Now is the time for austerity

Contrary to some of the headlines, yesterday’s British Budget was an austerity budget. Its aim was to bring current spending and taxes into balance in three years, with a capital deficit restricted to 3% of GDP. With the current budget deficit at around 11% of GDP, that is a sharp contraction. The Institute of Fiscal Studies points out that most households will be worse off next year. The ratio of tax to GDP is widely projected to be the highest since the years of postwar austerity. Austerity is what current economic conditions demand. The main risk is that it will not be enough, and that it will precipitate a recession in the run up to the next general election.

That the Budget felt the opposite is down mainly to brazen but effective news management by the Chancellor of the Exchequer, Rishi Sunak, and also to a stroke of good fortune. The main bad news was the substantial rise in National Insurance, alongside the withdrawal of most of the emergency support for Covid, notably an uplift in Universal Credit and the furlough scheme. This news had been broken weeks ago, and presented as in the former case a bold stroke to deal with the growing crisis in social care, and in the latter as the coming to an end of the pandemic nightmare. The stroke of good luck was that the independent Office for Budget Responsibility that produces the economic forecasts on which the Budget is base offered a more optimistic picture of the years ahead than hitherto. It charted a rapid recovery from the pandemic with a reduced level of long-term damage. The country is indeed rapidly recovering from the shutdowns that disrupted the economy, making the furlough scheme in particular redundant, and this does improve the economic statistics – but beyond that this all chaff. The tax rises have little to do with the social care crisis; rising prices mean that the Universal Credit cut is causing hardship; economic forecasts have a paradoxically backward looking methodology which makes them very unreliable. Mr Sunak has navigated these treacherous waters cleverly, but what does this all mean in the cold light of day?

Austerity, by which I mean the squeezing of the government deficit by raising taxes or cutting spending or both together, has a bad name at the moment. In this country it is attached to the policies of the Conservative/Liberal Democrat coalition of 2010 to 2015, after the Great Financial Crisis (GFC), and to the following Conservative-only government. The crisis had shredded government finances, but its aftermath left economic demand weak. Economists pointed out that in these circumstances it was usually wise to loosen government finances, not tighten them. Years of hardship and lacklustre growth bore this analysis out. The defenders of austerity stuck to economically illiterate but intuitively appealing arguments, making an analogy with prudent household budgeting and the idea of protecting future generations from debt. There was a literate defence of government policy to be made, at least up to 2015, but practically nobody made it – I was a lonely voice (Lib Dem Business Secretary Vince Cable also made a valiant attempt). This put the blame on the unbalanced nature of the economy before the crisis and the need to restructure it. But even I (and surely Vince) thought the austerity was overdone, especially with regard to public investment. Meanwhile the literate economic critique gave the left their opening to demonise “Austerity” as vicious crime against humanity. Loose fiscal policy and economic growth came to be seen as two sides of the same coin.

Given that experience, it was natural to respond very differently to the next economic crisis, brought on by Covid-19. Government coffers were immediately opened up with a number of very generous schemes to support individuals and businesses. These were successful in alleviating a lot of hardship – though economists making comparisons between different countries have struggled to draw a connection between fiscal generosity and the scale of economic damage. Britain’s government was one of the most generous, but many others suffered less economic damage. That, though, is more a reflection of poor management of public health than the economic policies. Also Britain was coping with a further disruption: dropping out of the European Single Market and customs union, and the implementation of tighter immigration controls – which collectively I will call “Brexit”. All the same it points towards a greater truth: this crisis is very different from the previous one, and that affects the economic response.

In retrospect the remarkable thing about the GFC is that it affected the demand side of the economy more than supply. Important though it may be to the functioning of the economy, the financial sector at the centre of the crisis did not have such a big impact on the “real” economy – relatively few jobs were directly impacted, and a lot of those were saved by narrow but generous government intervention. What it did was to increase the level of net saving by making it harder for people to borrow, while at the same time the shock stopped businesses from investing. Increased saving paired with reduced investment is the very definition of a Keynesian recession, to which the public policy response should be to loosen fiscal policy.

But the problem this time is very different. Demand is alive and well; the impact of the crisis on jobs has been muted, while the lockdowns have allowed many people to accumulate savings that are now available to spend. Supply, however, and especially in Brexit Britain, has been hit hard. This is particularly evident in trade and logistics, and also in energy. The problems are global, but Brexit has added an extra dimension in Britain, especially as many foreign workers went home as the lockdowns took effect. This was what the economy demanded at the time, but these workers are reluctant to come back, partly, but not only, because of immigration controls. In the last two decades Britain has relied on two safety valves to regulate its economy: imports and immigration. Mismatches in supply and demand have been met through both – and in particular the fact that the supply side of the British economy is relatively weak. Now neither is working properly – or rather they are only working in one direction – to accommodate reduced demand, as in the early stages of the pandemic, but not its increase. The result is visible: inflation.

Government politicians and economic forecasters shrug the problem off. The problems are temporary, they insist. Once more ships are back plying the seas and containers located in the right places, and businesses have adapted to the changed environment, then it will be business as usual. But this is complacent, and especially so in Britain. It reminds me of the early stages of the GFC (and has resonances with what I read of the oil shocks of the early 1970s); the crisis was evident by mid 2007 when the uncertainties arising from complex derivatives linked to the US housing market caused international interbank markets to freeze up. At the time (alas before I had started blogging) this was scary enough for me to sell all shares in my pension plan and invest in index-linked gilts. But most people were in denial, supported by the usual backward-looking economic data, which showed th problems to be limited. The metaphor I used at the time was of a ship holed beneath the waterline desperately sailing for safety. That metaphor works less well this time, but the problems with supply look deeper than most people are allowing. And in Britain the changes following from Brexit are long-term. The Prime Minister, Boris Johnson, cheerfully talks about the economy responding to the difficulties by restructuring to become a high-skill high-wage one; he is even encouraging people to push for wage rises. But such changes take time and investment – and meanwhile all putting wages up does is encourage a wage-price spiral. We have thrown away the stabilisers on our bicycle without having learnt to ride it unaided. These are exactly the conditions where governments should reduce overall demand by applying austerity.

What happens if the austerity is not enough? This was the topic of my last post. Inflation gets stuck at a high level; interest rates go up; hardship spreads across Middle England (and Scotland and Wales) and property prices dive; the costs of government spending go up. Recession follows. Most Government supporters seem to be in denial. The smarter ones (and I suspect that Mr Sunak is among them) hope that with clever footwork they can time the next election in a sweet spot while people are feeling good from inflationary payrises before the devastation strikes, perhaps supported by a (reckless) tax cut. But at least there is some appreciation that austerity needs to be the direction of travel. Alas the left have not caught up with this fact, ever unwilling to acknowledge that economic policy depends on context.

Rishi Sunak shows a sure touch with 2021 Budget

Yesterday Rishi Sunak, the British Chancellor of the Exchequer (though that job title belongs to no other country so far as I know), showed why is considered to be the country’s top performing minister after Boris Johnson, the Prime Minister. It was Budget Day; he got most things right, while putting off a lot of decisions for another day.

The central issue for the government is, of course, dealing with the pandemic. His decision was to continue with a whole raft of fiscal support measures, such as the furlough scheme, until the end of September. This is well after the vaccine programme is supposed to have brought society back to normal, sort of. This shows that Mr Sunak has learned from his mistakes. Last year he was too eager to hurry things back to normal and withdraw fiscal support. Like his boss, he seems to have effortlessly risen above the mistakes of 2020.

But how is this to be paid for? Government finance does not work like household finance, and especially not for a medium-sized developed country with its own currency, like the UK. Mr Sunak has simply added the costs to the national debt without any serious plans to repay it. After dealing with short-term support for the stricken economy, Mr Sunak’s next priority is to show how he will stabilise government finances in the new, shrunken, normal by reducing the budget deficit. He did this by freezing tax allowances and raising the rate of corporation tax (from 2023). The former will allow the government to benefit disproportionately from incomes increasing through inflation. This allows the Conservatives to stick to their pledge not to raise personal tax rates, nowithstanding the hurricane that has hit the economy.

A lot is missing from this plan. Public spending plans have not been changed once the emergency subsides, though it isn’t hard to see many ways in which the stress on public services will rise; some are painting this as strategic choice for a return to austerity, but surely it is too early to say for sure. The long-promised solution to social care funding did not materialise. The temporary increase in Universal Credit, which many want to make permanent, has been prolonged only until 30 September. There were various gimmicks under the heading of “growth strategy”, i.e. measures to encourage business investment, but nothing major. Tax advisers will indeed get an economic boost, especially from his 130% capital allowance scheme for “productive” investment. So the Budget was not the long-term strategic rethink many had been hoping for. The big question is whether the government has such a rethink in mind at all, or whether it is saving it for later. Saving it for later would be perfectly sensible in the current fast-changing environment. A lot of criticism is focused on these missing items, however. Another line of attack, notably from the Liberal Democrats, points to gaps in the emergency support, especially for smaller businesses. This is valid, but it is a bit late for a government rethink.

The leaves two bigger questions: is it sensible to put off dealing with the expanded national debt? And is it sensible to raise the rate of Corporation Tax? My answer to both is “yes”. The limits to government finance are very tricky to assess. On the one extreme we have countries like Argentina, constantly overdoing it and stuck in a world of inflation and debt crisis; on the other we have Japan, whose mountainous public debt and frlarge budget deficits are simply shrugged off. A large national debt needs to be refinanced over time, as the bonds that finance it mature. For now this is cheap and there are plenty of buyers. But that can change; interest rates can rise; investors can be scared off. There’s no sign of this at the moment, but this debt will be with us for a long time. Can’t the Bank of England take on the debt that the markets can’t digest anyway? Yes, but this is a bad idea if inflation is in the system, especially wage inflation. But some wage inflation is good – it is the process by which living standards increase, especially in poorer households. Another problem is if the country requires a lot of foreign currency (the position Argentina got itself into); this is a risk if the country has a large current account deficit. But there are no warning lights flashing on either inflation or currency needs. If that changes the government might need to raise taxes further – but not yet.

And as for Corporation Tax, the government’s reversal of strategy is spectacular. Starting with the Coalition with the Lib Dems in 2010, the rate has been steadily reduced to 19%; the plan now is to bring it up to 25%. This rise is widely portrayed as an attack on business. But that isn’t the right way to look at it. As a tax on profits, rather than on sales, employment or property occupation, it is a very efficient tax. The incentives to run a business efficiently remain unchanged by the rate. It is better regarded as a tax on capital. It is certainly one of the things that companies look at when deciding where to locate a business internationally – but it is still quite competitive at 25%, and basing attractiveness to business investment on tax rates is an invitation to footloose capital, not secure growth. Capital is already cheap, and the story of this century has been the rise of rewards on capital compared to labour. This looks like a good place a tax hike. There are problems with the tax, especially in its treatment of foreign trade and borrowing, but the rate is surely not too high.

Politically, though, this Budget is part of a general revival of the Conservatives’ fortunes. Mr Johnson and Mr Sunak are often painted as rivals, and doubtless they are, but so far this year they are working well together, promoting a narrative of a sure-footed, cautious but fiscally generous recovery from the pandemic. Labour, who had opposed the rise in Corporation Tax, are floundering.

The pendulum swings rapidly in politics, but Rishi Sunak is showing a sure touch. Later this year, as his bluff is called on public spending, it will be interesting to see what he and the rest of the government do.