2%.

But surely there was a debt crisis in 2010? Indeed there was, in other countries. Crucially, these were countries that could not print their own currencies. This became apparent when interest rates on Greek debt went through the roof. Interest rates on UK and US government debt after the recession stayed well below levels observed before the recession. UK and US governments never had any problems raising money, for the simple reason that there was never any chance they would default.

So wrong time, wrong country, but also maybe wrong people. Consumers and firms in the US and UK did feel they had borrowed too much, or wanted to save more, as a result of the financial crisis. The personal savings ratio in both countries rose substantially, and stayed high for a number of years. But people need something to save, like government debt. Which is one reason why interest rates on UK and US government debt stayed low: although the supply of that debt increased, the demand for it was increasing even faster.

So why do we not hear Labour claiming that they saved us from a crisis - at least their crisis was real! Why do claims that the current government saved us from an entirely mythical crisis generally go unchallenged? Such claims are the equivalent to the Republican Congress claiming they saved the US economy. Welcome to the strange world of mediamacro. What the media should be doing, the next time this government claims it saved us from the Great Government Debt crisis, is to borrow a phrase from Jim Royle: crisis my arse!   

Fiscal legacies and competence

I’m afraid this is more on Labour’s fiscal record, and the myth that this created a huge mess that current Labour leaders should apologise for. So if you have already been convinced that this is a myth, or if you will never be convinced that it is not, do not bother to read any further. However I will say something at the end about why this issue is so important, and therefore worth returning to.

The key thing to remember is that this debate is all about degree. I have argued (and repeat below) that UK fiscal policy was not tight enough in the years 2003-7, certainly in hindsight, but even given what we knew at the time. As I said before, some of the best myths are based on half-truths. The issue is how serious this fault was. The myth is that this was a mistake of the highest order, which had serious consequences and which therefore requires an apology [1].

Now the thing about myths of this kind based on half-truths is that those who perpetuate them have an ultimate fallback position. This is to switch back from myth to half-truth, and deny that they ever suggested the myth, or perhaps even to deny that the myth exists. Some of the comments on my earlier post have made this move, and Jeremy Warner in a response to my reply to his earlier post has done the same, although I have to add in a very courteous manner. I will return to this point after running through the facts.

One other point to bear in mind is the distinction between wisdom at the time and in hindsight. Any argument that is specific to the fact that we had a financial crisis and a huge recession in 2008 is likely to be in hindsight. So, for example, I have argued that Labour should have aimed for a declining rather than constant debt to GDP ratio, in part because it would have given itself a bit more room for manoeuvre once the recession hit. However I would never dream of labelling a past government irresponsible and reckless for not doing this, because few macroeconomists argued this before the Great Recession.

There are two types of argument put forward as to why the last Labour government’s fiscal record has been something that requires an apology. The first is that it left a serious economic mess that has been costly to clean up. Let’s call that the legacy argument. The second is that it demonstrates incompetence which, unless addressed, future Labour governments will suffer from.

Take the legacy argument first. The most obvious way in which a government can mess things up for the future is by an unwarranted increase in the level of government debt. This the last Labour government clearly did not do: before the recession hit the debt to GDP ratio was slightly lower than when they took office. Of course debt rose subsequently as a result of the recession, but I talked before about why that is irrelevant.

Looking at debt to GDP may be misleading for the obvious reason that it is a stock rather than a flow, and critics of Labour focus instead on the deficit. [2] However it is not so obvious that high deficits automatically represent a legacy problem. Those same critics usually add that Labour wasted money, and if this is the case then a new government can easily correct the problem by curtailing the wasteful expenditure. Everyone gains except those the money is being wasted on, and the new government gets the credit. The argument has to be that this ‘excessive spending’, once made, is costly to reverse. But let’s leave this point to one side, and just look at the figures.

Once again the data does not look promising for the critics. The current balance (which excludes investment spending) was -0.5% of GDP in 2006/7 and 2007/8, which is hardly a large number. Public sector net borrowing, which does include investment, was around 2.5% of GDP, which seems larger, but here zero is not the appropriate reference point. A sustainable deficit is one that leaves debt to GDP constant: to take some round numbers, if the debt to GDP ratio is to be sustained at 40%, and nominal GDP grows by 5%, we need net borrowing of 2% of GDP. So an actual deficit of 2.5% again does not seem that excessive.

But the critics say that is misleading, because the economy in 2007 was at the high point of a huge boom. (The phrase ‘credit fuelled’ usually gets added at this point.) They say, quite rightly, that such a boom will raise taxes, and it is wrong to follow that with higher spending. So was the UK economy in 2007 at the end of a huge boom? Here is the OBR’s assessment of the output gap.

The OBR’s output gap in 2007/8 was 2%, which could just count as a boom, although not huge by historical standards: the mid-70s, the end of the 1980s, and the end of the 1990s are all either larger or more sustained. [3] Here is the OBR’s series for net borrowing, both actual and cyclically adjusted.

Remember that 2% is a rough benchmark for a 40% debt to GDP ratio to be sustainable. The deficits from 2003/4 to 2007/8 were too high, as my paper clearly argues. But are they of a scale that leaves a really difficult legacy for subsequent governments? The obvious comparison is with the mid 1990s. Here we had a cyclically adjusted deficit that reached 6% of GDP, but it was brought down quickly by the then Conservative government. The idea that the deficits just before the recession were so large that they would inevitably create serious difficulties for a subsequent government does not stand up. [4]

So what about the economic competence charge? Here I have no interest in comparing Labour and Conservative governments in general - that is a completely different kind of exercise. What I am interested in, and have written about, is what we can learn from Labour’s record about macro fiscal management.

The first point is that the fiscal rules brought in by the Labour government in 1998 were progressive, both in terms of previous fiscal rules and compared to what was being done elsewhere. These included a ceiling of 40% for the debt to GDP ratio, which at the time few criticised for being too high or constant over time. Against this measure, fiscal policy was too tight in the early years of the administration. The subsequent relaxation can be seen as an attempt to correct that error, which it largely did. Debt was 36.4% of GDP in 2007/8, so correction was not complete: hence, Labour could argue, the fact that the deficit was above sustainable levels. The record shows that the Labour government did respond to fiscal outturns in the right direction. The budgets of 2006, 2007 and 2008 did involve fiscal tightening. [5] So at face value the main mistake the government made, relative to its own rules, was to run too tight a policy in its early years, but it successfully corrected that mistake in later years.

Looking at the actual record more closely, however, and you can see that there were two additional systematic mistakes that were made, which did not require hindsight and which we have learnt from. I go into detail in my paper, but they involve forecasts and cyclical correction. On forecasting, it really was a game of two halves: persistently too pessimistic, and then persistently too optimistic. On its own that is not crucial. What is important is that, towards the end of this period, Treasury forecasts were more optimistic than those of other forecasters, like the IFS or NIESR. One of the documented causes of deficit bias is overoptimistic forecasts by finance ministries, and this looks like a case in point. The second lesson is that looking at numbers ‘over the economic cycle’, as Labour’s rules did, is a problematic method of cyclical correction, for reasons I outline in my paper. Two mistakes, but neither merits a charge of incompetence.

Furthermore, both these mistakes have already been dealt with by the current coalition. As I have said many times, the Conservative party deserves praise for setting up the OBR. I am pleased to have played a very minor role in helping convince them it was a good idea, and it is a great pity I could not persuade the Labour government at the same time. The coalition’s remaining fiscal rule looks at a cyclically adjusted deficit, rather than at deficits ‘over the cycle’. So unless any future Labour administration scraps the OBR, or goes back to ‘over the cycle’ rules (both extremely unlikely), then Labour has nothing left to correct!

With hindsight there are additional lessons we can learn, and the one I have stressed is that we should have a declining rather than a constant debt to GDP target. But you cannot label politicians incompetent for not realising this at the time, for much the same reason as you cannot damn them for not foreseeing the financial crisis. By such standards we are nearly all incompetent. [6]

So neither the legacy nor the incompetence versions of the myth stand up, either with a simple look at the data, or after more in depth scrutiny. But why am I so bothered about this. Why should I care if the Prime Minister says things like:

“This deficit didn’t suddenly appear purely as a result of the global financial crisis. It was driven by persistent, reckless and completely unaffordable government spending and borrowing over many years.”

and that the media does not challenge him on this? After all, this is just the kind of thing politicians do - distort the truth by as much as they can get away with for political ends. (With this particular speech, the distortion in one respect went too far, as the PM found to his cost: see here.)

Well, this blog is about presenting the macroeconomic facts as I see them, so when they do not fit a widely promoted political (of whatever colour) line, I should say so. However there is a much more important reason in this case, which is that myths influence policy. This myth is part of a pattern, particularly evident in Europe, of seeing our current problems as being to a significant extent about fiscal excess, and of setting current policy accordingly. So in Europe everything is seen as if it was Greece. (Talking of which, if you want to see what reckless borrowing really looks like, see the chart below.)

OECD Economic Outlook: General Government Financial Balances

Explaining our current problems as being in significant part as a result of fiscal excess helps buttress the policy of austerity, which in a ‘zero lower bound’ recession is completely the wrong policy to pursue.

Myths may also distort policy in the longer term too. I have asked many times why the current coalition embarked on their austerity programme when it was obviously such a risky thing to do. (It was risky because it either relied on the recovery being strong enough to take this deflationary shock, which we all know it was not, or it relied on unconventional and untested monetary policy being able to put things right.) Part of the answer - and I suspect it is a small part - is that some politicians looked back to a previous episode where a Conservative government ignored academic advice, and that was the monetarist experiment of Margaret Thatcher. In this post I looked in particularly at the affair of the letter from 364 economists. The myth on the political right is that events proved Mrs Thatcher right and the academics wrong. The reality is that the verdict on Mrs Thatcher’s economic policy is much more mixed, as I discuss here. If this myth played any part in emboldening the Conservative party to ignore the warnings from economists this time around, then current events show how dangerous macroeconomic myths can be.

[1] As suggested by Janan Ganesh here, for example.

[2] The Labour government, like its predecessor, to some extent used PFI to artificially reduce public borrowing. However the OBR calculate that “If all investment undertaken through PFI had been undertaken through conventional debt finance, PSND would be around 2.1 per cent of GDP higher than currently measured”. So not good, but not that big an issue in macro terms.

[3] As I note in my paper, if you look at the output gap series as currently calculated by the OECD and IMF, you get much larger figures for the size of the 2006/7 boom, and hence for the cyclically adjusted deficit. However, these numbers take a particular view of the productivity loss that emerged after the recession. (In simple terms, the UK’s measured productivity performance shows a sharp deterioration from the recession onwards, and the methodology these bodies use assumes underlying productivity does not change abruptly, so therefore underlying productivity must have been growing more slowly than anyone - including these same institutions - thought at the time in 2006/7.) The same numbers calculated in 2006/7 are much lower. Whether their current view is right or not, it is an argument entirely in hindsight.

[4] Remember the argument is all about scale, and whether deficits of this size created a serious problem for a future government that they keep having to remind us about. To give these numbers some kind of meaning, the increase in VAT from 17.5% to 20% raised taxes by about three quarters of a percent of GDP. Now you could say, quite rightly, that deficits were more difficult to deal with this time around because we hit the ZLB, but again that is an argument in hindsight, and one which is particularly inappropriate for the current government to use.

[5] The 2008 budget did not tighten in that fiscal year, which given the signs of the financial crisis already apparent showed foresight.

[6] Of course Gordon Brown was foolish from a political point of view to first talk up his prudential credentials, and then through a series of minor manoeuvres (see my paper for details) undermine that image. But that is politics, and here I focus on the numbers.