The Budget shows that the Tories are in a political cul-de-sac

I will break my self-imposed silence because yesterday’s British Budget is one of those great set-piece occasions which can be used as a moment of reflection. Predictably, most in the news media squander this in a silly game of speculation about the short-term prospects of political leaders. But the Budget poses more profound questions.

The government faces two profound economic problems, which it must either learn to live with or expend political capital to solve. These are low productivity and housing. There are other big problems, of course: Brexit, austerity, regional disparities and income inequalities, for example. But Brexit is more about means than ends; austerity is symptom of the productivity problem; and the other problems are not so high on political agenda right now, though they are important to both housing and productivity. Broadly speaking, the government is being forced to embrace the productivity problem, and is doing its best to confront aspects of the housing problem, without being able to do enough.

Let’s look at productivity first. This is about production and income per hour worked. Since unemployment is now low, and immigration is looking less attractive, increasing productivity is the key to raising incomes, and, above that in my view, to raising taxes. Weak tax revenues lie behind austerity – the cutting of public spending to levels which are now unsustainably low. The government is forced each year to spend extra money to fix some crisis or other brought about by austerity. This time it was Universal Credit and the NHS. Next year it will be police and prisons, after that it will be schools and student loans. And so it goes on – this is no way to build for the future. The government could try to raise taxes, but this is so politically unpopular that not even the Labour Party is talking about it – they persist in thinking that there is easy money to be raised from big business, rich people and confronting tax evasion. So growth it must be, and productivity must rise. But productivity is stuck in a rut. The big news for this Budget is that at long last the Office for Budget Responsibility has given up hoping that there will be a bounce back, and so reduced its forecasts of income growth, which are used to set tax and borrowing assumptions. The Chancellor, Philip Hammond, talked about fixing this, as all politicians do, but in practice has done very little about it. Labour, for all their huffing and puffing, are no better. Both parties propose a number of sensible small things, like increasing public investment and education, but nothing that gets to the heart of the issue.

So the political class have chosen to embrace slow productivity, by their actions if not their words. They are right, though they need to think through the consequences. My take on the productivity puzzle is different from pretty much everybody else I have read. I think that the primary cause is what economists call the Baumol Effect. The problem is not the failure of British businesses to embrace improvements, but the limited demand for goods and services that are susceptible to advances in productivity, such as manufacturing. There are things that can be done to raise such demand, but these mainly have to do with increasing incomes for those on low incomes – people with high incomes consume less as a proportion of income, and spend more on low-productivity items that confer status. Also if demand for exports could be raised, and imports diminished, that would help – international trade is mainly about high productivity goods. But nobody really has much idea how to deal with these problems beyond tinkering at the edges with minimum wage adjustments and such.

So what of housing? What, exactly, is this about? It is about high costs to both buy housing and to rent it. This is a very complex problem with deep roots. Most analysis is superficial, but this article in the FT by Jonathan Eley is a good one. Among a number of interesting points he makes is that the low number of new housing units being built in recent decades compared to earlier ones is a bit misleading. In those earlier decades a lot of housing was being destroyed: slums and temporary housing for victims of bombing in the war. It is not necessarily true to suggest that the problem is that too few houses are being built. In fact there are deep structural problems with the housing market. One is that private borrowing has been made too easy; another is that changes to housing benefit has subsidised demand for private rental accommodation. The result of this and a number of other things has forced up the price of land relative to the housing  built on it, and made trading in land central to economics of private sector developers.

The upshot of this is that it is hard to see any solution to the housing problem without a substantial intervention by the state to directly commission house building, and social housing in particular. Another issue is building on greenbelt land outside cities, which is now forcing suburbs to turn business premises into housing, and turning suburbs into an unhealthy housing monoculture. Caution on greenbelt building is warranted, of course, as suburban sprawl, as demonstrated in so many countries in the world, is not desirable either. Mr Hammond did practically nothing on either of these critical issues. He did try to tackle the housing problem, but mainly through the private sector and private markets which are structurally incapable of making things better for the growing proportion of the population weighed down by excessive housing costs.

That is entirely unsurprising. Solving the crisis, especially in an environment of low economic growth, means that current levels of house prices and rents have to fall. That is a direct attack on the sense of wellbeing of the Conservatives’ core constituency: older and better off voters. And if that isn’t enough, property developers and others with a vested interest in the current system are showering the Conservatives with money. A politically weak government is no shape to take this on.

And that, I think, is the most important political fact in modern Britain. Housing costs are not an intractable problem that we must learn to live with, like productivity. One day it will solve itself in an immense period of pain as land prices, and much of the financial system, collapses. The sooner it is tackled the less the pain will be. Labour may be useless on productivity, but they are much stronger on housing. They have a much better prospect of doing something useful. That does not mean they will win the next election – the forces of darkness on the right should not be underestimated. But it does mean that Labour is looking to be the lesser of two evils.

For my party, the Lib Dems, this is important. It means its stance of equidistance between Labour and the Tories needs to be modified. The turning point, in hindsight, should have been that moment in coalition with the Tories when the then Chancellor George Osborne said that he could not support the building of more council houses because that meant more Labour voters. The coalition should have been ended then and there. Just as in the 1990s when the Lib Dems leaned towards Labour, the party needs to accomplish the same feat now. It is much harder because Labour has abandoned the centre ground. But that is where the country is at.

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Britain’s politicians scrabble over a weak economy.

Yesterday was one of the great annual set-pieces of British politics: the Budget. The Chancellor of the Exchequer, George Osborne, set out his plans for government finances: taxes and spending. This year, behind the theatricality, it was a bit of a non-event. There were few changes to previously announced plans. Mr Osborne rowed back somewhat in his longer term plans to cut government spending. There were some cheap gimmicks. Political inactivity is not necessarily a bad thing. But what is most remarkable is that neither he, nor the Labour opposition, were prepared to talk about the British economy as it really is. Is it any wonder that politicians fail to be trusted?

Mr Osborne’s speech contained a quite astounding piece of hubris. He claimed that Britain was on the path to becoming the most prosperous country in the world – overtaking Germany in the process.  But there is a big flaw in this notion. Britain’s output as a nation is lagging the impressive growth in the workforce. Britons are working harder but have little to show for it.  Mr Osborne sneered about the French economy – and yet French workers are over 20% more productive. Further, Britain is running a substantial current account deficit – which means that, like its despised Labour predecessor, the economy continues to be built on debt supplied by foreigners (or, perhaps, running down the nation’s overseas assets).

Dwelling on this weakness would have made the political message too complicated. His mission was to point out that Labour’s dire forecasts for the economy had not come to pass. So we heard little of any ideas about how lift the economy from its evident mire. Some talk of making life easier for manufacturing. There was the core idea of economic liberalism (that the left calls “neoliberalism”) that a smaller government will allow the total economy to be more productive. Little was heard of the government’s most promising idea – greater devolution of power to regional centres.

Weak fare. But while Labour love to point out the economy’s weaknesses – especially the low wages of many workers – they haven’t any better ideas of their own. Indeed their thoughts on a more intrusive state clamping down on “predator” capitalism seems destined to make the economy smaller, if a little less unequal. Many of their supporters, including journalists at the Guardian, seem to rely on half-digested Keynesianism. Increased state spending (or less austerity as they prefer to put it) will raise demand in the economy which will then lead to growth. As a formula in 2010 or 2011 this might have had some merit. In the near full-employment world of 2015 it does not. Such policies are more likely to lead to an even worse current account deficit, and an economy even more dependent on debt, public or private. It does not address the productivity problem. To be fair, the Labour leadership seems to understand this – but they are still bereft of ideas to tackle it.

So the Tories say the economy is gathering strength fast, and Labour that it is still on its knees. There is a paradox though. The Conservative fiscal policies are appropriate to the idea of continued economic weakness, and Labour’s on confidence in the economy’s continued strength.

How so? If you think the economy is weak, you need to make sure that government expenditure is kept in check. There is nothing certain about future projections of economic growth – and with a weak economy there will be risks on the downside. With the European and world economies looking weak also, this is easy to appreciate. Fiscal restraint may not appear to be necessary based on forecasts, but it gives the government more options in an uncertain world. In contrast, if you think the economy will bounce back strongly, and that the productivity problem sort itself out, then Labour’s much more relaxed approach to government finances make much better sense.

The problem is, of course, that nobody understands why the British economy remains as weak as it does. Is it because deep structural problems, based on poor skills, changing industrial needs and changing consumer preferences (e.g. towards more work-life balance)? Could it be the progressive hollowing out of local economies outside the main economic centres? Is it because North Sea oil is running out, and the apparently highly productive finance sector just a chimera? Or is it just a temporary blip? Will businessmen respond to the right signals to launch an investment drive that builds economic strength? Perhaps labour shortages will force businesses to use their existing workers more efficiently and pay them better.

Regular readers of my blog will know I tend to the more pessimistic of these explanations – though this is based more on instinct than data. I believe it is perfectly possible to advance human wellbeing in spite of an economy that is weak in terms of income growth. But that does mean that we must break our addiction to debt, public and private. For that reason I like the right’s focus on government parsimony, and the left’s focus on inequality. Alas neither of our main political parties seem to grasp the real nature of our economic plight.

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Pensions, savings: sensible steps forward

This week’s UK Budget has revealed the usual muddle amongst politicians, journalists and the public over the whole issue of pensions and savings – with opinion strongly favouring several flavours of having your cake and eating it. This masks some profound and sensible reforms carried out by the coalition government.

First version of the cake. We like people to save. But we want them to spend to promote economic growth. We worry that a large part of the population will become dependent on the state and taxes because they save too little. But when they do, as in the early part of the 2008/09 crisis, we bemoan that fact that people aren’t spending and so causing economic slump. So interest rates crash to the floor in an attempt to reduce savings and increase consumption (alongside the vain hope that companies will be encouraged to invest more).

Next version. We want people to save more to not be dependent on the taxpayer, but we also want target state spending on the less well off, and tax the rich to pay for it. So we encourage people to save, and then confiscate the proceeds.

Another version of this is that we love the idea of exempting pension saving from tax but think that people who have accumulated sufficient savings for a reasonable pension (a million pounds for a pension of £35,000, for example) are part of a rich elite whose broad backs should carry the largest burden.

There is a genuine dilemma at the heart of this of course. For that reason a lot of hope resides in get-out-of- jail-free cards. One of these is strong economic growth. But that requires lots of people to work – which means retiring later and allowing immigration. We are clearly entering an era of low growth, thanks to demographics, personal preferences (i.e. people choosing unpaid leisure over work) and the changing nature of technological advance and the global economy. Remarkably few people have tried facing up to the consequences of this. Even some intelligent economists think that “trend growth” is a law of nature. Another get-out-of-jail-free card is that rising property values will compensate for lack of saving. Collectively this cannot make sense, but it has worked for many individuals, who therefore don’t engage with wider worries about the future.

Now let’s consider some difficult facts. I have already mentioned that economic growth is likely to be much lower in future. The next difficult fact is that private pension saving has collapsed in the last 25 years. Generous final salary schemes have been replaced by inadequate money-purchase schemes. It is now use just blaming Gordon Brown’s tax raid on pension schemes in the later 1990s for this (or Mrs Thatcher’s ill advised liberalisation of pension selling before that) and some are prone to do when you mention this. This at worst mildly accelerated a growing trend. The economics of businesses supporting these pension schemes became toxic even without the tax changes. This means that, as a generality, most people will not now have adequate private sector pensions. Instead as they approach retirement they will have accumulated a few tens of thousands of pounds in probably several schemes.

The next difficult fact is that the economics of long-term saving are toxic for all but the very well off (liquid assets of over £0.5m, say). The poor face the prospect of losing entitlements to state benefits if they accumulate wealth. Everybody will see any savings eaten away by costs which, even without a host of rip-offs, will always weigh most heavily on those with smaller savings. It becomes perfectly rational for a lot of people to not to bother with pensions savings – unless you count trying to own your own home.

When you consider all this, the attraction of tax funded state pensions become clear. That is why the current government has been right to make it reasonably generous, notwithstanding criticism form the right that we can’t afford it. It was also right to make this pension independent of private saving.

Now, what about the tax treatment of savings? To simplify, there are three groups of tax privileged savings. The first is domestic property. To buy your own home you pay out of taxed income and stamp duty on the purchase price, but the gain is exempt from tax. The second is Individual Savings Accounts (ISAs), which, like property, are paid for out of taxed funds (subject to an annual limit) but income and capital gains are tax free. And third are pension plans, for which contributions are exempt from income tax, but it is taxable on drawdown.

The first and last of these are problematic. Domestic property because its tax exempt status has made it a highly attractive investment – but instead of this fuelling much in the way of building new, efficient property, it has simply driven prices up, making ownership out of reach for many younger people and driving a wedge between families with property and those without. Pensions are a problem because that particular route for providing tax exemption makes for maximum complexity. In fact they have become so hedged about in rules that most people don’t understand them.

ISAs, on the other hand, have an elegant administrative design which makes them easier to own than even taxed assets. They also have more chance of channelling investment into more productive parts of the economy.

Here’s why this week’s proposed reforms make sense. Currently money purchase pensions are forced to buy annuities, except in some carefully crafted circumstances, which tend only to apply to the better off savers. The original fear behind this annuity rule was the worry than pensioners would blow their savings quickly and then throw themselves into the arms of the state. But the state of private pensions is such that most people will rely on the state anyway, and most pension pots are so small that the amount of income that would be derived from an annuity would be derisory (and, presumably, a lot of value would be lost in administration costs). And those with larger pots are likely to be prudent with their wealth. If done properly, this will simplify the pension system, and make private pensions more attractive.

Extending the ISA allowance is more controversial. Many simply view this as benefiting the wealthy, as nobody else can save up to the £15,000 a year limit. There is some truth to this, but it will help level the playing field between financial investments and owning your own property. Since it is unthinkable to tax capital gains on homes, it may help to make other assets comparable in their tax status.

A lot of nonsense has been uttered as commentary: fears over people blowing money on cruises and fast cars – or rushing into buying property. My main worry is that the reforms will make it easier for better off people to save for their children, to pass on at death. This could reinforce the effect of inherited wealth, which is already growing. There may be mounting pressure to reduce Inheritance Tax.

But overall this looks a sensible step forward – and actually quite brave. It is surely no accident that unlike its predecessors the current government’s Pensions Minister, Steve Webb, really knows his stuff, and has been kept in post for the whole period. Liberal Democrats can take pride that he is one of theirs. There is strong political consensus in his reforms, and no party political benefit. But it is nice to feel that our party has contributed something useful to the process of government.

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