Thursday, 20 November 2014

The UK feel good factor

I thought I’d use the improved ONS website to try and answer a very specific and topical question. If UK GDP growth has been so good (OK, I’m exaggerating) over the last two years, and the economy is growing faster than the Eurozone and Japan, why are most people still worse off than before the recession? [1]

The first reason is straightforward. A large amount of the increase in GDP we have seen since 2007 is the result of there being more people in the UK. The chart below plots real GDP and real GDP per capita, where I’ve normalised the second series so it starts at the same point in 2007 Q1. [2]

While the level of GDP in the second quarter of 2014 was well past its 2007 peak, the level of GDP per head was below that peak. GDP per head is a much better measure of how prosperous each individual person in the UK feels. (Incidentally, GDP per head in the US and Japan in 2013 exceeded 2007 levels. UK levels in 2013 relative to 2007 were similar to the Eurozone, but going up in the UK, down in the EZ.)

There are two other important differences between total GDP and how prosperous consumers feel. The first is how GDP is distributed between wages, profits and taxes. The chart below shows the shares of these three items (plus an ‘other’ category that includes self-employment income) over the same period.

The top line is the share of ‘wages’ (compensation of employees) in GDP. Movements have not been dramatic, but this share is now lower than in 2007. A major reason for this is straightforward: higher indirect taxes. VAT was reduced in 2009, but restored in 2010, and raised again in 2011. Austerity has played a part in reducing real incomes. You might think another factor is changes in direct taxes and benefits, but as this recent post showed, cuts in taxes have largely offset cuts in benefits on average (but not for those in the lower quarter of the income distribution).

The second important factor is what economists call the terms of trade. We buy many overseas goods, so if their price has been rising relative to the price of goods produced in the UK, we will feel poorer. Here the major change occurred in 2008, with the large depreciation in sterling, although higher commodity prices will also have had an impact.

This leads to some data that is increasingly quoted in the media, which is the average earnings index relative to the consumer price index. People have been getting excited by the fact that the two measures are now growing at roughly the same rate, and when you look at the time series from 2007 to today you can see why. (The most recent ASHE survey from the ONS is rather less optimistic, with real earnings growth still falling.)

Real earnings were over 8% lower in 2014Q2 compared to their average in 2007. This overstates how much poorer we are on average for various reasons, but poorer we certainly are. Real disposable income per head was about 2.5% lower in 2013 than 2007. Consumption per head in 2013 was also substantially lower than in 2007, and also lower than it was in 2005 and 2006. [3] And if you think that was because 2007 was a debt fuelled consumer boom, think again. In fact, according to the latest data from the ONS, the savings ratio in 2013 was a little below its level in 2007.

So although GDP may be higher than before the recession, when we take account of the fact that there are more people in the UK, government takes more in indirect taxes, and import prices have risen much faster than the price of UK output, we end up significantly poorer.

[1] This post in complimentary to this interesting Chris Giles article in the FT.

[2] GDP is in £ million, 2011 prices. If you type ‘ONS UK GDP per capita’ into Google, you go straight to the (new?) Economic Time Series page on the ONS site - just scroll down for these series. (Alternatively go to the ONS site, select ‘browse by theme - Economy’ and the link is at the bottom right.) Most of the data in this post can be found there. I do have a request though - can we have the index numbers for the average earnings data there too please, with annual and quarterly averages as well as monthly? More generally, anyone can derive percentage changes from a levels series, but you cannot do the reverse accurately.

[3] Blue book chapter 1, table 1.5. 

Wednesday, 19 November 2014

Avoiding Fiscal Fudge

There has been some recent disquiet in the UK about politicians before the election failing to offer voters a clear account of how they would achieve their fiscal plans. The Financial Times has taken the lead, but others have concurred. A point I have stressed is that each party’s aggregate fiscal plans are quite different, even though Labour in particular seems to want to hide this fact. But the complaint I want to focus on in this post is about something different - it is about failing to make it clear how plans will be achieved in terms of detailed policy changes.

While I think journalists and bloggers are right to complain, I think it is even more productive to suggest what can be done about it. Politicians do what they think is most likely to get them votes. In a time of austerity, they have calculated that any bonus they might get by being transparent will be more than offset by votes they will lose from coming clean on specific cuts or tax increases. This is hardly a unique UK phenomenon - the phrase ‘magic asterisk’ comes from the US, and Paul Ryan managed to fool quite a few ‘serious people’ by deploying it before the last US election. If the factors that enter this calculation do not change, neither will the behaviour of politicians.

In 1996 I wrote a paper with the title of this post. It was the first time I proposed setting up an independent fiscal institution, or fiscal council, like the OBR. One of the few examples of such a body at the time came from the Netherlands. Those who complain about lack of transparency on fiscal matters before elections should really examine what happens today in that country. There the Dutch equivalent to the OBR offers to cost the fiscal plans of any opposition party before an election. They take up this offer, because failing to do so would be seen as a clear sign that plans were not credible. The detail that the Bureau for Economic Policy Analysis (CPB) go into is extraordinary, as I noted at the beginning of this post: here (pdf) is an example.

So in the Netherlands we have a situation where the fiscal plans of each party before an election are transparent, detailed and independently costed. There is no fiscal fudge. To use a bit of economics jargon, it is a political economy equilibrium which each individual party finds it too costly to depart from. In most other countries we have an alternative equilibrium that involves plenty of fiscal fudge, from which it would be too costly for any individual party to try and break. Is there something peculiar about the Netherlands that means their set-up could not work elsewhere? I have heard excuses along those lines, but none which I find convincing.

So how might we get from where we are now to something like the Dutch example? Well it so happens that in the UK we have a unique opportunity if Labour forms the next government. Ed Balls recently asked the OBR to cost their post election plans, but this would involve an extension of the OBR’s current mandate, and George Osborne did not want that to happen. Of course political advantage was behind both the request and the refusal. However, given the request, if Labour forms all or part of the next government, it will be very difficult for them to reject extending the OBR’s remit in this way. Those who complain about lack of fiscal transparency should help make sure this happens. Of course the details of how the OBR might do this need to be worked out, and it may not be appropriate to do it exactly as they do in the Netherlands. But the UK also has another piece of good fortune on this front: the previous director of the Dutch fiscal council, Coen Teulings, is currently a member of the economics department at Cambridge, so is easily on hand to give advice. We should not miss this opportunity to end fiscal fudge.  

Tuesday, 18 November 2014

Redistribution under the UK coalition government

In his party conference speech, David Cameron did mention inequality. He did not say, as Ed Miliband said recently (see postscript to this post): “This country is too unequal. And we need to change it.” Instead he said “Under Labour, inequality widened. With us, it’s narrowed.” So do the two quotes above mean that both major parties now aim to reduce inequality?

Here is the evolution of two aggregate measures of UK income inequality over time, as calculated by the IFS from this recent study.

The main change is the large increase in inequality that occurred under Mrs Thatcher from 1979 to 1990. There was then a small tendency for inequality to increase until around 2007, since when inequality has fallen. The main reason for this recent fall is the decline in real wages over this period, while benefits have remained more constant in real terms. The share of the top 1% also rose during the Thatcher period, but unlike the measure above continued to rise sharply until around 1997/8. It then remained relatively stable until around 2004, rose sharply until the financial crisis, when it fell back in 2010/11 to end 90s/early 00s levels. (For details, access the PSE database here.)

If the decline in real wages since the financial crisis has reduced overall inequality, what impact has government fiscal changes had? In a landmark report issued this week, Paola De Agostini, John Hills and Holly Sutherland analyse who has gained and who has lost as a result of the direct tax and transfer changes made by the coalition government. (Indirect taxes are excluded.) One of the things I liked about the analysis is that it attempted (with some success) to reconcile its own results with similar analysis undertaken by the UK Treasury and the IFS.

The headline result is shown in this chart.

The black dots track who has gained and who has lost as a result of the coalition’s changes to direct taxation and benefits, including pensions. The poorest have lost out, while the main gains have been in the middle of the top half of the income distribution. So while a decline in real wages may have reduced inequality in the years following the recession, government policy has attempted to move things in the opposite direction. So perhaps what the Prime Minister should have said is “Under Labour, inequality widened. With us, it’s narrowed, but we are doing what we can to change that.”

There are many other interesting results from the study, but let me mention just three here. The first is contained in the most right hand black dot. Over the period in which the coalition has been in power, changes in direct taxes and benefits have had no significant overall impact on incomes, compared to what would have happened if indexation had run its normal course. That means that the impact of benefit cuts in reducing the deficit has been almost exactly offset by tax cuts.

The second told me something I should have realised about the Treasury’s analysis of the distributional impact of budget measures. The Treasury’s analysis is similar, but with one important difference - the biggest losers in their figures are the top income decile. As the report shows, the main reason for this is straightforward - the Treasury analysis starts from January 2010, not (as in this report) from May 2010. Why does this make so much difference? Because the new higher 50p tax rate introduced by Labour actually started in April 2010. George Osborne subsequently reduced this to 45p. So the Treasury’s figures show the top decile losing as a result of the top tax rate going from 40p to 45p, while this study starts at the 50p the coalition inherited.

The third bit of the analysis I wanted to mention was how these numbers might change by 2019/20 under current plans. The broad picture remains similar, but with one large question mark for the lowest decile, concerning the introduction of the new Universal Credit (UC). One of the hopes for UC is that it will increase the uptake of benefits. The report calculates that if everyone who currently claims any one of the benefits UC replaces takes up UC, then UC will lead to large (+3%) overall gains for the bottom decile. Whether this will happen depends in part on the efficiency and manner in which it is introduced.

Sunday, 16 November 2014

Can we have our instrument back?

This is a rather long post about how one of the instruments of macroeconomic policy has been taken away, and replaced by a fetish about government deficits. It is not technical.

The latest Bank of England forecast has inflation returning to the 2% target by the end of 2017, which is in three years time. That is an unusually long time to be away from target. So what is the MPC proposing to do about this long lapse from target? Absolutely nothing. Tony Yates goes through all the detail, but remains mildly shocked. Much the same thing is happening in the US. In both countries the main discussion point is not what to do about this prolonged target undershoot, but instead when interest rates will rise. Two members of the MPC are voting to raise rates now! [1]

Cue endless discussion about whether the Bank or Fed think Quantitative Easing does not work anymore, or has become too dangerous to use, or whether the target is really asymmetric - 1% is not as bad as 3%. [2] All this is watched by a huge elephant in the room. We have a tried and tested alternative means of getting output and inflation up besides monetary policy, and that is called fiscal policy. We teach students of economics all about it - at length. But in public it has become like the family’s guilty secret that no one wants to talk about.

Once upon a time (in the 1950s, 60s and 70s) governments in the US, UK and elsewhere routinely used both monetary and fiscal policy to manage the economy. Governments did not stop using fiscal policy for this end because it did not work. Instead they found, and economists generally agreed, that when exchange rates were not fixed monetary policy was a rather more practical (and probably more efficient) instrument to use. They certainly did not stop using it because it caused the rise in inflation in the 1970s. That rise in inflation was the result of oil price shocks, combined with in many countries real wage resistance by powerful trade unions, and policy misjudgements involving both monetary and fiscal policy.

When, in the previous paragraph, I wrote ‘economists generally agreed’, I am talking about what could be described as the academic mainstream. However there were also two important minority groups. One, and the less influential, argued that the mainstream was wrong, and fiscal policy was better than monetary policy at stabilising demand. The other, often among those labelled monetarist, not only took the opposite view, but had a deep dislike of using fiscal policy. For example, many believed its use would be abused by politicians to increase the size of the state (and almost all in this group wanted a smaller state). For some there was the ultimate fear that politicians would run amok with their spending, which would force central banks to print money, leading to hyperinflation - we can call this fear of fiscal dominance. However, as I noted above, the rise in global inflation in the 1970s was not an example of fiscal dominance. I shall use the label ultra-monetarist for this second group: ultra, because it is not clear Friedman himself would be among this group.

These minorities aside, the mainstream consensus was that monetary policy was the instrument of choice for managing demand and inflation, but that fiscal policy was always there as a backstop. So, when Japan suffered a major financial crisis and entered a liquidity trap (interest rates fell to their Zero Lower Bound (ZLB)), the government used expansionary fiscal policy as a means of moderating the recession’s impact. At the time the results seemed disappointing, but following the experience of the Great Recession Japan’s performance in the 1990s does not look so bad.

The key event that would eventually change things was the creation of the Euro. For countries within the Eurozone, monetary policy was set at the union level, so to control demand within each country fiscal policy was the only instrument left. Unfortunately the influence of ultra-monetarists within Germany had always been very strong, and for various reasons the architecture of the Eurozone was heavily influenced by Germany. This architecture essentially ignored the potential use of the fiscal instrument. Instead the influence of monetarism led to what can best be described as deficit fetishism - an insistence that budget deficits should be constrained whatever the circumstances.

Within the Eurozone individual governments no longer had their own central banks who could in extremis print money. The worry among the ultra-monetarists who helped design the Eurozone architecture was that some rogue union members would force fiscal dominance on the union as a whole, so they put together fiscal rules that limited the size of budget deficits. This was both unnecessary, and a mistake. It was unnecessary because the Eurozone set up a completely independent central bank, and made fiscal dominance of that Bank illegal. It was a mistake because it completely ignored the issue of demand stabilisation for countries within the Eurozone - in practice it either took away the fiscal instrument (in a recession) or discouraged its use (in a boom [3]).

While the design of the Eurozone reflected the obsessions of ultra-monetarists within Germany, in the rest of the world the academic mainstream prevailed. So when the financial crisis hit, and interest rates fell to the ZLB across the globe, governments in the UK and US again used fiscal stimulus as a backup instrument to moderate the recession. The IMF, normally advocates of fiscal rectitude, concurred. The policy worked. But two groups were not happy. The ultra-monetarists of course, but also many politicians on the right, whose main aim was to see a smaller state, and who saw deficit reduction as a means to achieve that goal. Both groups began to warn of the dangers of rising government debt, which was rising mainly because of the recession, but also because of fiscal stimulus where that had been enacted.

What happened next was that the Eurozone struck back, although not in a calculated way. It turned out that it did contain just the kind of rogue state the architects had worried about: Greece. The fiscal rules failed to prevent excessive Greek government borrowing. Did this lead to fiscal dominance and hyperinflation in the Eurozone? - of course not, for reasons I have already given. But it did lead governments in the Eurozone to make a fatal mistake. What should have happened, and always does happen to governments that borrow too much in a currency they cannot print, is that Greece should have immediately defaulted on its debt. But instead Greece was initially encouraged to borrow from other Eurozone governments, perhaps because some countries worried that default might lead to contagion (the market would turn on other countries), but perhaps also because default would have hit commercial banks in the larger Eurozone countries who owned this Greek debt.

Eventually contagion happened anyway, and Greece was forced into partial default, although not until it had taken the poison of loans from other Eurozone countries which were conditional on crippling austerity. Equally important was the impact that Greece had on the use of fiscal policy in the rest of the world. Those ultra-monetarists and right wing politicians that had been warning of a government debt crisis used the example of the Eurozone to say that this proved them right. Many (but not all) economists in the mainstream began to believe it was time to reverse the fiscal stimulus, as did the IMF. 

From that point on, the idea that you could - and when monetary policy became ineffective should - use fiscal policy to stimulate the economy became lost. Even in 2009 it had been a difficult policy to sell publicly: why should government be increasing debt at a time that consumers and firms had to reduce their own debt? For those who had not done an undergraduate economics course (which included most political journalists), politicians of the right who said that governments should act like prudent housewives appeared to be talking sense. Greece and the subsequent Eurozone crisis just seemed to confirm this view. Deficit fetishism became pervasive.

Of course this about turn was just what both ultra-monetarists and politicians on the right wanted. The focus on government debt had an additional advantage in certain influential quarters. What had started out as a crisis caused by inadequate regulation of the financial sector began to appear as a crisis of the government’s making, which if you worked in the financial sector which had just benefited from a massive public subsidy was a bit of a relief. You could be really cynical, and say that austerity made room for another big financial bailout when the next financial crisis hit. 

But those with a more objective perspective watched the years after 2010 unfold with growing concern. There were no government debt crises in the major economies outside the Eurozone - instead interest rates on government debt fell to record lows. The market appeared desperate to lend governments money. The debt crisis was confined to the Eurozone. However austerity within the Eurozone, undertaken across the board and not just in the crisis economies, did nothing to end the crisis. The crisis only ended when the ECB offered to back the debt of the crisis countries. The offer alone was enough to halt the crisis, and interest rates on periphery country debt started to fall substantially. But austerity’s damage had been done, creating a second Eurozone recession. The fiscal policy instrument works, even when you use it in the wrong direction! Austerity delayed the UK’s recovery, and while growth was solid in the US, austerity there too meant that the ground lost as a result of the recession was not regained.

So those with a more objective perspective, including many in the IMF, began to realise the fiscal policy reversal in 2010 had been a big mistake. The world had been unduly influenced by the rather special circumstances of the Eurozone. Furthermore within the Eurozone the crisis that austerity had meant to solve had actually been solved by the actions of the ECB. It began to look as if austerity - in perhaps a milder form - had only been required in a few periphery Eurozone countries.

All this should have meant another policy switch, at least to end fiscal austerity and perhaps to return to fiscal stimulus. But deficit fetishism had taken hold. This was partly because it suited powerful political interests, but it was also because it had become the pervasive view within the media, a media that liked a simple story that ‘made sense’ to ordinary people. Politicians who appeared to deviate from the new ‘mediamacro consensus’ of deficit fetishism suffered as a consequence.

So as 2014 ends, we have at best an incomplete recovery and inflation below targets, yet central banks are either not doing enough, or have given up doing anything at all. A huge amount of ink is spilt about this. But if central banks really do believe there is nothing much they can do, with a very few exceptions they fail to say the obvious, which is that it is time to use that other instrument, or at least to stop using it in the wrong direction. Perhaps they think to say this would be ‘too political’. The media in the UK and US continue to obsess about government deficits, even though it is now clear to almost everyone with any expertise that there is no chance of a government funding crisis, so the obsession is completely misplaced. Within the Eurozone deficit fetishism has achieved the status of law!

There are some who say we cannot use the fiscal instrument to help the recovery, and get inflation on target, because debt will become a problem in 30 years time. It is as if a runner, who normally gets their fuel from eating carbohydrates but has run out of energy in mid-race, is denied a food with sugar (HT Peter Dorman) because a high sugar diet is bad for you in the long term. Others in the Eurozone say we must stick to the rules, because rules must be kept. But rules that create recessions with no compensating benefits are bad rules, and should be changed. Rule makers can make mistakes, and should learn from these mistakes. [4] It is perfectly possible to design rules that both ensure long term fiscal discipline, but which do not throw away the fiscal instrument when it is needed.

So every time someone writes something about what monetary policy could or should do to get inflation back to target, they should say at the outset that this goal could be achieved - in a more assured way - by a more expansionary fiscal policy. Political journalists who presume that more borrowing must be bad should get a severe telling off from their economist colleagues. For one thing that should now be clear is that rising debt since the recession has done no harm, but austerity policies that tried to tackle rising debt have done considerable damage. The 2010 Eurozone crisis was a false alarm. Macroeconomics needs to get its fiscal instrument back, and deficit fetishism has to end, but this is being prevented by an alliance between the political right, the ultra-monetarists, and I’m afraid the media itself.

[1] In the UK there is a certain irony here. When inflation was above target in 2010-13, most of the MPC was brave enough to avoid raising rates. Although they forecast that inflation would come back to 2% within two years, this forecast was met with considerable skepticism. Three members of the MPC in 2011 voted to follow their ECB colleagues and raise rates. Perhaps as a result, the Treasury wrote a paper in 2013 which said that on occasions like that (when inflation was above target in a recession) the MPC could be a little more relaxed about the speed at which inflation returned to target. The irony is that this latitude is being used (abused?) now, when inflation is below target and we are still recovering from a recession.

[2] Maybe in the US the target is asymmetrical - but shouldn’t be - but in the UK it is symmetric by law.

[3] In a boom, when fiscal policy should have been contractionary, budget deficits were low as a result of the boom, so the rules suggested no action was required.

[4] Equally those that lent money when they should not have lent money have to accept that they made a mistake.

Friday, 14 November 2014

Growth vindicates Greek Austerity

I cannot resist quoting from this editorial in today’s Greek edition of the FT.

Greek government and Troika’s austerity policy vindicated

Since unveiling its austerity strategy to reduce its yawning budget deficit in 2010, the Greek government together with the Eurozone’s Troika has faced immense pressure to change tack. An alliance of Keynesian economists and opposition parties has accused them of choking off growth. The prophets of doom predicted years of stagnation with soaring unemployment and falling living standards.

After a run of positive growth numbers this year, the Greek government and Troika have reason to feel vindicated. They have won the political argument. True, the Greek economy is still a quarter smaller than its pre-crisis peak. But the current acceleration looks like the beginning of a sustained recovery. The anti-austerians grumble that the upturn would have come earlier had the Greek government and Troika eased up on the fiscal squeeze. This is impossible to prove as economic history offers no counter-factuals. What we do know, however, is that the critics overstated the obstacles standing in the way of a recovery. Their position was too extreme and they have found themselves snookered.

OK, the FT here is the Fictitious Times, but otherwise I have kept pretty close to the beginning of this real Financial Times editorial about somewhere else. The numbers may be different, but the reason why this editorial would be ridiculous are exactly the same as why the original editorial was. And yes, I know I have complained about it a few times, but because the FT is a quality financial paper that generally gets things right, and which other journalists look to for economic expertise, it is important not to forget the occasional lapse from otherwise high standards. And the FT are not the only respected economists who sometimes mistakenly treat growth from a deep recession as an indicator of a successful policy.

Thursday, 13 November 2014

A simple guide to the UK fiscal deficit

Confused about the government’s deficit? Are we most of the way there, as the Prime Minister has claimed, or is there rather more to find, as the IFS suggest? And what is 'there' anyway - what are we aiming for exactly?

The first way to make things intelligible is to express everything as a percentage of annual GDP. So if you see a figure in £ billion, just divide by something a bit larger than 17 to get it as a percentage of annual GDP. (UK GDP in 2013 was £1713 billion.)

The second thing to get clear is what the reference point should be. When is a deficit too big? The answer that some would like to suggest is that any deficit is too large, and that we should aim to eliminate the deficit completely. However for economists a more natural reference point given our current position is to ask what level of deficit would keep the ratio of government debt to GDP stable. Public sector net debt, which is the definition the OBR tends to use, is approaching 80% of annual GDP. If the economy grew by 4% in nominal terms each year, then a deficit (‘public sector net borrowing’) of 3.2% of GDP would keep the debt to GDP ratio stable at 80%. (0.04 x 80% = 3.2%.)

How does that compare with where we are now? The most relevant figure here is the cyclically adjusted deficit excluding Royal Mail and APF transfers, which the OBR estimated in March was 5% of GDP for financial year 2013/4. [1] That was the OBR’s best guess at what the deficit would have been in 2013/14 if the economy was on track, with a zero output gap.

That is looking at the position in the recent past. Of course the government already has policies designed to make additional future savings, so to factor these in we need to look at where the OBR expects us to be in the first year of a new government, which will be financial year 2015/16. In March it expected a cyclically adjusted deficit excluding transfers of 3.4% of GDP for that year. In other words, the government will have just about got us to a position where the debt to GDP ratio is no longer rising, if it implements planned savings and everything pans out as the OBR expects. As a result, the OBR suggests 2015/16 will be the year debt/GDP peaks.

That means a lot of ‘progress’ has been made compared to a peak actual deficit of just over 10% of GDP in 2009/10. [2] I personally would not call it progress, because I would have increased the deficit in 2010 to help end the recession more quickly, but this post is just about trying to make sense of the numbers.

The fact that by 2015/16 we will have roughly stabilised the debt to GDP ratio might surprise many people (but not all, as this poll discussed by the FT indicates). Are not the papers full of all the additional austerity there is still to come after the next election? One reason they suggest that is that all political parties are not content to just keep the debt to GDP ratio constant at 80%. They think this number is too large for the long term health of the economy, and there are a number of reasons why they may be right, which I discuss with Jonathan Portes here. But the speed at which debt is reduced is a choice - one that I have discussed here, here and here - and not some imperative that must be done or something terrible will happen.

One final point to note. I have talked about the deficit above, which includes public sector investment. Figures are often quoted for the current budget, which excludes this investment. So, for example, while the Chancellor plans to eliminate the total deficit by 2018/19, Labour intends to achieve only a zero current balance, and has left open the possibility that its target might not be achieved until 2020. Currently investment is around 1.5% of GDP, so just add this to any current balance deficit to get a rough idea of what the implied total deficit would be. So if we start from a cyclically adjusted deficit of 3.4% in 2015/16, the Conservatives aim to get this down to zero in 2018/9, but Labour only aim to reduce it to around 1.5%, possibly at a later date. That implies much less austerity under Labour’s plans, even if we make no allowance for additional Conservative cuts to finance the tax breaks Cameron announced. For a much more detailed analysis, which comes to similar conclusions, see this from the Resolution foundation.

If that also comes as a surprise, because you had read that all parties would have to undertake painful austerity, it is because Labour seem quite happy to give that impression. Having argued in 2010 that the Conservative plans were too far, too fast, and lost that election (and according to mediamacro, lost the argument more generally), they do not want to fight on that territory again. The aim of this post is to help distinguish important real fiscal choices from the spin that often surrounds them.

[1] The OBR expected in March that the ‘headline’ deficit for financial year 2013/14 would be 5.8% of GDP. However this figure is flattered by some one-off (Royal Mail and APF) transfers, and so a more meaningful number excludes these, which is 6.6% of GDP. The OBR estimate that 1.6% of that 6.6% is simply the result of the currently depressed economy.

[2] The OBR estimate that about a fifth of that deficit was a temporary result of the recession, so they estimate a cyclically adjusted deficit of 8% that year, which is the more relevant benchmark if you want to think about the proportion of austerity we have already had compared to what might be still to come.  

Wednesday, 12 November 2014

Why are the Conservatives so incompetent at running the economy?

If that question seems odd to you, you are one of the majority in the UK who think the Conservatives are better at managing the economy than Labour. Why do people think this? My guess is that it is very simple. The financial crisis happened while Labour was in power. This led to the largest recession since the Great Depression.

But surely everyone knows that the financial crisis was a global phenomenon that started in the US? Surely everyone knows that if the Conservatives had been in power there would have been just as little financial regulation, so the impact of the crisis on UK banks would have been much the same?

The problem is that most people do not know this. What they hear is the Conservatives repeating relentlessly that it was all Labour’s fault. In his latest party conference speech Cameron says: 
“A few weeks ago, Ed Balls said that in thirteen years of Government, Labour had made ‘some mistakes’. ‘Some mistakes’. Excuse me? You were the people who left Britain with the biggest peacetime deficit in history…who gave us the deepest recession since the war…who destroyed our pensions system, bust our banking system…who left a million young people out of work, five million on out-of-work benefits – and hundreds of billions of debt. Some mistakes? Labour were just one big mistake.”
This line is repeated by the majority of the UK press. It is hardly ever challenged by reporters in the BBC or other TV media. It has become so pervasive, that even some of my non-macro colleagues repeat elements of it back to me. [1]

So what if we take the financial crisis out of the equation, on the basis that it would have happened whoever had been in power. Here is average UK output per head (GDP per capita) since the 1970s.

I have drawn a trend line at 0.25% per quarter, so we can separate any evaluation into trends and deviations from trends. In terms of trends, there is no obvious difference between administrations. The Conservatives were in power from 1979 to 1997, but the trend rate of growth was not obviously better or worse during this period compared to the 1997 to 2007 period that Labour were in power. Fortunately that broad diagnosis is confirmed by those who look at these things more scientifically. [2]

In terms of deviations from trend, we have the major recessions of the early 1980s and 1990s, and the period since the Great Depression. Now the early 1980s was a global recession following a second oil price shock, where all countries were trying to get inflation down, so in fairness I ought to take that period out of the equation along with the Great Recession. However it should be noted that this period of Conservative administrations started with a radical new macroeconomic policy of targeting the money supply, which in its own terms was a disaster as the targets were never met, and the policy was abandoned after a few years. Hardly a great example of being able to manage the economy.

The 1990 recession was more home grown. It was partly a result of excessive inflation caused by bad fiscal and monetary policy under Conservative chancellor Nigel Lawson, but it was made worse by fixing Sterling to the DM at an overvalued exchange rate. So a pretty clear case of macroeconomic mismanagement under a Conservative administration. Then we have 2010 onwards. Rather than recovering from the recession, income per capita has diverged further away from its pre-crisis trend. Now you might say in mitigation that this disappointing post-recession performance has been global, but the UK has been more disappointing than either Japan or the USA. Although the UK, the US, the Eurozone and Japan suffered a major recession, by 2013 both the US and Japan had exceeded their 2007 level of GDP per capita. Furthermore the recovery in the Euro12 was also more rapid than in the UK, but then fell back following the Eurozone crisis. As a result GDP per capita in both the Eurozone and the UK remains well below 2007 levels. The best that can be said for the UK recovery is that it has been as poor as the Eurozone, without the excuse of a government funding crisis. 

Of course there is much more to say about all this, but the point I want to make here is fairly simple. Once we recognise that the financial crisis was a global event, then the three remaining major departures from trend growth happened under Conservative led administrations. In all three cases they can be associated with poor policy decisions taken by those administrations: money supply targets under Thatcher, ERM entry under Major, and austerity under Osborne.

So the idea that the Conservatives are more competent at macroeconomic management is a myth, and if anything the opposite appears to be true. Now I’m not going to discuss here why recent major mistakes seem to happen under Conservative administrations, although that would be an interesting question. Instead I want to focus on why the myth of Labour incompetence persists in mediamacro, and therefore in the minds of most people? There are two obvious explanations. The first is that the media is totally incompetent, and thinks that because the Great Recession happened under Labour, it must all be Labour’s fault. The second is that the media takes its cue from either the right wing press, or from a financial sector that also has clear interests to pursue.

A third explanation I have heard on the few occasions I enter Labour circles is that they are partly to blame, perhaps because they allowed the Conservative narrative about fiscal profligacy to go unchallenged for too long, or because they fail to campaign strongly enough on issues that matter to voters. If you think that, you should read this article by the Australian economist John Quiggin. He says that complaints that the Australian opposition are pursuing a ‘small target’ strategy, focusing on minor differences with the government, rather than confronting the government on the major issues are misplaced. “In reality, some version of the small target strategy is effectively forced on the main opposition party by the way in which our political system and media now operate.”

As evidence for that in the UK, just think of Ed Miliband’s last speech, and the media reaction. As I wrote about here, after the speech the left of centre journalist Jon Snow asked Miliband what the greatest issue facing the next British government is. Miliband responded that it is getting the country to work for most working people rather than be stuck with a more unequal country. There it is - inequality - put at centre stage. But all Snow could do was respond that this was the second time Miliband had forgotten to mention the deficit, and proceeded to rant on about this.

When I wrote that post, it was before Cameron’s speech. I suggested that Cameron would fail to mention the productivity slowdown that is a key factor behind the UK’s poor recovery from the recession, but no journalist would bother to even mention this. He didn’t, and I do not remember anyone even noting this failure, even though Labour talk all the time about the decline in living standards that it has produced. In mediamacro, the deficit is all important, but the decline in average living standards not so much. And people wonder why many potential voters are disaffected from mainstream politics.

In a recent post, the US economist Robert Reich berates the Democrats for failing to campaign on falling median wages and the growing inequality that lies behind it. The reason he gives is simple: money buys votes in the US system, which Jeffrey Sachs calls a plutocracy. In the UK Labour has tried to raise the link between inequality and falling real wages, as my example above shows, but the UK media does not appear to want that discussion to take place. I would really like someone who knows the UK media from the inside to explain why.


[1] Isn’t the bit about the deficit just a little bit true? Yes exactly that. Labour’s fiscal policy could have been better, particularly in hindsight, as I detail here. But did it amount to fiscal profligacy - absolutely not. Did it have anything to do with causing the recession - absolutely not. Could a tighter fiscal policy have allowed Labour to do a little more in terms of fiscal stimulus to fight the recession - maybe, but remember that Cameron and Osborne opposed the countercyclical fiscal policy Labour did enact. In what world does that opposition show economic competence?

[2] See, for example, this from John Van Reenen. A less scientific response would be to claim that trend growth was falling under Labour, and that 2007 represented a large macroeconomic boom. You will find many in mediamacro who assert this as a fact, but the evidence just does not support this claim.

Postscript 13/11/14. To reinforce my point about inequality and Labour, here is an extract from Miliband's speech at the Senate House today: "Now I have heard some people say they don’t know what we stand for. So let me take the opportunity today to spell it out in the simplest of terms. It is what I stood for when I won the leadership of this party. And it is what I stand for today. This country is too unequal. And we need to change it." It will be interesting to see how this rather important statement is reported.