What does being an iron Chancellor actually mean?

 

Rachel Reeves in her conference speech (text version) only mentioned the word ‘iron’ twice (‘iron discipline’ and ‘iron-clad fiscal rules’) but that and the nature of her speech was enough for the headline writers to label her as a potential Iron Chancellor. Which, I suspect, is exactly the way she and her team would have wanted it.

Thanks to the combination of a Global Financial Crisis (GFC) and the right wing press with its influence on the mainstream media [1] the last Labour government ended with a reputation for being loose with the nation’s finances. That reputation is completely undeserved, as I have shown many times, but it is impressions that matter here. In contrast, because of austerity, the Conservatives get far too easy a ride. It is the Conservatives who have treated fiscal rules as something you change every other budget to suit the numbers or politics, yet it is Labour who have to say their fiscal rules will be iron-clad.

The reality is that the fiscal rules Reeves is proposing are almost exactly the same as adopted by John McDonnell when he was shadow Chancellor. Let me repeat that. The reality is that the fiscal rules Reeves is proposing are almost exactly the same as adopted by John McDonnell when he was shadow Chancellor. The big difference between the two shadow Chancellors is that McDonnell announced higher spending and taxes that satisfied those rules (in 2017 at least), but Reeves has been more cautious, so far. In addition, Reeves with Starmer’s support has exerted more discipline on other shadow ministers over what they commit to.

At the centre of these fiscal rules is the golden rule: aiming to match current spending with taxes. However no Chancellor would be foolish enough to try and do that year to year. Best practice for a government like the UK is to have a rolling five year ahead target. I talked about why the golden rule is a good fiscal rule recently here.

That rule is fine as long as the economy is doing OK. The catastrophic mistake George Osborne made was to try and follow it when the economy was just starting its recovery from the GFC recession. [2] Since then, fiscal rules have often had clauses of various kinds to deal with that situation. Labour’s proposed rules do that too, by saying that in a crisis or the recovery from it fiscal policy would be used to support the economy rather than meeting the golden rule. Whereas McDonnell suggested that the Bank define when that was necessary, Reeves has the OBR doing that job. So Labour’s fiscal rules will not repeat the disaster of 2010 austerity.

Crisis apart, the golden rule implies using borrowing to invest, and again Reeves has been very clear that this is what Labour will do. However, like McDonnell’s fiscal credibility rule, Reeves also has the commitment to reduce government debt as a share of GDP, probably as a rolling five years ahead objective. This was included by McDonnell’s team in their fiscal credibility rule against my advice, because it was thought to be politically necessary to do so.

As regular readers will know, my negative view on targeting debt to GDP (or any stock measure for that matter) has not changed since I wrote this with Jonathan Portes. That successive Shadow Chancellors feel the need to include a poor target because otherwise they would get a lot of flak from the media tells you all you need to know about the lack of economic expertise in our media. That expertise says that government debt is not a bad thing, sometimes it is good to let it increase, and we have no reason to believe that current levels of debt are in any way harmful or risky. To suggest that a government that follows the golden rule would be irresponsible if it failed to reduce its share of debt in GDP is just economic illiteracy.

Hopefully this particular target will disappear once Labour are elected. It probably needs to because the amount of additional public investment that is needed after years of underinvestment is immense, and it would be a crying shame if this didn’t happen because of a daft fiscal rule. Because public investment encourages growth it helps reduce debt to GDP in the longer term, so cutting back on such investment because it would in the short term raise debt to GDP is classic short-termism.

Turning back to current spending, it is clear that the next government, whatever its colour, will have to raise taxes and spending once they are in power. As Sam Freedman says here “Starmer’s holding position that he wishes to run “a reforming state, not a cheque-book state” is transparent nonsense”. As I suggested here, the only issue is whether a Labour government does the politically smart thing and acts boldly to increase a variety of taxes in its first budget, or whether tax increases are reluctantly spread out over its first term. The public’s desire for more tax and spend is clear from the latest British Social Attitudes survey, although not quite as strong as it was in the nineties.

Reeves’s line that money for additional spending will come from growth is also at best a holding position. Spending on the NHS, social care, education and so on as a share of GDP needs to rise, which means higher taxes as a share of GDP. Once again, those who criticise these fictions of reform or spending through growth really should focus their attention on a media that makes such fictions a sensible political strategy for a Labour opposition that wants power.

Will Labour be constrained by the macroeconomic situation it finds itself in? We can consider two possibilities, even though reality will probably be somewhere between the two. The first is that inflationary pressure and high (by recent standards) interest rates continue. As long as Labour follow the golden rule, any extra current government spending should not be too inflationary because they are funded by permanent increases in taxes. [3] The shift from private sector to public sector spending will happen through higher taxes.

The same is not true for additional public investment, however. In this case the shift from consumption to investment will come through higher than otherwise interest rates. However the impact on interest rates is likely to be small, as public investment can increase substantially in proportionate terms without rising very much as a share of GDP. Perhaps more of a concern will be getting the resources for the projects (e.g. construction workers).

The second possibility at the other extreme is that UK inflationary pressure disappears very quickly, as the lagged effects of recent rises in interest rates begin to be felt. At worst, the UK may be in recession when the general election is finally called, and by the time Labour takes power interest rates could be back to their lower bound. In some ways this reduces Labour’s problems, because they can in the short run use increases in public investment and current spending to boost the economy. However, one big advantage of rolling five year ahead targets is that the recession will be forecast to be over in five years, so the tax implications of permanently higher current government spending cannot be avoided.

One final point that Reeves’s speech brought home was that Labour will be fighting the 2024 election not just its traditional ground of public services but also on the economy. To Reeves’s credit, she has been persistent at putting better growth at the centre of her message. While I agreed with that, if only because the Conservative’s record has been so poor, many others thought otherwise, because of the structural reasons why the Conservatives tend to perform better in polls about ‘the economy’. Reeves was correct, and not just because of Truss: Labour were level with the Conservatives on the economy six months earlier. What the Truss disaster ensures is that even if growth picks up next year, the Conservatives are unlikely to get much credit for it. [4]

[1] Also to some extent due to the failure of Labour to counteract this message, in part because they had an extended leadership campaign.

[2] The centrepiece of Osborne’s fiscal rules was also a 5 year rolling target for the current deficit. That rule was adopted because it was suggested by the IFS, who Osborne’s advisor Rupert Harrison had worked for. Unfortunately the IFS do not do macro, so their thinking ignored the problem of recessions where interest rates hit their lower bound.

[3] In theory a permanent increase in taxes should lead to an equal decline in consumption. There are two reasons why there might nevertheless be a positive impact on GDP. First, consumers may not regard the tax increases as permanent. Second, private consumption tends to be more import intensive than government spending.

[4] Before the 1997 election, the economy had been recovering well for a few years, but it wasn’t enough to help the Conservatives, in part because the forced exit from the ERM had blown their reputation for economic competence.

Thirteen years of creating doubt and uncertainty for UK business

France has 12 high speed train lines, and is planning to build 4 more. Spain has even more. Yet the only high speed line the UK currently has leads out of the country. Our Prime Minister, without apparently consulting anyone, has cancelled the more useful part of our second high speed line to Manchester. As Tom McTague writes: “The man from Goldman Sachs looked at the books and made a decision — and we are all supposed to accept that this is how we are governed.”

In economic terms the UK is essentially a country of two halves: the South East with London at its centre, and the rest. Below is a crucial chart taken from this post by Tom Forth, showing productivity levels in Europe’s major cities.

Near the top is London with other capitals as you might expect, but in the middle we have the other major cities of France, Germany, Italy, Netherlands and Belgium. At the bottom are the UK’s major cities. As Forth shows in his blog, this regional divergence in the UK has steadily increased over the last two decades, but as some other European countries show this is far from inevitable.

If you want to know why the performance of the UK as a whole has declined over the last decade and a half compared to most other major economies, here is a place to start. It is a mistake to see ‘levelling-up’ as just a distributional issue. When most of the country isn’t working very well, it is not surprising that the country as a whole performs badly.

A big reason for this poor performance is poor connectivity. Not just connections to London, but also connections between cities and between the cities and surrounding areas. The point of HS2 was not to get from London to Manchester faster (a very London-centric point of view), but to create greater capacity for more local passenger trains and freight on the existing lines. The most useful part of the HS2 project was not London to Birmingham, but the additional legs from Birmingham, which are the lines that have been cut.

The excuse Sunak used for cancelling the Manchester leg of HS2 was that since the pandemic people were using trains less. Demand had shifted down he argues, perhaps because more people were working from home or using zoom for meetings. Yet what evidence is this based on? Here is the latest quarterly data for the total number of rail journeys in Great Britain.

It is true that in the first quarter of this year total journeys were still less than pre-pandemic, but the numbers have been steadily rising over the last few quarters. It is way too soon to declare that there has been a fundamental shift in rail usage. [1] The suspicion has to be that the real reason for taking that decision now is to ‘make room’ for tax cuts before the next election, where the space they are making room in is a stupid fiscal rule on top of unrealistic forecasts.

Evidence that this was a hasty short term decision to save money rather than any long term strategic plan comes from the raft of measures assembled to suggest that ‘every penny of the money saved’ will be spent on other transport projects for the north. The most embarrassing is that it included a commitment to establish a rail link that already exists, but there are plenty of other contenders for that top spot. That suspicion also comes from the spin: if No.10 says they are focused on the long term that means they are doing the opposite and are hoping the spin will cover that up. Put this together with his various measures to make it even more difficult for the UK to hit its net zero targets, and we have a Prime Minister personally taking decisions for the benefit of his own short term future and to the detriment of the UK in the longer term.

Cancelling HS2, and rolling back on net zero, are two vivid examples of a long term UK problem that has become acute since 2010. The government does not invest enough, and partly as a result the private sector does not invest enough. As this excellent report from the Resolution Foundation’s Felicia Odamtten & James Smith shows, public and private sector investment are complements; the former encourages the latter. This chart from the report shows that UK public investment is consistently below the international average, and that average includes many countries that have underinvested over the last two decades like Germany and the US.

Before the financial crisis the impact of this lack of public investment on UK economic growth was masked by other positive factors (e.g. EU membership and the single market). Pretty much everything the government has done since 2010 has made this situation worse. Under the Labour government net public investment (the chart plots gross not net) increased from 0.5% of GDP to 3.0% of GDP, but 2010 austerity involved a sharp cut back in public investment to 1.5% of GDP. It briefly returned to 3% of GDP in 2020, but is now declining and is expected to decline further.

You can see that lack of public investment pretty well everywhere you look. The impact of this on the economy is not just about infrastructure like roads and rail. We have an acute shortage of hospital beds, way below most other OECD countries in per capita terms, and less equipment like MRI machines than most other OECD countries. That leads to a less healthy population and therefore to a reduced and less productive workforce.

But as the Resolution report also points out, stability in decisions is also important. Building new infrastructure will encourage private investment once it’s built, but you would hope (given how long these things take to do) that the announcement of infrastructure plans would also encourage private investment (which also can take some time to create). If you keep changing plans, or overturn the expectations business has of what governments will do, you increase doubt and uncertainty which in turn discourages research and investment. Here lies one of this government’s biggest failures, and it began in 2010.

Recessions happen, but the UK experience of the postwar period is that governments would do what they could to generate strong recoveries from recessions as quickly as possible. In the UK in particular, it is remarkable how quickly growth returned to its long term trend after each economic downturn, and a major reason for that was Keynesian countercyclical policy (monetary or fiscal). That gave business the confidence to plan ahead and invest.

Cameron/Osborne changed all that. With austerity they did the opposite (with monetary policy largely out of action), and so the recession led to a shift downward in GDP. There was no recovery for three years, and it was tepid when it came. From that point on every business knew that their plans had to allow for future recessions which might also lead to permanent shifts down in UK output.

The next rug to be pulled out from the legs of businesses operating in the UK was of course Brexit. Not only was any business importing or exporting from or to the EU hit by making it more difficult to trade, but the UK also lost its attractiveness for any potential foreign direct investment looking to access the Single Market. Ending free movement meant that inflation in the UK following the pandemic was worse than elsewhere, requiring tougher measures from the Bank Of England.

But through all this, the government kept its commitment to net zero, and to HS2. Businesses producing greener products (from energy to cars) knew that there would be an expanding market coming soon for their products. They could base their business beyond the South East of England, knowing better communications were on their way. Now, with a stroke of Spreadsheet Sunak’s pen, this rug has been pulled away too.

Measuring the impact of policy uncertainty on UK investment and R&D is not easy, but recently some studies have attempted to do that. [2] They confirm that greater policy uncertainty reduces both innovation and investment, and that policy uncertainty has on average been significantly higher over the last decade and a half than during the previous decade. Sunak’s decision to end the commitments to HS2 and net zero in an effort to obtain some political gain just continues a pattern we have seen since the Conservatives took charge of economic policy thirteen years ago. Uncertainty generated by this government’s economic policy changes are an important factor behind the UK’s relative economic decline over the last fifteen years, and Rishi Sunak’s administration has turned out to be as bad as his predecessors in this respect.

[1] The number of passenger miles travelled has been flat over the last four quarters, but that is still far too flimsy a foundation for such a major decision.

[2] The seminal study is Baker, Bloom and Davis (2016), QJE 2016. Their Economic Policy Uncertainty index (a more recent version is here) shows uncertainty stepping up around the Global Financial Crisis period, and staying higher subsequently.

Braverman is a feature not a bug of Conservative electoral strategy this century

 

Much has been written about how the dividing lines of UK politics have changed from being class based to age based. As John Curtice put it just before the General Election in 2019: “The kind of job that someone does is expected to make very little difference to how they will vote at this election. On the other hand, whether they are young or old may matter a great deal.” [1]

This in turn partly reflects a gradual shift in the subject matter of political debate over the last few decades. The big divisions are no longer over economic policy, but instead are about social issues like immigration and nationalism. Economic issues still matter a great deal to the electorate, of course, but on paper at least the two main parties since Thatcher offered broadly the same policies with relatively small, if important, differences. (The Corbyn years were an exception which did not end well for Labour, although not primarily because of their economic policies.)

I would suggest there are two main reasons for this shift. The first, elaborated in the latest British Social Attitudes survey, is that voters have become much more socially liberal over the last several decades. This includes all groups in society, but not surprisingly the views of the young have moved faster than the old (helped, perhaps, by the expansion of numbers going to universities). This rapid social change is bound to make those left behind by its speed (if not direction) feel uncomfortable.

Differential change creates the potential for political division, but only if political parties wish to exploit it. The second reason for the shift in the nature of the political divide is a deliberate change in emphasis by the Conservative party. Of course the Conservative party has always tended to be socially conservative, although this has reflected their party membership more than the attitudes of most Conservative MPs. What changed in the 1980s was the party and the press making immigration [2] their main line of attack.

To be fair, with Labour adopting large parts of Thatcher’s neoliberal agenda under Blair/Brown, it was to some extent a forced change. In particular, Labour’s shift to the right may have put them to the right of voters on some issues (like public ownership), meaning that the Conservative’s more right wing position became even less attractive. When it came to the main division between the parties, on public service provision versus tax cuts, voters tended to side with Labour.

Nevertheless, it would be going too far to say that the Conservative party and the party in the media were reluctant to shift into promoting a social conservative agenda before the Global Financial Crisis. What really convinced the Conservative party to focus on immigration in the 80s was the electoral maths.

1. As I have noted many times, the socially liberal young are mainly where the jobs are, in the large cities. The socially conservative old are more spread out among MPs constituencies, which is an advantage under a FPTP system.

2. The socially liberal vote in England was split among at least two, and increasingly three, parties, whereas (until UKIP at least, and to some extent after) the socially conservative vote was united under the Conservative banner. [3]

3. Older voters are more likely to turn up to vote

So if the Conservatives could shift the issues on which general elections were won or lost to the socially liberal/conservative divide, they would stand a much better chance of winning those elections. Yet despite their domination of the media agenda through the efforts of the right wing press, the electorate didn’t play ball sufficiently until a major recession was added to the mix.

The problem the Conservatives faced, and continue to face today, is that issues like immigration and crime tend to take second place in most voter’s minds to economic issues. The exception was Brexit, where the Leave side managed (with the help of mainstream broadcasters) to sideline the economics and win a victory based on reducing immigration and a nationalistic desire to take back control. But this apart, the party faces the problem of how to convince enough social conservatives that issues like immigration are more important than issues like the economy, their standard of living or health? That will be particularly so after large commodity price increases, over a decade of almost zero real wage growth and an NHS in crisis.

One way to raise the importance of issues like immigration is to link it to economics using plausible lies. By making claims, for example, that public services are more difficult to access because of immigration, with no mention of how immigrants make a vital contribution to staffing some of those services. Or claims that immigrants steal jobs or keep wages low, with no mention of how new workers contribute to demand as well as production. Claims that it costs a fortune to put up asylum seekers in hotels, with no mention of how this is because the government has allowed huge delays in processing claims.

Another, perhaps unintended, means of minimising the importance of economic issues was to insulate their target voters from the consequences of economic decisions, which I think is the strongest argument against the state pension triple lock. House price inflation, helped by a period of austerity that kept interest rates low, also helped.

But a large part of the answer is also by using fear.

It is easy to see the language used by Suella Braverman as just a play for the leadership after the next election, but there is more to it than that. The same language, involving dehumanisation, wild exaggeration and lies over issues like immigration and asylum, can be found regularly in the right wing press and on GB news. Labelling any asylum seekers who don’t get to the UK via the occasional official route as 'illegal' may seem like just another bit of spin, but it opens up a Pandora’s Box where those seeking refuge from persecution can be equated to the worst kind of criminals.

If you think this kind of rhetoric will only impact a small minority, I suggest you read this article by Aditya Chakrabortty about what happened when the Home Office took over a hotel in a Welsh town. 

As Tim Bale writes, the Conservative party is now the party of Enoch Powell. A lot of this happened first in the United States, of course, where the term culture war signifies the same idea. Here is Brad DeLong reviewing this book:

“I date the start of this democratic decline to 1993, by which point the neoliberal (market-fundamentalist) Reagan Revolution had already failed in policy terms. In the 1994 midterm election, Newt Gingrich, then the House Minority Whip, concluded that since the Republicans could not campaign on policy successes, they would instead run on scorn and fear – of black people, “feminazis,” gays, Mexicans, professors and other clever types, and anyone who had gotten rich the wrong way or would never come to Jesus.”

The problem with a strategy based on fear and outrage is that it invites continual escalation, all the time distancing those who promulgate this rhetoric and those who absorb it from the rest of society, from facts and from science. [4] It becomes a petri dish for both populists and conspiracy theories. It may start with calling asylum seekers illegal, and being against 15 minute cities, but you just need to look at the Republican party today to see where it ends up. It not only changes some on the receiving end of this propaganda but also those pushing it, such that their respect for democracy gradually ebbs away.

Hopefully this descent into ever more extreme social conservatism will do little but please the existing base of right wing parties, and may alienate everyone else. But it would be a mistake, as I argued recently, to think that it will disappear quickly after one or two election defeats. In particular, shifting from social to economic issues would require right wing parties to move to the left, and that is something the money that backs them is not going to allow for some time. Meanwhile there is always the chance that something may turn up which gives the party of Enoch Powell (or Donald Trump) the chance to gain or retain power.

[1] This remains true even if we look at current polling. In this recent YouGov poll, the support for Labour was higher among ABC1 than C2DE.

[2] Some argue that immigration became a major issue because Labour allowed numbers to increase, but in my view this suggests that facts have rather more importance to both the right wing press and public opinion on this issue than they do in reality.

[3] I’m tempted to add, but don’t really have the evidence to do so, that as the left wing political parties became more middle rather than working class (Piketty calls it the rise of the Brahmin Left), their interest moved from redistribution to more social issues.

[4] In part this is because Labour, seeing the electoral advantages in winning the socially conservative vote, triangulate towards the Conservative position on these issues.

Challenges to the strong golden rule: MMT and bond market paranoia

 

The idea that responsible fiscal policy involves matching plans for future taxes to projected day to day government spending, often called the golden rule, has a long history. It is often expressed, as Shadow Chancellor Rachel Reeves did recently, as saying governments shouldn’t plan to pay for current spending byborrow. There is a lot to discuss on how you should implement this golden rule (like what matching taxes to spending actually means), but here I want to focus on the principle behind the idea.

Furthermore, I want to look at a strong form of golden rule, which says that following the golden rule is all responsible fiscal policy should do. If you have a fiscal rule that implements the golden rule, you not only don’t need any additional rules, but you shouldn’t have any additional fiscal rules. In particular, as I have persistently argued, you should not have any aggregate rule that restricts public investment. [1] From memory, no UK government has ever implemented this strong form of the golden rule, because even when they followed that rule they also had additional fiscal rules.

In this post I’m going to look at two very different objections to this strong golden rule, coming from MMT on the one hand and on the other coming from what often seems like bond market paranoia. But first we need to add a big caveat, which is that the golden rule should not apply in recessionary periods [2] In recessionary periods short term nominal interest rates are either at or could soon be at their lower bound. At that lower bound monetary policy can no longer provide a predictable stimulus to the economy, and so fiscal policy should take its place. [3]

Outside of recessionary periods short term interest rates can rise and can therefore do the job of stabilising the economy. Fiscal policy therefore no longer needs to step into that role. Here I would argue that something like the strong golden rule should apply. [4] Both MMT and those worried about the bond market would disagree.

Reasonable and unreasonable MMT

MMT has two arguments against the golden rule, which I will call reasonable and unreasonable. The unreasonable argument is that interest rate increases do not reduce aggregate demand and inflation, and therefore fiscal policy has to play the macro stabilisation role at all times. It is an unreasonable claim because it contradicts the large amount of evidence that higher interest rates do reduce aggregate demand and inflation, evidence that you will find in the academic economic literature.

Estimating the impact of higher interest rates on aggregate demand and inflation is quite hard, in part because central banks put interest rates up when inflation rises. This simultaneity problem means eyeballing data just doesn’t count as evidence. For me, some of the most convincing evidence comes from studies that look at unexpected monetary policy changes, such as here for example. Until MMT can provide studies that are of a similar quality that come to a very different conclusion, then arguments that higher rates don’t reduce demand and inflation are just baseless assertions. [5]

The reasonable MMT objection is that even though interest rates can stabilise the economy, it would be better if fiscal policy did so. You could argue, for example, that fiscal policy had a more predictable impact on aggregate demand than interest rate changes. I have discussed the relative merits of fiscal or monetary stabilisation elsewhere, but the key point is that today, in almost all advanced economies, central banks use interest rates to target inflation. Given this, and the reasonable view that this works, the idea that fiscal policy should take this role instead is not a description of how economies actually work, but instead a suggestion of an alternative way they might work..

A standard half-truth that MMTers often state is that the only constraint on fiscal decisions is the demand for real resources and therefore inflation. This would be the case if interest rates were held constant when inflation rises, but they are not. So the constraint on higher government borrowing is not real resources and inflation, because the central bank will raise interest rates which will divert resources from the private to the public sector, and keep inflation under control.

Perhaps the MMT argument should be, for the economy as it actually operates, that the real constraint on fiscal policy is the level of interest rates. So why isn’t this a disincentive enough to prevent governments using borrowing to match higher spending or lower taxes where inflation is either stable or rising? Why do we need a self-imposed financial constraint of the golden rule as well?

Why higher short term interest rates are not a sufficient constraint on fiscal policy

The problem is that the implications for interest rates of breaking the golden rule may not be clear or felt for some time. Imagine, for example, that a year before an election a government permanently announces increased spending in lots of popular ways, and pays for that increase by borrowing, thereby breaking the golden rule. Interest rates may not immediately rise, because demand fluctuates from year to year for countless reasons other than fiscal decisions. Interest rates will be higher than they would otherwise have been, but most people do not follow central bank decisions that closely. The temptation for governments to use borrowing to finance popular spending increases ot tax cuts to gain votes therefore remains.

The golden rule provides a more direct and immediate check on government fiscal plans and decisions. If the government finances higher current spending or less taxes by borrowing, that will tend to increase inflation and therefore lead to higher interest rates. Rather than wait for interest rates to rise, breaking the golden rule gives us advance warning that this could happen.

So by sticking to the golden rule outside of recessionary periods, the government is in effect committing to take decisions on day to day spending and taxes which will not put upward pressure on interest rates. Nice to have, but hardly the most important commitment the government makes. The golden rule certainly does not represent an externally imposed financial constraint on what the government can do. Instead it is just good practice. The interesting question is whether there are exceptional situations other than recessionary periods where that good practice should not be followed. [6]

What about the bond markets

Following the golden rule alone does nothing to ensure that the government debt to GDP is stable or falling, or that the total (current+investment) government deficit hits some target. Any period of high public investment could mean higher debt to GDP, although public sector net worth would not change. Any fiscal rules that targets the level or change in government debt, or the total (rather than current) deficit, are not following the strong golden rule.

I suspect governments have departed from the golden rule mainly because of a feeling that they have to target government debt in some way. In my view this is a consequence of mistakenly looking at just one side of the balance sheet. Governments need to start thinking about their net worth, not their debt. (Arguably a growing failure to invest in public services across Europe at least is a consequence of this mistake.) But those who worry about the bond market (or say they do) would say we need additional targets to placate that market.

Does that market need placating? If government borrowing is rising because it is investing, why would any rational trader worry about this additional borrowing? The situation is just like a firm borrowing to invest, except that unlike a firm the government will never be forced into bankruptcy because it can create its own currency. As a result, bond holders will always get their money back. The chance that a country like the UK that is following the golden rule will choose to default on their debt is zero.

What can happen in rational bond markets is that interest rates on government debt (long rates) can increase, making it more costly to borrow to invest. Whether this happens depends on what bond traders think will happen to future short rates. If they think that higher public investment means that the Bank will have to raise rates in the future, current long rates may rise even if current short rates do not.

Whether long rates do rise following high public investment financed by borrowing depends a lot on the nature of that investment. Investment that enables more green energy will tend to lower future energy prices, putting downward pressure on future inflation [7]. But even if high public investment puts up long term interest rates, this increase is likely to be modest.

What about irrational bond market panics? The first point is that I cannot think of any bond market panic that occurred when a country was following the strong golden rule and borrowing to productively invest. The second point is that in the case of a disorderly bond market the Bank is likely to step in, as they did after the Truss fiscal event.  

This is why the Truss fiscal debacle provides no justification for going beyond the strong golden rule. That fiscal event broke the golden rule, and the predictable result was higher interest rates. More importantly, it greatly increased uncertainty in markets for sterling assets, because it was unclear whether tax cuts would be accompanied by spending cuts, and even if they were, whether such cuts were credible. The Truss event provides a good example of why governments should follow the golden rule, but does not provide any evidence that we need additional targets like falling debt to GDP. [8]

As Toby Nangle writes, "fear of bond market monsters is a bad reason to delay investment in vital infrastructure or the green transition." Imposing fiscal rules, like falling debt to GDP, that go beyond the golden rule because of fears about the bond market are both pointless and risk delaying that vital investment. 

[1] Paying for investment through borrowing not only makes intuitive sense, because it’s what consumers and firms do, but it also makes sense on fairness grounds. The benefits of investment are spread over time, so the taxes to pay for it should be too. If taxes only have to rise to pay the interest on borrowing this means that future as well as current generations pay for the investment. Of course this definition of public investment may apply rather more widely than the national accounts definition.

[2] I define ‘recessionary period’ as either a recession is likely to happen in the near future, a recession is happening or the economy is recovering from a recession. This terminology is deliberately broader than just when output is falling.

[3] In a recessionary period should we worry that the bond market will react negatively to all the extra deficit spending that fiscal stimulus is likely to create. (IMF evidence suggests fiscal stimulus could well reduce the debt to GDP ratio in a recession, but we don’t need to make that argument here.) This bond market paranoia was the public basis for UK austerity that began in 2010. Bond market paranoia in a recession is completely misguided because of Quantitative Easing: the central bank buying government debt to keep long term interest rates low. In the unlikely event that traders stopped buying UK government debt, the central bank would step in to buy government debt. We saw that happen during the pandemic as well as after the Global Financial Crisis.

Indeed we could go further. In a recession any central bank that allowed long term rates to rise because of worries in the bond market would be failing in its duty to stabilise the economy. In addition, a responsible central bank is likely to step in and buy government debt whenever the bond market acts in a disorderly manner, as it did after the Truss fiscal event. Having a central bank in charge of its own currency is our safeguard against bond market panics, whether we are in a recessionary period or not.

[4] One caveat would be that the institutional framework exists to check that public investment projects generate an adequate social return. If that institutional framework didn’t exist, then you might want to set some limits on public investment as a kind of second best. But that does not apply in most advanced economies. It is silly to use aggregate fiscal rules to kill off dozens of good public investment projects just because you are suspicious that the odd lemon might get through.

[5] There is an element of conspiracy thinking involved in this claim. It requires all the central banks that are currently changing interest rates to control inflation to be participating in some kind of mass delusion, where none have noticed that what they are doing has had no impact or is making things worse, or those that have noticed are silenced for some reason. Equally it requires that mainstream academic economists are so indoctrinated by the idea that higher rates reduce inflation that they will not allow contrary evidence to be published.

[6] A war is an obvious example, but some have plausibly argued that climate change (and specifically a green new deal) could be another

[7] To the extent it reduces national vulnerability to volatile oil and gas prices, this reduces uncertainty which will also put downward pressure on long term bond rates. However any investment in domestically produced goods is a claim on resources, so for this reason short term interest rates might be slightly higher if the economy is otherwise strong.

[8] Indeed, Kwateng did say that he would stick to the falling debt to GDP target, and that did nothing to prevent rates rising.

Democracy on a knife edge in the United States

 

Asking if US democracy as we know it will survive either seems very depressing or rather melodramatic. However it is actually quite hard to be melodramatic about the consequences of Trump becoming President again. Trump failed last time to turn the United States into a dictatorship of the kind he so admired overseas not because he didn’t want to, but because he was prevented from doing so. He and his supporters have learnt their lessons and will be much more difficult to stop if they get another shot, while those forces that held Trump back in his first term have not been reinforced.

Much of the resistance to Trump during his first term came from the established bureaucracy of government. The solution proposed by Trump supporters is to fire large numbers of them from day one. To put it in their language, they would get rid of the ‘deep state’ that opposed Trump during his first term. With the Department of Justice in his hands, a judicial system, already much more political than in the UK, would lose all independence. He would target his political opponents as he tried to do last time, and the Republican party starting impeachment hearings against President Biden on no basis whatsoever show they would be happy to go along with this. What the Republican party would surely do is ensure the US electoral system became even more biased, making it even harder to elect a Democratic President or Congress again.

The rest of the world would quickly see the effects of a Trump second term. He is unlikely to back Ukraine in the same way that the US is currently doing, forcing Europe to provide much more military support. He plans a 10% blanket tariff on all goods imported to the US. Trump and his party is likely to do everything it can to slow down the transition to green energy, which given the country’s carbon footprint would be seriously bad news for the survival of human civilisation as we know it. More generally, when Trump’s decisions are largely divorced from the normal pros and cons of politics, it is difficult to know what additional harm he could do freed from any executive restraint.

Donald Trump is the clear frontrunner to be the Republican candidate for the 2024 election despite the fact that he is facing trial in two separate cases for trying to overthrow the results of the last election, which he clearly lost. One is for putting pressure, in a recorded phone call, on Georgia’s secretary of state to find 12,000 votes to swing the state in his favour during the election. The second is a more general charge of trying to overthrow that election result by various means, including his role in the 6th January attack on the Capitol.

It seems incredible that someone charged, and perhaps even by then convicted, of trying to overthrow a democratic and fair election could legally become President, but there seems to be nothing in the US Constitution that clearly prevents that. Where there is any doubt, the key point to note is that the final legal decision maker in the US, the Supreme Court, has a Republican majority and is almost certain to vote in Trump’s favour.

If he cannot be legally prevented from becoming the next POTUS, will voters prevent that happening? Republican voters will not, and increasingly the Republican party is now Donald Trump’s party. Although there are quite a few Republican politicians who are unhappy that this has happened, few have dared voice their opposition. The reason is fourfold. First, a majority of Republican voters are supportive of Trump, for reasons discussed below. Second, Republican candidates at most levels of government are chosen in primaries by Republican voters. Third, there is enough of the 0.1% who think Trump will be good for them to ensure Trump supporting candidates will always run for those seats and have the necessary financial backing. As a result, opposing Trump is close to electoral suicide for any Republican politician. Finally, these politicians increasingly worry about their or their families' personal safety. Never underestimate the power of occasional violence from the extreme right.

This is why Trump is likely to be the Republican candidate in 2024. Fortunately there are enough voters (mainly Democrats and Independents, but also a few Republicans) who still believe in democracy to outnumber those voting for Trump, but three things may nevertheless mean that Trump could still become President.

The first is that many voters will not see the election as Trump vs US democracy. Of course with one of the two candidates having tried to overturn the result of the 2020 poll it is not as if Trump’s contempt for democracy is hidden from them. Instead it is because elections are always fought on many issues, and all the signs are that the non-partisan media will treat 2024 as just another election.

Remember the 2016 election where the non-partisan media obsessed about whether Clinton had used her personal email account for official business. This is how ‘balance’ works in the US media: journalists feel they have to be equally critical of both sides, so implicitly the trivial (which email account did Clinton use) is equated with the serious (is Trump suitable to be President?). We see the same thing happening today. The media obsess about Biden’s age, to balance their critical coverage of Trump’s various appearances in court. But worrying that the President is too old is a different class of concern to worrying about whether US democracy will survive.

On the crucial issue of the economy Biden should be way ahead. From the perspective of Europe (or virtually anywhere outside the US) the US has made a far better recovery from the pandemic then nearly every other major economy, and it looks like inflation has returned to target without the need for a major recession. Unemployment remains very low. But this is not how it is seen in the US, where sentiment about the economy is very depressed. There is a great deal of speculation about why this is, and whether it represents a media failure or something real (high interest rates, a short term confusion between the price level and inflation, or the onset of another Covid wave), but the upshot is that the economy is not as yet the strong card it should be for Biden.

The second reason why Trump could beat Biden is because the Electoral College, rather than the popular vote, decides who wins, and the Electoral College is heavily biased towards Republicans.

The third, and perhaps most alarming, is that Trump and the Republican party will dispute the result of any General Election result that Trump loses. Trump, once again, has learnt from his failure to overturn the 2020 election result, and has been trying to ensure that his people are in positions of power to at least sow confusion about the validity of any general election result in key states, something he failed to pressure Republican officials to do last time. The danger is that Trump, backed by the Republican party, can put a sufficiently strong case that he actually won to the Supreme Court, who will given its composition rule in the Republican’s favour.

That someone with such disregard of democracy should once again have another shot at gaining the White House seems incredible, so it is worth exploring why that can happen. There are two different but plausible stories you can tell. In the first, a majority of Republican voters have such great faith in Donald Trump that they are happy to overturn democracy to see him elected. To put the point in another way, they are happy with democracy as long as it only involves true Americans. The second story is that a majority of Republican voters are so misinformed by the media they consume that they actually believe Trump really won in 2020, and that it is Democrats rather than Trump who is a threat to democracy.

Reality probably combines both stories. There is little doubt that many Republicans want to believe the stories they are fed by the right wing media, and as a result allow themselves to live in a fantasy world where, for example, Trump was cheated in 2020 by voter fraud or whatever. On the other hand if the right wing media that provides this fantasy world did not exist, at least some of those Republican voters might be forced to confront reality. The evidence is also clear that exposure to right wing media does increase the Republican vote.

Whatever the causes and extent of the “The Paranoid Style in American Politics”, a crucial question is how such a minority can potentially overthrow US democracy. How is it so easy for a would-be dictator to capture one of the two main political parties in the United States, and therefore get close to power? There are of course many answers to that question, but perhaps two of the most important are the lack of control over the influence of money in politics (including through the media), and the widespread use of closed direct primaries in a two party system since the beginning of the last century. [1] If Trump loses, US democracy is safer but far from completely safe. There are plenty of Trump successors around. More importantly the voters to whom Trump appealed, together with a right wing media that feeds them and a voting system that gives them power, are not going to change.

[1] Recent UK history provides a similar illustration of the perils of party membership power within political parties on the right. Liz Truss became Prime Minister not because she was elected in a general election, but because she was chosen by just 80,000 Conservative party members. She was elected on a platform of tax cuts, when that was the last thing the country needed. Her attempt to implement those tax cuts quickly unraveled, and her period of being Prime Minister lasted only 49 days.

The next time someone says the government cannot borrow to invest, just mention RAAC

 

Kids not being able to go to their normal school because those schools are crumbling away is as good an example as any of the impact of 13 years of austerity government. It began with Gove scrapping Labour’s Building Schools for the Future programme (a decision he subsequently said was one of the worst he made) when the Conservatives came to power in 2010, and it may well end with thousands of children being forced to relocate to temporary accommodation because Sunak when Chancellor failed to respond to warnings from his own Education department.

It is also an example of the impact bad fiscal rules can have. As I have argued many times, whether to undertake public investment (which can vary from large infrastructure projects to replacing crumbling concrete) should depend on the merits of the investment, and not on some arbitrary aggregate limits. Yet governments have at various times imposed fiscal rules that either included public investment (a target for the total deficit, or a falling debt to GDP target) or in some cases imposed a limit on total public investment itself. [1]

The case of crumbling schools caused by RAAC concrete also clearly shows why arbitrary aggregate limits on public investment make no sense. When the roof of a primary school in Kent collapsed in 2018, ignoring the problem became, in the words of the National Audit Office, a “critical risk to life”, which meant many schools with Raac concrete in them needed replacing fast. That means spending a lot of money quickly. As we now know, and as the Treasury were told, not doing so would mean some school buildings would become unsafe to use. Unlike current spending on day to day services, the need for public investment can vary substantially over time, and sometimes that investment just has to take place.

What did Sunak, or the Treasury, expect to happen when they revised down a RAAC based bid from their education department by a factor of 4? Were they crossing their fingers and hoping that the engineers were being over cautious, and that no more buildings would collapse? Or did they not even get as far as reading what the department had written, and instead just looked at numbers on a spreadsheet? Did no Treasury official raise their hand and say ‘but minister, what will happen when they start closing schools because they are unsafe’?

The term ‘Treasury brain’ is fashionable, but if the politicians in charge are determined to spend less public money then the Treasury can do little to stop them. Furthermore, these politicians are invariably short term in their political outlook, so they will always be tempted to cut investment rather than current spending. Investment by its nature has its benefits in the future, while current spending cuts will be noticed today. This is why it’s important to design fiscal rules that stop politicians doing this. If the Treasury can tell a minister that cuts to public investment will not do anything to help that minister meet their fiscal rules, they are less likely to make those cuts. [2]

The same is true for short term cuts that end up costing more in the longer term. Treasury brains are more than capable of seeing the foolishness of doing this, but if the remit from politicians is to get down borrowing over the next few years by whatever means possible, Treasury civil servants cannot keep options from politicians. Again fiscal rules need to be medium to long term, to avoid this kind of foolishness.

The whole current system, where dangerously crumbling concrete is kept in place because fixing it would require some borrowing, is predicated on a kind of deficit fetishism that treats reducing government borrowing as more important than almost anything else, including teaching children. Politicians are putting reduced borrowing ahead of essential investment. Asked why, they will mutter phrases like ‘fiscal responsibility’, and the media will find a City economist to talk about ‘bond market jitters’. Someone will mention the Truss fiscal event, as if borrowing to stop schools collapsing on children can be equated to cutting the top tax rate. (In reality the reaction to the fiscal event was all about interest rate uncertainty and pension funds taking risks rather than excessive government borrowing.)

Fiscal responsibility does have a real meaning. It makes sense to ensure taxation matches current spending in the long run so debt to GDP levels are sustainable. Fiscal rules are useful to prevent politicians cutting taxes or spending more to win elections and funding these giveaways by borrowing. But refusing to borrow to enable schools to remain open and safe is clearly not in any sense fiscal responsibility. For once household and firm analogies are appropriate. People borrow if necessary to fix serious problems with their homes, and firms would of course borrow to prevent their factories falling apart, so why not the government when it can borrow more easily and more cheaply than any household or firm?

However there is one area where aggregate conditions, rather than the individual merits of any investment, does matter. This is borrowing costs, which should influence when (not if) investment is done. The ideal time to start replacing RAAC concrete was when borrowing costs were almost zero, because short term interest rates were at their lower bound. Yet, as this graph from the IFS shows, this government cut capital spending on education compared to levels under Labour, just at the point when borrowing costs were at their lowest. Cutting investment when borrowing is cheap, and being forced to do the investment when borrowing costs are much higher, is a good example of this government’s economic incompetence.

This is one area where the way the Treasury does things may be lacking. Whether a project is worth doing is typically assessed using a constant 3.5% real discount rate, with some exceptions. There are good arguments for using a discount rate independent of market rates, although whether the rate should be as high as 3.5% is another matter. But deciding that public investment projects are worthwhile to do, and deciding when to do them, are two different choices. The latter will depend on many things, including the state of the economy and the cost of borrowing.

It is obviously cheaper for the government to undertake a worthwhile investment when the cost of borrowing is very low. Yet it is unclear how that basic point influences government spending decisions. Needless to say, a focus on reducing borrowing when the economy is depressed, and interest rates and borrowing costs are likely to be low, is completely the wrong thing to do. But even if that was not the case, it is not clear that Treasury practice encourages investing when it is cheap to borrow.

Closing schools because the government refused to replace crumbling concrete is also a perfect example of what this government has become in another sense. Before the 2020 spending review, Sunak as Chancellor was told by the education department that at least 300 schools needed replacing a year because of crumbling concrete, and they asked for funding to replace 200 a year in the first instance. Instead Sunk decided to halve the school rebuilding programme target from 100 to 50 schools per year. But when presenting the results of this spending review, he described it as producing a “once in a generation investment in infrastructure”. It’s not just that they lie all the time, but when Sunak like Johnson makes grandiose claims it is generally to disguise monumental failure.

Unless something unforeseen happens, we are destined for a year when all we can do is look forward to a change in government. An incoming Labour government may not have the same aversion to the public sector as this current lot, but they will still have fiscal rules. The government will still be working in a media environment where government borrowing is viewed with suspicion, and the distinction between how day to day spending and investment is funded is rarely made. Labour are committed to borrow to invest, but are saddled with Conservative fiscal plans that are unworkable and a falling debt to GDP rule that discourages investment. Rachel Reeves’ priority in government should be to raise taxes to match increases in day to day spending, and to scrap the falling debt to GDP rule so that we can start investing in the public sector after a decade and a half of complete neglect.

[1] That limit, of 3% of GDP, has now become redundant as the share of public investment is planned to fall to almost 2% in five years’ time. (Public investment reached 3% of GDP three times in recent financial years: 2008/9,2009/10 and 2020/21.

[2] It would be nice to say that good fiscal rules that excluded public investment would completely avoid austerity driven cuts to that investment, but unfortunately the experience of the Coalition government suggests that is not true. As I noted many times, the structure of the primary fiscal rule first introduced by George Osborne did exclude public investment, because it had a target for the current balance (the total deficit minus net investment). As a result, there was no need for the Coalition government to cut public investment, yet that is exactly what they did, particularly in 2011 and 2012. That decision alone cost the average household thousands of pounds in lost resources.

It was this cut in public investment that really hit the UK recovery from the Global Financial Crisis recession. Quite why the Coalition government decided to cut public investment so drastically when it did nothing to meet their fiscal objectives is unclear. Did the Treasury just ask departments to cut all spending, and naturally (see above) these departments initially chose investment over current spending? Or did the Chancellor not understand his own fiscal rule?

This is why I hesitate to claim better fiscal rules might have prevented this government cutting back on public investment. When politicians have an ideological belief that everything in the public sector is inefficient and wasteful, they may ignore even the most enlightened fiscal rule.

Equally when fiscal rules become things that are changed every couple of years, as they have been since 2015, then unfortunately it also tempting for politicians that know they are nearing fiscal limits to include public investment in any target, because it is easy to cut.