Sometimes the real economic gamble is sometimes too little government borrowing – not too much

With his dad jokes and fetish for spreadsheets, Philip Hammond does not fit the stereotype of a “gambler”.

But the Institute for Fiscal Studies (IFS) nevertheless argues that the chancellor rolled the dice in last week’s Budget and took a rather risky wager.

Instead of using his lower borrowing projection “windfall” from the official independent forecaster to reduce the deficit more rapidly, Hammond essentially spent it all on the health service, while leaving the overall path of government borrowing more or less unchanged.

He could have had a projected budget surplus in five years’ time, but instead there’s still set to be around £20bn of borrowing in 2023-24.

Virtually the entire UK news media took up this “gambler” theme in their headline coverage of the aftermath of the Budget.

Yet we should be extremely wary of this framing. Because it obscures the crucial truth that, in economics, the gamble is sometimes borrowing too little, not too much.

The IFS, to be fair, was using the phrase in a narrow sense of the chancellor jeopardising his chances of meeting his own self-imposed fiscal rules.

Those Office for Budget Responsibility (OBR) borrowing downgrades – whose origins remain mysterious given the official forecaster hasn’t upgraded its nominal GDP or growth forecasts which would be the most obvious explanations for higher than expected tax receipts lately – could very well be reversed in future budgets.

Since 2010, most underlying borrowing revisions have been negative (implying more borrowing than previously expected) rather than positive for the public finances.

What the lord of forecasting (in this case OBR director Robert Chote) giveth, he can also taketh away. He even warned as much last week

And what would happen then? Would Mr Hammond really try to hike taxes while the government is walking the tightrope of a hung parliament? Would he cut public spending when the prime minister has told the country that austerity has ended? Isn’t it more likely that the result would be more borrowing? And what would happen to his fiscal rules then?

All this raises the question of whether or not the chancellor’s fiscal rules are sensible. If a man had resolved to jump off a building, we wouldn’t describe a decision to place obstacles between himself and the ledge as a “gamble” because it might mean him not achieving his suicidal goal.

Hammond’s rules, including a deficit below 2 per cent of GDP in 2020-21, are not suicidal. They are far less economically destructive than those of his predecessor George Osborne, who was insisting on running an absolute budget surplus in 2019-20, ignoring the advice of just about every independent public finance expert.

Yet there are other fiscal rules available. There is no reason to believe Hammond’s represents perfection. Indeed, it’s quite possible for a country to borrow indefinitely and still see the debt stock as a share of GDP decline provided (roughly) that the growth rate is higher than the deficit as a share of output.

Labour’s own fiscal rule targets a day-to-day budget surplus in five years’ time with a suspension if interest rates are still stuck close to zero, meaning monetary policy and the Bank of England cannot reliably help to boost growth if we go into recession.

That’s a perfectly reasonable rule, consistent with stable public finances, and one which requires less consolidation – and allows more near term borrowing – than the Chancellor’s.

And then there’s the state of the overall economy to consider.

The OBR judges that there is now no slack in the UK economy, suggesting any additional borrowing would be inflationary. But the OBR may well be wrong about that. Several other credible forecasters think there remains an output gap. Oxford Economics puts it at more than one per cent.

And even if we were to accept that the economy is running roughly at capacity, an output gap could easily open up again if we have a chaotic Brexit. At that stage additional public spending will be an economically stabilising influence, just as it was during the last recession.But the media’s wholesale adoption of the “gamble” framing from the IFS briefing, and the failure to put it in the specific context of the chancellor’s own chosen fiscal rules and the neglect of all questions of macroeconomic management, is evidence of what the Oxford professor and magisterial economics blogger Simon Wren-Lewis has rightly called “mediamacro”

A key element of mediamacro is the naive assumption that higher government borrowing is inherently dangerous and that lower borrowing is always praiseworthy.

This is a rule of thumb used by far too many political journalists, commentators, presenters, editors and producers. Some of them do it for ideological reasons, out of their desire for a smaller state and tax cuts. Some lazily accept the framing of politicians. But most ubiquitous and dangerous are those who consider themselves to be neutral and non-partisan yet still drift into looking at fiscal policy through this distorting prism.

It’s depressing and really rather shameful that after a decade of well-documented macroeconomic mistakes across the western world, it’s apparently still necessary to restate the truth that a national economy cannot be usefully compared to a household, and that the only kind of economic “gamble” some seem able to recognise is the one where the risk is more borrowing.

Here’s what to look out for in Philip Hammond’s Budget this week – and how to tell if the Government is serious or not

At 12.30pm on Wednesday Philip Hammond will step up to the House of Commons despatch box and deliver the UK’s first Autumn Budget. The long tradition of the Spring Budget will thus come to an end. But some of Hammond’s colleagues in the Conservative Party are warning that it could be the end of the road for him as Chancellor too.

Hardline Tory Brexiteers, affronted by Hammond’s cautious approach to leaving the European Union, are pushing for him to be replaced with an enthusiast for the project. And then there is the competence factor. A national insurance increase for the self-employed in the March Budget was withdrawn on Downing Street’s orders within weeks, in an epic humiliation for Hammond. If this Budget similarly unravels it is hard to see how he could carry on.

The overall economy is slowing as higher inflation bites into household wages, which are still growing only feebly, and as businesses sit on their hands rather than invest due to the uncertainty created as Brexit approaches in 2019. That context inevitably limits Hammond’s room for manoeuvre against his self-imposed fiscal rules.

Yet the political bomb that went off at the June general election, robbing the Conservatives of their expected majority, has scrambled politics and created huge pressure for more spending. Even many Conservatives are calling for the Chancellor to ease austerity in order to take the wind out of the sails of the Labour Party under Jeremy Corbyn.

So the personal stakes are high, the economic outlook is uncertain and the political scene is unusually fluid. So what are the big issues to look out for on Wednesday? How is Hammond likely to approach them? And what numbers should we pay particular attention to?

Housing

Ministers have been talking up their plans for a large expansion of house building to address what they now accept is a UK “housing crisis”. The Communities Secretary Sajid Javid has been lobbying for a substantial increase in public borrowing to deliver more homes and promised last week that the Budget will show “just how seriously we take this challenge”.

The Treasury has flown a kite of a stamp duty cut for first-time homebuyers. But what really matters is how much state money will be put into supporting housing construction, after the relatively modest sums announced during the Tory party conference in October were widely dismissed as inadequate. Housing associations will be looking for significantly more grant money to enable them to build more social housing for rent.

Local authorities seem likely to win permission to borrow to start the construction of council housing again after it effectively ground to a halt in the 1980s. But keep an eye on how much additional council borrowing will be projected by the Office for Budget Responsibility to gauge how significant this loosening – and therefore housing delivery by local authorities – is expected to be.

Public sector pay

The Conservatives’ 1 per cent cap on public sector pay has already been lifted for prison officers and police. But the pressure to ease it for teachers, nurses and other public servants is now intense, especially with multiple warnings over recruitment.

Yet lifting the cap will not be cheap. The Institute for Fiscal Studies calculates that allowing wages to grow in line with inflation would cost around £6bn extra by 2019-20. The unions are demanding even more – a 4 per cent rise. If the Conservatives do relax the cap substantially this will have an immediately obvious impact on the public borrowing projections.

Young people

Labour enjoys a huge polling lead among the under-40s, largely thanks to Jeremy Corbyn’s striking promise to abolish tuition fees and ambition to “deal with” their debt burden. In response, the Government has already made the tuition fees system more generous. And there have been some suggestions that the Chancellor in the Budget might cut national insurance contributions for younger workers, financing it by restricting pension tax relief for older workers. But the big question is whether such incremental reforms will draw attention away from Labour’s simple, eye-catching, offer to the young?

Welfare cuts

Cuts to working-age welfare and universal credit put in place by the previous Chancellor George Osborne were set to bite over the coming years, and are projected to push up inequality and poverty. There have been signals the Chancellor will cut the contentious six weeks that recipients of universal credit must wait. This will cost some money, but the bigger question is whether Hammond will defray the overall package of cuts.

A key number to look out for is whether the £12bn of savings projected to come from the welfare budget over the next five years actually comes down or not on Wednesday.

Infrastructure investment

As well as talking up house building, ministers have been stressing their commitment to more infrastructure investment to help solve the UK’s productivity crisis. There will almost certainly be plenty of talk about this in the Budget – there always is.

But how should we judge the substance? In the March Budget public sector net investment was pencilled in to creep up from around 2 per cent today to 2.3 per cent in 2021-2022. Labour’s manifesto, by contrast, pledged to take it up to 3 per cent of GDP. Will the Conservatives match Labour?

Fiscal policy

The Chancellor’s fiscal rule requires him to run a structural deficit of no more than 2 per cent of GDP in 2020-21. In March he had around £26bn of headroom against this target. Public borrowing has been rather lower than expected so far this fiscal year, but the OBR has said it plans to slash its productivity forecasts on Wednesday, which will probably have the effect of wiping out some of this fiscal improvement over the medium term. The big-picture macroeconomic question for the Chancellor is whether he scraps or modifies his 2 per cent target in order to spend and borrow more on all the areas discussed above – and also on the NHS and education.

There is a strong economic argument that doing this would actually help support overall GDP growth at a time of weak private-sector demand and growing Brexit headwinds. When Labour has argued for such a relaxation of spending cuts in the past the Government has always batted it away with the claim that the bond markets would panic if they deviated from the fiscal plan. Yet it’s notable that even some professional investors in UK Government debt are now urging the Chancellor to increase borrowing to spend on infrastructure.

This article was originally published in The Independent on 20/11/17

Why we should worry less about inflation and pay more attention to wages

It takes two to tango. And it takes two economic statistics to create a squeeze on household living standards. The first is something we hear a great deal about: inflation. Most of us are well aware that inflation is up sharply since the June 2016 Brexit vote due to the slide in the pound, which has forced up import costs and made the goods and services we all buy more expensive.

The Bank of England hiked interest rates earlier this month, the first increase in the UK’s benchmark cost of borrowing in a decade, arguing that a monetary tightening is now necessary to bring inflation back down to its official 2 per cent target over the next few years.

But inflation above 2 per cent in itself is not an inherent problem. Eminent economists, including the former chief economist of the IMF, have suggested central banks should be mandated by governments to adopt a 4 per cent price target, double the current one. And though all the world’s independent central banks target it, there really is indeed nothing magic about a 2 per cent bull’s eye. So long as the rate of growth in a price index is stable it could be somewhat higher without the sky falling in.

Which brings us to the second crucial economic factor in determining the welfare of most households: wages. If UK wages were growing at their pre-financial crisis rates of 4 per cent plus, today’s inflation rate of 3 per cent would be perfectly bearable. In such circumstances real wages would be going up and most households would not be suffering from a cost of living squeeze.

But average wages are not growing at historic average rates. They are growing at only around 2 per cent. And this is not a recent deterioration. Average wages have been abysmally weak ever since Lehman Brothers went bust and we went into recession. On the current official forecasts we are set for the worst decade of pay growth since Nelson beat the French at Trafalgar.

Inflation, of course, matters. The Brexit vote undoubtedly delivered an unpleasant inflation shock to households via the record slump in the pound on the night of the referendum, when it became clear a majority of the British public had voted for an act of economic national self-harm.

But the Office for National Statistics reported that inflation remained at 3 per cent in October, despite expectations that it would go higher. This suggests that inflation might have peaked, that the one-off shock of the currency effect has worked its way through. There are strong reasons to believe that the Bank of England is wrong to believe that inflation would soon get out of hand without a rate hike.

The greater economic welfare challenge for the country as a whole is not inflation but wages. And here an emphasis on prices risks letting the Government off the hook. Ministers take the conservative economic view that wages are determined by productivity growth – the degree to which we are becoming more efficient in producing goods and services – and that there is nothing, at least in the short-term, that they can really do to affect that.

But there are sound reasons for suspecting that if there had been more spending in the economy over the past decade that productivity would have grown over the past decade (rather than flat-lining) and that deep spending cuts by the Government have thus indirectly held back wage growth by supressing aggregate demand.

You will struggle to find a respected economist who believes that Brexit (putting trade obstacles between us and our biggest trading partner and restricting immigration) will enhance the UK’s productivity performance. The vast majority believe it will add insult to injury.

Yet a counsel of despair about the UK’s prospects is also dangerous – and risks letting the Government off the hook for running a fiscal policy that is still excessively tight.

A chunky increase in state spending on infrastructure and research now will, as a new report by the IPPR think tank argues, increase the future efficiency of the British economy but also inject some welcome spending demand today.

There’s also a case for the Government being bolder when it comes to increasing public sector wages given this is likely to have a knock-on effect on wages in the private sector. The orthodox viewpoint that wages can only grow as fast as productivity is contradicted by evidence which shows that wage growth can sometimes serve to drag up productivity.

The Government (and any administration that might follow it) face a paradox. Brexit-related uncertainty is already slowing the economy and leaving the European Union will make the country poorer than otherwise over the long term. That is a basis for realistic pessimism, as opposed to the fantasies of some prominent Brexiteers.

Yet the appropriate setting for ministers remains optimism over the ability of fiscal policy to help the economy return to productive and sustainable growth and for living standards to, finally, start rising again at the rate they did before the great crash. A failure to invest in the economy and to support aggregate demand over the coming years will not make the Brexit wound any smaller and would merely compound the waste of the past eight years of austerity. We will find out at next week’s Budget whether Philip Hammond has it in him to ride those two horses named pessimism and optimism.

This piece originally appeared in The Independent on 14/11/17