The impact of austerity in the UK

When they do their forecast evaluation report, the OBR also look at the impact of fiscal policy on GDP. Here is the relevant chart from their report published yesterday.

There is a useful innovation compared to previous years, which comes close to an something I suggested a few months ago. The orange bar shows the impact of fiscal measures implemented in that year. The total effect of fiscal policy is this plus the impact of previous fiscal policy actions unwinding.

Suppose for example that fiscal policy reduced GDP by 1% in year 1, but its impact on the level of GDP was expected to decay by half in year 2. If no fiscal policy was enacted in year 2, then fiscal policy in year 1 would increase growth in year 2 by 0.5%. Why might the impact of fiscal policy on the level of GDP decay over time? The obvious explanation is that monetary policy ensures that it does by stabilising the level of GDP. This assumption is problematic when interest rates are stuck at their lower bound, which is why it is useful to publish the within year estimates as well as the total estimates,

You can see when this matters from 2012 onwards. We have a run of years where the total impact of austerity on growth is zero or positive, but only because of the unwinding of previous austerity. If monetary policy, or anything else, had not been able to offset earlier fiscal tightening, then instead the impact of austerity would be to reduce growth in all those years. In that (extreme) case the level of GDP in 2016/17 would be over 4% below what it would otherwise have been without any fiscal tightening from 2010/11.

As the OBR’s assessment of fiscal impact is in their publication on forecast errors, they naturally talk about whether there is any relationship between the two. This year they included this chart.

It is important to understand what we are looking at here. It is not whether there is a correlation between fiscal consolidation and GDP. As we have seen the OBR assumes there is, and indeed their calculations were the source of my estimate that the average household had by 2013 lost a total of £4,000 worth of resources as a result of austerity. The foolishness of austerity in 2010 was not that the OBR underestimated its impact, but that it left us vulnerable to negative shocks because interest rates were at their lower bound. The shock that hit in 2012 was the Euro crisis and the impact of austerity there.

What the chart above might tell us is whether the OBR have in fact underestimated the impact of austerity i.e the numbers in Chart E are too small. Each year there are hundreds of potential reasons for forecast errors, of which underestimating the impact of austerity is just one. So the best we can expect, if the OBR are underestimating the impact of fiscal policy, is a negative relationship going through zero between the two variables in Chart D but with lots of random variation on top. That is what we see in Chart D.

The OBR, productivity and policy failures

Chris Giles had an article in the FT yesterday about the UK’s continuing dreadful productivity performance, and the implications this might have for forecasts of the public finances. It has the following chart comparing successive OBR forecasts and actual data.

I want to make two points about this. The first is about the OBR’s forecast. [1] It is easy to say looking at this chart that the OBR has for a long time been foolishly optimistic about UK productivity growth. Too often growth was expected to return to its long run trend shortly after the forecast was published but it failed to do so. Expect lots of articles about how hopeless macro forecasts are in general, or perhaps how hopeless OBR forecasts are in particular. It was obvious, these articles might say, that trend productivity growth in the UK has taken a permanent hit following the financial crisis.

Anyone saying this is ignoring the history of the UK economy for the 50 years before the GFC. After each downturn or recession, labour productivity growth has initially fallen, but it has within a few years recovered to return to its underlying trend of around 2.25% per annum. This means not just returning to growth of 2.25%, but initially exceeding it as productivity caught up with the ground lost in the recession. In a boom sometimes growth exceeded this trend line, but it soon fell back towards it.

This made sense. Productivity growth reflects technical progress and innovation, and they tend to continue despite recessions. A firm may not be able to implement innovations during a recession, but once the recession is over experience suggests they make up for lost ground in terms of putting innovations into practice.

Given this experience, OBR forecasts have always been pretty pessimistic. They have assumed a return to trend growth, but no catch up to make up for lost ground. If they had also forecast, in 2014 say, that given recent experience they expected productivity growth to be almost flat for the next five years that would have been regarded as extreme at the time. Why would UK firms continue to ignore productivity enhancing innovations when the macroeconomic outlook looked reasonable?

And of course in 2014 UK productivity growth was positive. This brings me to my second point, which follows from this quote from the FT article:

“In the Budget, both the OBR and Mr Hammond are likely to stress that the downgraded forecasts do not reflect a new assessment of the damage to the UK economy from Brexit, but a reassessment of likely productivity growth after so many recent disappointments.”

Chris may be right that they will say this, but is it remotely plausible? As my recent post tried to suggest, UK productivity growth can be seen as suffering from three large shocks: the recession following the GFC, the absence of a normal recovery as a result of austerity, and then Brexit. The first two of those shocks led to a period of intense uncertainty, causing UK firms to put on hold any plans to innovate. Just as they thought things had returned to a subdued version of normal they were hit by the third, Brexit. During periods of intense uncertainty, productivity stalls or may even decline a little, as firms meet any increase in demand by increasing employment but not investing in new techniques. [2]

This story involving uncertainty seems to fit the data. Once the recovery (of sorts) finally began in 2013, productivity growth picked up. That sustained growth came to a halt when the Conservatives won the 2015 election, and the possibility of Brexit began to be an important factor for firms. [3]

These two points are related in the following way. The experience of the 50 years before the GFC suggested that you could hit the economy with pretty large hammers, but it would eventually bounce back. However that may have been contingent on a belief by firms that if policymakers were wielding the hammer (using high interest rates for example) they would take it away fairly soon, and replace it by stimulus. That belief was shattered in the UK by the GFC and austerity, where policymakers decided to keep using the hammer. What little confidence remained was destroyed by Brexit.

Discoveries are still be being made in universities around the world, and we know innovations are still being implemented by leading UK firms. It seems completely far fetched to imagine the GFC is still having some mysterious impact on the remainder of UK firms such that they refuse to adopt these innovations. A much more plausible story is that we are seeing what happens when most firms lose confidence in the ability of policymakers to manage the economy.

[1] I am on the OBR’s advisory panel, but as our job when we meet once a year is to be critical of OBR assumptions, and as we have no role in producing their forecasts, I think what I say here can be completely objective.

[2] Productivity can initially fall because new employees are not as productive as those who have been working in the firms for some time, for example.
Postscript (7/10/17) For evidence on the impact of Brexit on productivity, see work by Bloom and Mizen here.

[3] An alternative story is that the UK has settled into a new slow growth ‘equilibrium’, where the majority of firms are so pessimistic they hardly innovate at all.      

The OBR’s risk assessment lacks context

In its recent report on fiscal risks, the OBR talks a lot about all the shocks that could make the government debt to GDP ratio rise again. It then says the following:

“None of this should be taken as a recommendation to refrain from particular spending increases or tax cuts, or to avoid particular fiscal risks – that would lie beyond our remit. And there are those who believe fiscal policy is still too tight, given the pace of economic growth and the looseness of monetary policy. But ….”

Should I be grateful for the second sentence, being one of ‘those’ who think that way?

I think the reverse is true. The OBR has played the tune the government wanted, but it is the wrong tune, and this now mature and independent organisation is capable of much better than this. I will first deal with a particular issue to do with monetary policy, and then talk more generally about the concept of ‘fiscal risks’.

Our macroeconomic institutional architecture is based around what I have called the consensus view about macroeconomic policy. This consensus involves what economists call an assignment. The stabilisation of output and inflation is assigned to independent central banks operating monetary policy. Fiscal policy should be confined to managing the government’s deficit and debt, and to help it with that task there should be a combination of fiscal rules and independent fiscal institutions (aka fiscal councils, like the OBR).

In a consensus assignment world, the job of a fiscal council is to stop deficit bias: the tendency clearly observable in some countries before the global financial crisis for deficits to creep up over time. In particular, when all is going well and the deficit appears not to be an issue, it is their job to tell the government to 'fix the roof while the sun shines’.

As I and others have noted many times, this consensus assignment has an Achilles Heel, which is that nominal interest rates cannot go below a number close to zero, the so-called Zero Lower Bound (ZLB). In the absence of some mechanism to allow interest rates to become significantly negative, that ZLB problem means that sometimes fiscal policy makers have to help monetary policy in its stabilisation role. The simple consensus assignment breaks down.

Although most academic macroeconomists recognise that, our institutions find it hard to do so. Monetary policymakers in the UK and Eurozone find it very difficult to say that they have lost their main instrument, and that therefore they can no longer reliably do their job. It seems that our fiscal council, the OBR, has similar problems.

We are currently at the ZLB. The most immediate risk we therefore face is that we are hit by a negative shock and monetary policy is unable to respond effectively. Hence the quote from their document above. But as far as I can see that is it. In their section in the Executive Summary on the risk due to a recession I would have thought the ZLB problem was worth at least mentioning, but it does not appear. Indeed I’m not sure the term ZLB or liquidity trap appear anywhere in the document.

I’m sure the OBR would in defence say two things: assessments of fiscal risks generally look at risks to fiscal sustainability not macroeconomic stabilisation, and their remit precludes them from talking about alternative fiscal policy paths. This is all true. The Treasury wanted a report that would enable them to say we must continue with austerity because of all the risks identified by the OBR. The Treasury also wrote the OBR’s current remit. 

But the OBR is supposed to be independent. Just because the government tries to pretend that there is no Achilles Heel to the consensus assignment, that does not mean it has to go along with that act. In particular, it will (I hope) have noted that the main opposition - which came close to defeating the current government - has a fiscal rule that explicitly says that fiscal policy needs to switch from stabilising debt to stabilising the economy when interest rates are at their lower bound (like now). In this context, I think something beyond a single sentence alluding to the ZLB would have been appropriate.

Tony Yates said similar things yesterday. He also made another important point: a key role of government in many areas is to be a risk absorber. It assumes risks, because it is beneficial to take risks away from individuals or individual generations and spread them more widely, and often the state is the only institution that can do this. In addition, its deficit and debt should be a macroeconomic shock absorber. Given all that, why exactly should we be concerned if various shocks increase government debt? That is what is supposed to happen!

To put the term risk and attach it to some level of debt or deficit, giving us ‘fiscal risks’, is questionable. It is a bit like saying their is a risk that your central heating will come on if it gets cold: that is not a risk, but why it is there. The OBR would no doubt respond that the government has a mandate in terms of a deficit or debt target, and it has been asked to look at risks that this may not be met. But that should not stop an independent OBR from asking more fundamental questions.

Implicit in the idea of ‘fiscal risks’ is either a belief that there is an optimal level of debt which is below current levels, or a view that there is some level of debt so high that markets would start worrying about the government choosing to default. If we are worried about a debt burden on future generations, does it make sense to put all that burden on a current, already disadvantaged, younger working generation? Unless these key issues are addressed, all the risk assessment the report undertakes is meaningless, or worse still just provides support for the government’s misguided policy. It is time the OBR stopped being constrained by its remit, and started providing the public with a useful framework in which to think about ‘fiscal risks’.

Measuring the impact of austerity

Ben Chu has a good article disposing of some of the nonsense ideas associated with austerity (which refuse to die, because they are useful to politicians, and much of the media is generally clueless). Perhaps the most silly, which I encounter a lot, is that the UK has not really endured austerity because debt has been increasing, or some other irrelevant measure has been rising.

If trying to reduce the deficit - what economists call fiscal consolidation - had no adverse effects on the economy as a whole it would not be called austerity. Austerity is all about the negative aggregate impact on output that a fiscal consolidation can have. As a result, the appropriate measure of austerity is a measure of that impact. So it is not the level of government spending or taxes that matter, but how they change.

An obvious measure to use is the change in the deficit itself, generally adjusted for changes that happen automatically because output is changing. I have used that measure many times, because it is produced by the OBR, IMF and OECD among others. But it is not ideal, because the impact of changes in taxes on demand and therefore output is generally smaller than the impact of a change in government spending, because some of any tax increase comes from reduced saving. (This is also true, but perhaps to a lesser extent, of government transfers.)

There is no simple way of dealing with this measurement problem, because the amount of any tax increase people will find from their savings will depend in part on how long they expect taxes to be higher. As a result, some people prefer to focus just on government spending to measure fiscal impact (although the data you will easily find is government consumption, and as fiscal consolidation normally involves cuts to government investment it is important to add that on). However it is also possible to apply some simple average propensities to consume from tax cuts and transfers to get a fiscal impact measure.

This is what the Hutchins Center fiscal impact measure does for the US.

These are not multipliers (so are different from what the OBR does for the UK, for example [1]), but just the direct impact of government spending and taxes on aggregate demand and hence GDP. The average total impact is something like 0.4%, so this would be fiscal policy that was in this sense neutral.

Compare the mild 2001 recession with the much larger 2008/9 recession. In both cases during the recession fiscal policy was strongly counter-cyclical, helping to reduce the recession’s impact. After the 2001 recession ended, fiscal policy continued to support the recovery for around two years: these were the Bush tax cuts. The recovery in GDP was reasonably strong: growth from 2003 to 2005 of 2.8%, 3.8% and 3.3%.

In 2010, we had a much deeper and longer recession, but the fiscal support was only marginally greater than 2001, despite interest rates being stuck at their lower bound. On this occasion fiscal support was strongly opposed by the Republicans. It continued for another year and a quarter, and then became strongly contractionary from 2011 to 2015. GDP growth was slower than in the previous recovery, despite the deeper recession: from 2010 to 2014 2.5%, 1.6%, 2.2%, 1.7%, 2.4%. This is not surprising, as fiscal policy was reducing GDP by around 1% during 2011,2012 and 2013, rather than adding the normal 0.4%.

The speed and extent to which austerity was applied after the Great Recession was very unusual: the textbook says secure the recovery first, allow interest rates to rise, and then worry about government debt. There was no economic justification for switching to austerity so quickly after 2010: the motivation (as in the UK) was entirely political. It produced the slowest US recovery in output since WWII. (This is a very useful resource in comparing US upswings.) As I showed here using simple calculations, if total government spending from 2011 had remained neutral instead of becoming sharply contractionary, US output could easily have got close to capacity (as measured by the CBO) by 2013.

To subtract 1.5% from GDP would not matter if something (consumption, investment or net exports) filled its place. But that will only happen by chance or because of a monetary policy stimulus, and monetary policy was stuck in a liquidity trap. This is the real crime of austerity. Decreasing demand and output just when the economy is beginning its recovery from the deepest recession since WWII is as foolish as it sounds, but to do this at just the time that monetary policy was unable to effectively fight back is macroeconomic madness. As I will argue in later posts, it looks increasingly likely that this has made us all permanently poorer.

[1] If somebody publishes similar estimates for the UK, please let me know. Personally I think it makes more sense to publish data like this than use a multiplier based analysis, simply because these measures are more direct, and involve fewer ‘whole economy’ assumptions. Crucially, there are no implicit assumptions about monetary policy being made. It would be interesting to know why the OBR decided not to take this approach.

Should we demand ‘fully costed’ programmes?

Chris Dillow says we should not, and indeed that journalists who constantly ask ‘where is the money coming from’ are pandering to the idea that the height of economic competence for any government is to balance the books. I think his argument makes some good points, but taken at face value it is untenable.

To see why it is untenable, imagine a political party that promised to increase public spending, cut taxes, cut back on borrowing and let the central bank control inflation. Should journalists simply let that pass, as if the government budget constraint no longer existed?

You could respond by saying that a government that promised the earth would obviously not be credible. The problem with that argument is that a majority of the British people recently voted for a plan that would damage trade with our largest trading partner and most of that majority still believed they would be no worse off as a result. It is part of a journalist’s job to remind the public that basic trade-offs and constraints exist.

But I think Chris is right about individual policy measures. It makes little sense to require that each item of addition spending is matched to a measure to raise additional revenue, because this is not how fiscal policy actually works in any country. Whether all taxes should be tied to particular items of spending (hypothecation) is an interesting issue well beyond the scope of this post. Given this is not how current fiscal systems work, journalists and politicians should not encourage a belief that it is.

But if Chris is right about individual policy measures, when do we get the discussion of the overall fiscal picture that I argue is necessary? The answer is a simple demarcation. If an individual spending minister or shadow minister is proposing a particular measure, don’t ask them how it will be paid for. Instead ask them whether that measure makes sense on its own merits, and why doing something else within that minister’s remit would not be more preferable. For example ask an education minister whether it wouldn’t be better to avoid coming cuts to school budgets rather than spending money on grammar schools or cutting tuition fees.

On the other hand, if the actual or potential Chancellor is being questioned, it makes sense to ask whether the programme as a whole would increase or decrease borrowing. Chris is right that all a Chancellor can do is plan for a particular level of borrowing, but that alone is insufficient grounds for not asking about their plans. Instead what it suggests is a good line of questioning for journalists: if the deficit unexpectedly increases/decreases what would you do? With any luck that sort of discussion could involve some macroeconomics that went beyond bookkeeping.

It is here that we can judge macroeconomic competency. In the current context, for example, any politician that fails to note that we are in a liquidity trap (interest rates are close to their floor and the central bank is increasing the extent of its unconventional monetary policy) and that therefore some temporary borrowing on current account would be a good thing is either not competent or is for some other reason still attached to austerity. Any politician that says we must target the overall deficit rather than the current deficit and thereby hold back public investment despite real interest rates being approximately zero is not competent.

A really intelligent way of helping the electorate judge these issues during elections is to enable the OBR to cost the programmes of the main political parties, as the Netherland’s fiscal council does. All it would need is a modest increase in resources for the OBR, which would be a small price to pay to improve the level of public debate. Ed Balls asked for that in 2015, but Osborne refused. It was typically short sighted, because at the same time he could have given them the remit to cost the implications of leaving the EU. That would have allowed the OBR to tell us that Brexit would cost the government around £15 billion a year (Table B1) before rather than after the vote. If the assessment of the economic costs of Brexit had come from the independent OBR rather than the Treasury, that alone might have been enough to change the result.

The Kerslake Review of the Treasury

This review, published today, was commissioned by John McDonnell but is entirely independent. Although it is ultimately Lord Kerslake’s review, it is the product of a small panel of which I was a member, and also reflects submitted evidence and meetings of invited experts. I can say that in my area, macroeconomic policy, this external evidence was very influential and let me thank again all those involved. This post just focuses on these macroeconomic aspects of this review of the Treasury. [1]

The obvious place to start is to think how the role of the Treasury has changed in the last two decades. In 1997 setting monetary policy was delegated to the Bank of England. In 2010 the forecasting aspects of fiscal policy were delegated to the OBR. To a government obsessed by cutting the size of the state that might suggest that the Treasury did not need to have a large macroeconomic capacity, But if you think about the major macroeconomic disasters if the last decade, that view is completely misguided.

One way of thinking about these disasters is that they reflect a failure to consider potential risks to the economy, and what might be done to both mitigate those risks and respond to them if they occurred. No one was ever going to predict the exact time and date of the financial crisis, but someone in government should have been thinking about what risks a rapidly expanding banking sector might pose. There were not many who warned about the risks, but enough to warrant a risk analysis. As I have said before, I doubt that this could have avoided a crisis - the banking lobby is too strong - but at least the government would have given some thought about what to do if it happened before it happened.

When it came to austerity, everything would have been relatively unproblematic if the economy had grown at the pace at first expected in 2010, because monetary policy would still have had control. (Interest rates would have been above their lower bound.) But someone should have been focusing on what happens if things turned out to be less rosy, and making sure ministers had to address these risks. At the very least that analysis would have pinpointed the need to change fiscal policy the moment that more pessimistic outcome came to pass, but perhaps also thinking about this risk might have injected a note of caution into policy before this happened. In a secret Treasury that might not have stopped a determined politician, but if this risk analysis had been made public?

Who in government should have been doing this risk analysis? The obvious institution is not the central bank, which can be far too tentative in the area of fiscal policy and too biased on financial policy, but the Treasury. The Treasury, to use a phrase suggested at one of our evidence gathering meetings, should be “the country’s risk manager of last resort”. The Treasury is uniquely capable of getting information from all the parts of government, including the Bank, and putting it together within a consistent macroeconomic framework.

But this isn’t the only reason why the Treasury still needs a strong macroeconomic capacity. It sets the rules by which fiscal and monetary policy operate, and the danger of not having this capacity is that the rules get determined by political whim, or don’t change through inertia. And it also needs the capability to undertake large pieces of complex analysis very quickly, as we have again seen over the last two decades.

What do I mean by capacity? Above all people: people who have the ability to do and understand state of the art macro analysis. If you compare the number of macroeconomists at the Treasury and the Bank there is a huge imbalance which is not conducive to good policy making. It is absurd to think that you need suites of models to set interest rates, but virtually nothing to set monetary and fiscal policy rules and analyse the impact of potential risks to the economy.

None of this is guaranteed to stop the Treasury become obsessed with the deficit and ignoring macro analysis, but the stronger the macro team is in the Treasury the less likely this is to happen. One other way that is often suggested of combating this danger, and which we considered, involves splitting off from the Treasury key aspects including macro policy into a new Economics ministry. My own view, which is similar to that expressed in the report, is that such a split just runs the danger of institutionalising the dominant role of balancing the budget in policy making.

There is one final benefit of enhancing the macro capacity of the Treasury, and that would be to provide the potential to increase openness. I take it as given that greater openness would be a good thing, and also being an essential way of utilising existing expertise around the country. It is far from clear why risk anaysis has to be secret. To take just two examples, the Bank makes a concerted attempt to find out what is being done in UK universities that might be useful to it, and it publishes a regular blog where their economists can flag interesting data and analysis. It would be good if the Treasury had the capacity to do something similar.

[1] There is a great deal more in the report, both about macro policy and issues around devolution, working with other departments, the overall goals of policy and much more. I also feel I need to note one area where I disagree with how Bob talked about the report yesterday (on Peston’s show and to the Guardian). While I’m sure it is true that the Treasury has lost trust as a result of its incorrect pre-referendum short term forecast, by highlighting this in the context of this report you inevitably give the impression that it did something unprofessional. But both assessments were signed off by Charlie Bean. and the Treasury were hardly alone in expecting negative short term impacts from Brexit. Worse still, it risks suggesting that their long term analysis is suspect.

The OBR and the impact of Brexit

In doing my homework for an appearance at the Treasury Select Committee this morning, I noticed one point which is of some relevance to the debate about whether the OBR is being too pessimistic about the impact of Brexit. Two major ways in which Brexit will have an influence on the public finances is through lower immigration from the EU and lower productivity. The two are linked, because the OBR correctly assumes that lower immigration of skilled labour will in itself reduce productivity. (Productivity also falls in the OBR’s analysis because of reduced investment.)

The OBR also assumes that Brexit will reduce the trade intensity of the UK: less exports and imports. This is pretty obvious to anyone who has looked at international trade: transport costs may not be as high as they once were, but gravity equations tell us that geographical distance is still a key factor in influencing whether trade takes place, which means that reduced trade with the EU will not be matched by new trade outside the EU.

The Treasury analysis of Brexit assumed that this lower trade intensity would also reduce productivity. The OBR do not include this effect, calling it too uncertain. This is a slightly surprising judgement. To see this, look at this piece by Maurice Obstfeld, chief economist at the IMF. Here is a quote:

“Empirical research supports Ricardo’s fundamental insight that trade fosters productivity [by increasing efficiency through comparative advantage]. But the productivity and growth benefits of trade go far beyond Ricardo’s insight. With trade, competition from abroad forces domestic producers to raise their game. Trade also offers a wider variety of intermediate production inputs firms can use to produce at lower cost. Finally, exporters can learn better techniques through their engagement in foreign markets, and are forced to compete for customers by raising efficiency and upgrading product quality (for example, Dabla-Norris and Duval, 2016).”

Now few things are ever certain in economics, but none of these transmission mechanisms from greater trade to higher productivity are particularly fanciful: they all make common sense (at least as seen by an economist). They are all one directional, which means assuming an effect of zero is an extreme point in every case. In this sense, the OBR is being rather optimistic about the impact of Brexit on the UK economy.

2016 Autumn Statement

Got back from a trip to London to give my lecture (pics above: thanks to everyone at SPERI and New Statesman, plus Beth Rigby for chairing and everyone else for coming) looking forward to not thinking about economics for the rest of the day, only to find the Chancellor had given an Autumn Statement. Luckily the whole thing appears to be a damp squib compared to the expectations raised beforehand, so here are just a few points. On helping the so-called just about managing, see the ever excellent Ben Chu.

Public investment

Remember all the talk beforehand about substantial increases in public investment? What we got is increases of 0.3% or 0.4% of GDP in each of the financial years from 2017 to 2020. These increases give us figures that are slightly above the numbers we saw from the Labour government in the years immediately before the financial crisis. We should be spending much, much more when interest rates are so low.

Fiscal rules

There was also much speculation that we might return to more sensible fiscal rules, now that Osborne’s had been busted. Instead the new Charter for Budget Responsibility is honestly not worth the paper it is written on. We have a target for the total cyclically adjusted deficit (including investment) for a fixed year. Whatever the number involved, this makes two mistakes: having a fixed rather than rolling date, and by including public investment in that target. It is a recipe for panic cuts in public investment a year or two before the target date.

There is also a target of a falling debt to GDP ratio by the same date. I’m at a loss to understand why you need a target for this as well as a target for the deficit. The change in the debt to GDP ratio is after all just the change in debt (which is the deficit) and the change in GDP. So targeting the change in the debt to GDP ratio just adds to the deficit target some things that you cannot control: GDP growth and your position in the business cycle. I knew there would be no zero lower bound knock out, because that would be a clear admission that 2010 austerity was a mistake. But I did hope for something more intelligent than this.

I fear George Osborne has totally discredited the idea of a fiscal rule. Remember that Labour stuck to its fiscal rules for 10 years, before they inevitably fell victim to the largest recession since the 1930s. Yes there was fiddling at the margin, but the important point was that they did have a strong influence on what the Chancellor did. I now suspect that, by breaking a whole series of rules within a shorter period of years, whatever a Conservative Chancellor says has become pretty worthless.

The fuel duty fiddle

There is this great chart in the OBR’s autumn statement document.

It shows how Conservative Chancellors keep postponing rises in fuel duty. One obvious question is why. But the OBR is also concerned about whether this makes a mockery of its forecasts. Each year they are obliged by parliament to continue to assume that in all subsequent years the government will raise fuel duty after each ‘one-off’ cut. And almost each time the Chancellor announces a ‘give away’ for motorists: they will postpone any increase ‘just for this year’. You can see why they do it: it allows the papers to write favourable headlines. But if they really are going to go on doing this, it means that really their policy is to have no increases in fuel duty. Fiscal forecasts based on the assumption that they will increase fuel duty will be much too optimistic. The government is fooling parliament and the public, but the OBR cannot do anything about it because of the restrictive rules it is forced to operate under.

The cost of Brexit

The big news was of course the higher levels of borrowing. As this table shows, a significant part of that is due to the fiscal costs of Brexit.

Surprise surprise - there will actually be less money available for the NHS and other public services after leaving, rather than more. It is as if that red Leave bus just crashed and rolled over so it is now upside down. The two big factors are lower productivity growth and lower immigration. The OBR has, unsurprisingly, followed their own previous analysis (immigration) and the consensus economist view (productivity growth).

I can almost guarantee that the Sun and Mail will make no mention of this - or if they do it will only be to rubbish the OBR. So, following the theme of my lecture, I really hope that the broadcasters’ nightly news programmes pick this up. Channel 4 news did do so, but I didn’t watch the others (let me know in comments).

The NHS and squeezing the public sector

Not a penny more for an NHS in crisis. Make no mistake, as this blog has shown before, the current crisis in the NHS is simply because it has been starved of resources for the last six years. I really wish Labour (it has to be them, because they are the only party who the media will take any notice of) would run a campaign that busted the myth of a ‘protected’ NHS. But what Hammond’s refusal to do anything about this shows is that this government is continuing the squeeze of the public sector begun by the Coalition. Here is the relevant chart from the OBR. 

In the long run ... our children are adults

One of the annoying aspects of the Brexit debate is that every piece of macroeconomic news, every survey or data point, is interpreted as evidence one way or another about the economic costs of Brexit. The problem with this is partly that Brexit has not happened yet, but more fundamentally the important costs of Brexit were always long term. The Treasury’s analysis of the permanent costs of Brexit looked 15 years ahead, because that is the kind of time period over which the full impacts will be felt.

That has another annoying implication, which is that it will be very difficult to ever know what the actual costs of Brexit will have been. GDP being 6% lower after 15 years (the Treasury’s central estimate based on a bilateral trade agreement) will have a noticeable impact on economic growth, but who knows what the counterfactual is? As I have noted many times, the trend growth in UK GDP per capita was a remarkably steady 2.25% until the financial crisis, but since then productivity growth has collapsed, so who knows what it might have been without Brexit.

It is true that with rational expectations the future will have an impact on the present. That is why the exchange rate fell sharply on news of the vote. As I keep pointing out, unless those in the markets change their minds, that depreciation makes every UK resident poorer, perhaps forever. Equally if everyone anticipated that their future income will be lower they should reduce consumption now. But one reason the vote went the way it did is that many people did not believe that Brexit will have a long run negative impact on their standard of living.

We can make the same point in a more concrete way by thinking about the problem facing the OBR as it makes its forecast before the Autumn Statement in November. Those expecting to see something dramatic in these forecasts may be disappointed, partly because Brexit is likely to actually occur in the middle of the OBR’s 5 year forecasting period. Where the OBR will have to come clean about their view on the long term impact of Brexit will not be until next summer, when it does its 50 year ahead projections.

While these long term costs were always what really mattered, I have the impression (see also Paul Krugman) that the campaign spent much more time talking about short run impacts. As I have argued, these could be significant but are much more uncertain because they are more complicated. (How much will the depreciation boost net exports, for example?) So why was there so much focus on the short term in the campaign, and why did some (mainly politicians) start talking about Brexit creating a short term crisis?

I suspect (and this is just a guess) that one reason is that talk about long run costs had little impact in the media and on voters. (This is what the polls suggest: voters seemed more prepared to agree that there might be short run costs to Brexit.) To an economist that seems odd, because the economics behind the long term impact is much more solid than what might happen in the short run. Of course Keynes had a famous phrase about all being dead in the long run, but as Simon Taylor points out he made that comment to counteract a tendency for some to dismiss problems like unemployment caused by recessions as unimportant because it will disappear in the long run.

One suggestion I have seen links the lack of traction over long run costs to the fact that Leave voters tended to be older, and therefore that they did not care too much about the long run. I think this is unfair: most of those older voters also have children who they care about.

I suspect the problem came from a basic misunderstanding that was deliberately encouraged by the Leave campaign, which is to see all economic analysis as an unconditional macroeconomic forecast. The retort ‘who knows what will happen in 15 years time’ resonates if that is what you are familiar with. Too many people who should have known better, or perhaps chose not to know better, failed to make the distinction between conditional and unconditional forecasts. We had the ridiculous charge that the Chancellor should not have said people will be worse off in 15 years time, because with normal growth in absolute terms they probably will not be.

To see how nonsensical this framing is, think about the advice any doctor will give you that by smoking you will be worse off. Society does not collectively shrug that off by saying who knows what will happen in 10 or more years time. Except of course some teenagers do say this and come to regret it. Nor, by the way, do people tell medics that they failed for decades to predict that smoking would kill people so why should we take any notice now. We are completely familiar with doctors giving us conditional forecasts, but for some reason some in the media kept trying to view any analysis of long term Brexit costs as another unconditional macroeconomic forecast. [1]

One implication of this is that the consequences of Brexit may never become obvious, particularly to those who voted to Leave. Of course economists will do the best they can with the data, but I doubt very much that their analysis will get through to most people. One of the many sad aspects of the Brexit decision is that those who helped make it possible will never be held responsible for their actions.

[1] Note also that these long term Brexit costs essentially came from empirical studies with fairly common sense theoretical content well grounded in evidence. 

Why do people want less EU immigration?

Why will around half of the UK vote for Brexit? The answer you will hear time and again is EU immigration. But why do people dislike EU immigration? Of course people fear the unfamiliar, and that is a fear that can be played upon, but is that really why people dislike EU immigration? Not according to this poll.

More people think that EU immigration has been good for them personally than think the opposite. I’ll repeat that: more people think that EU immigration has been good for them personally than think the opposite. More people think the culture of Britain has been improved by EU immigration than the opposite.

The reason people think EU migration has been bad for Britain is the impact on the NHS, and therefore by inference other public services. It is commonsense to many people that EU immigration increases the pressure on the NHS and public services, and it is confirmed by the newspapers they read: here is one example, and here are some more.

What people miss is that EU migrants pay tax, which could fund public services. Indeed EU migrants tend to be young, so they are likely to pay more tax in than they are likely to take out from using public services. It is why the OBR believes that restrictions on immigration would hurt the public finances.

Which means that in reality EU migration creates more resources that allows the government to spend more on the NHS and other public services. Not only do EU migrants pay for themselves in this respect, they also make access easier for natives. Add in the negative impact of making trade with the EU more difficult, and it is clear that Brexit would have a negative impact on public services. No wonder Dr Sarah Wollaston switched sides.

Yet this is an argument David Cameron was reluctant to make, because it raises an obvious question. If EU migration is not the reason why the NHS is in crisis, what is? The answer is that his government has chosen to shrink the share of national income going to the NHS, when there are good reasons why this share should be rising. In other words the government has taken the taxes EU migrants pay, and used them to cut taxes or cut the deficit. Because Cameron will not make the case for why EU migration helps the NHS, that case is not heard by voters. Instead they are told all the time that the NHS has been 'protected'. Hence the poll result.

Whatever happens today, this point is of vital importance. So many people will be telling both the government and the Labour party that the EU referendum - whatever the actual result - has shown that to win votes politicians must cut immigration. What the poll above suggests is that what people really want is a better NHS, and that they incorrectly believe that less EU migration is a way to get it. .