Who is to blame for the UK’s economic mess?

As time passes it is clear that the UK’s economic crisis is amongst the worst of the major developed economies, though Japan may beat it on some measures.  It’s not in the league of some smaller economies, like Ireland or Greece, although a comparison with Portugal may be more nuanced.  Some people (notably Labour politicians) struggle to accept just how bad things are; others don’t get much beyond railing deficits and the National Debt.  It’s worth pausing to consider what went wrong, and to try and attribute responsibility.

What happened?  Until 2007, the UK had an astonishingly consistent record of economic growth.  This started with the departure from the European Exchange Rate Mechanism under John Major in 1992, and continued until early 2008.  Economists had taken an average annual growth rate of 2.5% for granted.  Unemployment fell, and most people felt better off, though the very wealthy did much better than the rest.  Public expenditure rocketed, with massive investment in the NHS in particular.  A recent study by the Institute for Fiscal Studies (IFS) shows that poverty was reduced, largely because of increased benefits and tax credits.

And then bang!  GDP shrank by 6% in a year, stayed flat for the year after that, before struggling to a bit under 2% growth in the year after that (taking the year to the 1st quarter from the ONS).  Forecasts are for consistently anaemic growth. This is striking.  When economies hit a recession due to a temporary shock, they bounce back quite sharply, as temporarily unused capacity comes back on stream; this is what has happened in Germany this time.  Not for us; a good 7% of the economy has vanished never to return.  What makes this particularly bad is that this 7% produced an awful lot of taxes, while public expenditure carried on regardless (with benefits increasing due to the extra unemployment and hardship).  This has left the country with a “structural deficit” of about 8%.  This is the excess of public expenditure over taxes after you strip out temporary factors; the actual deficit was much larger (it reached 11% and has now dropped to 10% per annum).  Now I’m not sure how we ended up with an 8% structural deficit after losing just 7% of GDP, of which presumably no more than half would will have been taxed.  The government was already running a bit of a deficit when disaster struck; I think that capital taxes must account for the difference, now that the property boom has disappeared.

What this comes down to is that a lot of the pre-crisis growth was not for real, and government finances were built on unsustainable foundations.  What was happening?  This phantom growth seems to have been related to a boom in personal borrowing to finance property purchases and good old fashioned consumption.  Symptoms included an over-sized finance industry (in earnings if not jobs) and unsustainable levels of consumption.

Who was to blame?  The three commonly cited answers are everybody-and-nobody/events-beyond-our-control, bankers, or the Labour Government.  Some Labour politicians still seem to subscribe to the first idea.  It was an international storm (I never want to hear the phrase “perfect storm” again) and we were caught in it; nobody was seriously criticising government policy before the crisis.  As the economy has failed to bounce back, this has become unsustainable; why are we having so much difficulty when other countries caught by the crisis are having an easier time?  Of course some try to say this is because of Coalition policies over the last year.  But almost all of the many critics of the Coalition policies accept that we were in a terrible mess in the first place.

So the critics shift to another target: Britain’s bankers.  These are an easy target, paying themselves handsomely while their organisations required government bailouts.  There is also a widespread conception that the bailouts cost a lot of money, and that this is one of the reasons that government debt is a problem.  Actually the government has largely got away with it, for which Gordon Brown and Alistair Darling deserve some credit (contrast the terrible hash that the Irish government has made).  A lot of government money was put at risk, yes, but the banks were charged for it, and the money lent will largely be repaid, and the guarantees not called on.  Where the bankers were culpable was in rampant lending, supporting excessive consumption and a property bubble.  But the lending was nothing like as reckless as in the US (or Ireland for that matter).  If the government had awakened to the idea that consumer lending needed restraint, something could have been done.  Let me be clear; the banks were reckless; we need to regulate them much better – but they were not the fundamental cause of the crisis.  We had a narrow escape.

Could the government have seen the vulnerability of the British economy?  There were not many prominent critics at the time, though Vince Cable was clear enough, for exactly the right reasons.  But it was a matter of undergraduate economics to see that economic policy was on an unsustainable path.  Literally.  As a second year economics undergraduate at UCL in early 2007 my macroeconomics lecturer, Professor Wendy Carlin, used the UK economy as a case study to illustrate her model for an open economy.  It was also used as an exam question.  Was the UK’s strong economic performance due to increasing economic efficiency or excess aggregate demand, she asked.  It was clearly the latter: the giveaways being the appreciating real exchange rate, and a large current account deficit (the economy as a whole consuming more than it was spending).

What should the government have done?  The first thing should have been to raise interest rates and tighten monetary policy much earlier.  Unfortunately this was genuinely difficult, because this was the Bank of England’s main target was inflation, and not the general standing of the monetary system. And the inflation rate seemed benign (thanks in large part to the overvalued pound).  The second thing would have been to regulate the banks harder, to restrain lending.  This was the FSA’s job, although the degree of independence of this agency is less strong.  Finally the government could have tightened fiscal policy to reduce the level of demand in the economy, through expenditure cuts or tax increases.  Nominally the government’s policy was to run a zero structural deficit, but it chose to fiddle with the statistics on the economic cycle so as to argue that it did not have to do anything.  The government was not egregiously profligate, as Coalition politicians like to suggest, but it was pushing the wrong way.

What comes over, above all, is a failure of leadership, especially from Gordon Brown, as a formidably powerful Chancellor of the Exchequer.  The tripartite arrangement for managing the financial system (between Treasury, Bank of England, and FSA) did not help, but it is very clear that if in doubt it was the Treasury’s job to lead.  They didn’t.  They could have leant on the FSA and Bank of England, as well as tightening fiscal policy directly.  But Mr Brown either refused to recognise the gravity of the situation, or his political courage failed him.  Given his constant level of denial about the seriousness of the crisis, I suspect it was mainly the former.  He could not face admitting that so much of economic achievement was unsustainable.  It is invidious to blame one man, when the hands of many were involved.  But Gordon Brown had the authority; there was enough evidence for him to act on; and he made things worse not better.  A career in the Treasury that had started so brilliantly ended catastrophically.

My next topic on the economy: is the Coalition economic policy making matters worse or better?

 

 

How would AV change UK politics?

In my post last week I explained why I am supporting the Alternative Vote (AV) in the forthcoming UK referendum.  This case was based on principle.  We have a system of single member constituencies.  First past the post (FPTP) carries a high risk of unrepresentative candidates being elected.  Of the various systems in use around the world to counter the weaknesses of FPTP (primary elections in the US, run-off elections in France, AV in Australia), AV seems to fit the British situation best.  I avoided asking what the impact of any change would be: just that the system is more democratic.  But there are pragmatic types out there for whom the likely impact of the changes is more important than first principles.  Today’s post is for them.  It will help show them why it is best to think about principles.

The trouble with most analysis of this in the UK is that it is based on looking at past FPTP results, supported by some opinion polls on second preferences, and then predicting how the outcome would have been with AV.  This runs into two problems.  First is that the next election is going to be quite unlike the last few, if for no other reason than that the current government is a coalition.  The next problem is that AV will change voting behaviours, and the campaign pitches of the political parties.  The usual conclusion is that the Lib Dems will benefit quite a bit, Labour marginally, and the Conservatives would lose out.  None of these effects would have been enough to change the outcome of elections except maybe the last one.  Extra seats for Lib Dems and Labour might have made the current coalition impossible, and even a Labour-Lib Dem one on the cards.  That’s enough for most Conservatives.  If we had had AV last time, Gordon Brown might still be PM.

The Lib Dems should benefit.  About time many will say – since the party is badly under-represented in parliament.  More pragmatic types worry that this would give a smaller party too much influence in the choice of coalition partners.  But the Lib Dems do face a problem.  In order to benefit their first preference votes need to get past either the Labour or Conservative candidates (in England – it’s more complicated in Scotland and Wales).  They might then attract second preference votes from whichever of these parties gets knocked out.  And yet the classic Lib Dem campaign technique is to persuade voters to vote for them because one or other of the major parties doesn’t stand a chance; this argument has much less resonance under AV.  Voters will say that they will simply give the Lib Dems a second preference, and give their first preference to their most preferred party.  As a result Conservative or Labour candidates currently in third place might sneak into second, knocking the Lib Dems out.  The Littleborough & Saddleworth seat at the last election was a Labour seat that people count as vulnerable to the Lib Dems under AV; but the Conservative vote was strong and under AV they might well have pushed past the Lib Dems into second place, which would, in fact, have made the seat safer for Labour.  This could be a big help to the Labour Party in the South West.  In Australia the two party system is entrenched (one of the “parties” being a coalition in an electoral pact).  The Lib Dems will be desperate for first preference votes under AV, and in the long term it cannot be taken for granted that the party would flourish.

Labour has less to fear.  It might help them pick up in areas where they are in third place – now great swathes of England.  They may not do so well from picking up second preferences from Lib Dem voters next time – but only because they will have done such a good job of persuading them to vote Labour as first preference.  They get some insurance against those voters drifting back.  It is a moment of truth for Labour supporters who believe that there is a “progressive majority” – a majority of voters for whom the Conservative Party is toxic.  If so the system ensures that the Conservatives never get a majority.

And that is the challenge for the Conservatives.  It will be much more difficult for them to sneak in a majority government against the votes of the a majority of the electorate.  But many Conservatives believe in something like a “silent majority” – the opposite of the progressive majority.  There are lot of people sympathetic to their policies that do not say so, and will not give them a first preference vote.  If so, they may pick up a lot of second preferences.  This could be particularly helpful to them at the next election, when both UKIP and the Lib Dems will be trying to pick off their voters.  If Labour succeeds in pulling past the Lib Dems in South Western seats, then this will make a few seats a bit safer for them, since they will get more second preferences from Lib Dem voters than Labour ones.

For the smaller parties AV is ambiguous.  It is difficult to see that extremist parties, like the BNP, will make any headway, since other voters will gang up against them.  Their best hope of an MP is under FPTP in a split seat.  But UKIP and the Greens may well think they can pick up a majority in favoured seats by scooping up enough second preference votes.  In the UKIP case they need to push past the Conservatives, either in what would now be very safe Conservative seats, or in Lib Dem held seats where they can hope to scoop up some Labour voters too.  For the Greens the game is to push past the Lib Dems, and scoop up enough of their votes to push past Labour (or the other way round), to mount a challenge on the Tories.  In both cases these are long shots, but you need a deal of optimism in politics.

In sum, the impact of AV is very uncertain in the UK.  The Lib Dems could assert themselves with a permanently larger block of seats, alongside a scattering of seats for the greens and perhaps UKIP.  Or the two party system could reassert itself, with the other parties finding it more difficult to pick up enough first preference votes.  But the outcome is uncertain for a good reason: electoral politics will be more competitive.  Who knows what voters would do?

 

 

Cuts: where will all the anger go?

Today the TUC is orchestrating a big demo in London against the cuts.  Yesterday the Labour party hosted a “People’s Policy Forum” on the cuts.  The focus of both events is anger.  The idea that the cuts are unnecessary is actively promoted; all that’s needed is for the rich to pay their due in taxes.  The Economist’s Bagehot gives an excellent description of Labour’s forum.  The anger is palpable, but where will it all lead?

The Guardian’s Polly Toynbee thinks this will be a turning point, leading to the complete rejection of government policy by the majority of British people.  After all, the cuts have hardly started to bite yet.  An alternative view is that the anger will transmute into depression, in the classic pattern of grief.  And from the depression will come a new consensus about the role of the state in our society.

I am reminded of a change management course I went to as a manager.  I was taught that any serious change initiative had to go through four phases: denial (a muted initial reaction as people think the change applies to somebody else), anger (the moment when indivuals realise that the change really does affect them), chaos (the dysfunctional early phases of change) and finally renewal (you finally start to make headway).  It is a mistake to think you can jump straight into the renewal stage.  Anger is a good sign, because it means you have got beyond denial; and, indeed, it may even help to provoke it a bit (though be careful, as this may prolong the chaos phase).  The art of change management is to get through denial quickly, and manage the anger and chaos phases as well as you can.  Having to put through a number of change programmes myself, I found this advice very helpful.  I would add that it is usually a good idea to take the time let the anger burn out before attempting anything complicated; that way the chaos phase is shorter and less damaging.  The fact that the anger is burning bright now is not an unhelpful sign for the government.

The problem for the cuts-deniers is that there is no way out.  Taxes on the rich have already been jacked up to beyond the point of sustainability (the 50p tax rate, capital gains tax, reforming pension taxes, the banks tax).  It is absurd to think that we can pull in much more from clamping down on tax evasion; if it was that easy, Gordon Brown would have done it ages ago.  Jacking up corporation tax will do nothing for jobs.  The Keynesian argument may bring in Nobel prizewinners, but it doesn’t offer much comfort either.  This runs that if the impact of the cuts is slowed down, the level of unemployment in the transitional period will be less, and this in turn will be less wasteful to the economy as a whole.  The same cuts have to be made, only more slowly.  Unless a private sector renaissance comes to the rescue, in which case extra taxes come in, which will stop the need for some of the cuts.  That seems completely infeasible.  It is a wonderful irony that those fighting the cuts are largely anti-capitalist, and yet only capitalism can save them.  The fact is that either the “squeezed middle” gets squeezed even harder for more taxes, or the public sector has to suffer some fairly drastic cuts.

And here’s the political problem for Labour.  To turf out the government they need the squeezed middle and the outraged public sector workers to gang up – but their interests are opposed.  Nothing will stop the cuts.  Not even a shock Labour victory in an unscheduled election later this year.  The anger has to turn to depression.

And it is not a given that this will rebound on the two governing parties.  For most voters, the world won’t end.  Labour’s credibility problem will be cruelly exposed in any election campaign.  If they want to restore the cuts, they will have to answer who is paying?  If they don’t, they will be saying that the coalition was right all along.  If the economy flags, as it well might, and the government doesn’t manage to cut the deficit as much as it plans, Labour’s dilemma will be all the more acute.  They might be able to say “told you so”, but they won’t be able to restore the cuts.

Labour are trying to recreate the anger of the 1980s against Margaret Thatcher’s government.  But this government is nothing like so reckless.  Unemployment is still much lower – there no swathes of closed factories and coal mines.  And Mrs Thatcher won.