29/11/11 - A turning point in British history
- 30 November 2011
- From the section Business
Yesterday will be seen as a landmark in British economic history, and in British politics. It will relegate George Osborne's emergency budget of June 2010 to a footnote and elevate Robert Chote's happy-go-lucky assessment of our economic prospects in November 2010 to the status of a case study in predictive failure.
Because yesterday's Autumn Statement will set the political tone of the decade: it will tie the hands of future governments; and it has already brought a philosophical debate on the British right to an abrupt end.
Within six hours of their tight-lipped ordeal on the government benches, Lib Dem MPs heard Danny Alexander pledge them to go into the 2015 election fully committed to £30bn more austerity than they signed up for in the Coalition Agreement. "You've bagged a tiger there," a stunned editor of the FT told my stunned colleague Jeremy Paxman. And there are more tigers and more stunning events to come.
First, to recap the main points. The Office for Budget Responsibility tore to shreds the economic forecasts on which the Chancellor's original plans were laid.
Under what we now call Plan A, a total of £107bn discretionary fiscal tightening - tax rises but mainly spending cuts - would rapidly balance the books. He would meet his own target of eradicating the structural deficit a year early, in 2014-15, and as the state rapidly shrank, private sector growth would kick in. This "rebalancing" of the UK economy would be led by a sudden switch to net exports (after 10 years of net imports) and a surge of private-sector investment.
The rapidity was important, and clearly spelled out by the Policy Exchange think tank in numerous studies and notes. The theory says if you rapidly reduce the cost of government borrowing, this channels private investment into productive business; on top of that, by signalling a rapidly shrinking state, you signal lower future taxes and generate behaviour changes that stimulate growth. In addition, the government took tax measures designed to amplify the latter effect: lowering taxes on business, even as they raised taxes on income and consumption.
We did indeed get lower government interest rates (bond yields) - a combined effect of QE and the "safe haven" effect from the turmoil in the eurozone. But we didn't get rapid growth, mainly because the channel from low bond yields to low business interest rates is the banking system, and it doesn't work.
In fact, though the rest of the world is rapidly cooling now, in the last months of 2011, Britain's recovery began faltering a year ago. US growth - even with near 10% unemployment - was an annualized 2% in Q3 2011. Germany has grown by 2.1% in the first three quarters of this year. The UK is now set as follows:
Plan A, in short, failed. It failed because the eurozone did begin to slow, and confidence was hit, and so exports - having surged - will not surge much more. But also because the very survival mechanism adopted by the Bank of England - near-zero interest rates, QE and talking down the pound, which has produced and maintained a 20% fall of sterling against world currencies - led to imported inflation. This has hammered the spending power of a workforce whose wages have been pinned to the floor, even in the weak recovery phase.
The OBR last year expected strong growth, falling inflation and even posited the happy accident that in the event of rebalancing happening too slowly, this would mean the government hitting its fiscal target sooner. It could see "no plausible divergences" from the rate of recovery predicted but did identify the danger that statisticians had mis-estimated the long-term growth potential of the UK economy. Revise that down by 1.5% said Chote, and you would then raise the danger of missing the target.
Yesterday the OBR revised it down by 3.5%.
Plan A then was based on three, linked, wrong premises: that Britain could quickly switch to a private, export led model; that the economy is bigger than it actually is; and that consumption could survive the inflation surge imported by the Bank of England.
If you look at that dispassionately, there were two logical actions Osborne could have taken in the face of the new evidence. One was to reinforce the "slash the state, rapid rebalancing" strategy: this would have meant reaching for emergency tax cuts - either in the form of VAT or a 100% total exemption for business investment which employers have calculated would cost the Treasury up to £12bn.
Of course this would have meant even further slippage of the fiscal targets. But the IMF had already signalled its readiness to countenance a relaxation of the targets, and advised tax cuts as the way forward if growth faltered. At the time, June 2011, this was interpreted as something the government had discussed and explored with the IMF: a kind of ready-made "Plan A+".
However, rereading the IMF June statement in view of yesterday throws considerable light onto the option George Osborne actually took. The IMF stated in June:
"In the event of both persistent weak growth and high inflation, the appropriate response depends on the source of this condition: if it is due to further commodity price volatility, policies need not respond unless there is clear evidence of second-round effects (e.g., higher import prices feeding into higher wage growth). In the more difficult case in which weak growth and high inflation result from a much narrower-than-estimated output gap (which would be indicated by rapid wage growth), policies will have little choice but to tighten to re-anchor inflationary expectations. A narrower output gap would also imply a higher-than-currently-estimated structural deficit and therefore would require further fiscal tightening over the medium term."
It's clear from this that even the IMF could not see what was happening on the balmy June streets of barely-growing Britain. There was a mixture of inflation-driven slowdown and a narrower output gap. But neither fed through to higher wage growth: in fact both are feeding through to deflationary pressures on incomes.
So faced with this mixture in practice, George Osborne did a modicum of private growth-stimulation measures yesterday, paid for by taking money from families on tax credits; and severely tightened the public finances for two further years.
Once you understand this, you understand the scale of the scales - as it were - that are falling from the eyes of the government. The theory of "expansionary fiscal contraction" - eagerly adopted in the Treasury after May 2010 - would have told George Osborne to cut spending harder in the short term, and cut taxes to stimulate growth. Instead he has kept spending neutral and done very little on the tax cutting front.
Instead of a rapid rebalancing, with a sunny uplands populated by cheery manual workers, newly retrained from health or social work, we face a long, slow rebalancing and six more years of fiscal austerity. And the time it takes for the economy to recover to its 2008 level is now predicted to last until mid-2014. This is much longer than the actual depression of 1930-33 in the UK, and not much less deep.
So why did Osborne make the choice to deal with deficit first, growth second? The answer came from Fitch Ratings within hours of his speech:
"The capacity of UK public finances to absorb adverse economic and financial shocks that would result in yet higher public debt while retaining its 'AAA' status has largely been exhausted."
Let's unpack this: Fitch calculates - on its own definition - UK debt will peak at 95% of GDP - higher than Germany or France. If there is a financial shock - such as a bank crisis or a Euro sovereign default - which lowers growth further, pushing UK debt higher, that - says the agency - would likely lead to a rating downgrade. At that point, depending on how bad the rest of the world is performing, the UK would lose its current historic low cost of borrowing advantage.
Put plainly - there is a danger that a euro crisis would plunge Britain into the same vortex of downgrades, austerity and low growth that Europe is suffering.
Yesterday, then, allows us to look at the real structural problems and opportunities that face Britain. We are a country that was not able to enact "expansionary fiscal contraction" - because we had kidded ourselves about our basic economic potential, and because imported inflation hammers consumption, and because our export markets are no longer growing. Like America, we have an impoverished middle class whose spending power cannot survive a slump in house prices, and which has no pricing power in the workplace to raise its wages relative to profits.
The alternatives to this? Raise your economic potential through investment: in machines, research and better skilled people; re-orientate to different export markets; and disincentivise the importation of low-skilled operations. I.e. become a high-skill, high productivity economy oriented to the world, not Europe.
What the right learned yesterday is there is no swift route to this; what the left learned is the size of the fiscal overhang it will inherit should it ever get back into power. For yesterday will shape Labour's future as much as it will the Coalition's: markets are already pencilling in an attack of the vapours in late 2014 if it becomes possible that a Labour government committed to missing Osborne's new fiscal target will be elected.
And don't kid yourself that Britain is somehow immune, either, from the "government by technocrat" virus sweeping Europe. We saw last night the Lib Dems forced to effectively write their manifesto on the set of Newsnight; Labour too will now be wrenched from the leisurely world of blue-skies thinking, by boxfresh young frontbenchers in as yet unwrinkled suits. It will see its core electoral base - the public sector workforce and low-income families - subjected to four more years of demands for givebacks, job losses, service cuts, tax-credit cuts. But it cannot publicly support their protest actions. Those of us who've reported from the streets of Athens, and know what a leaderless mass of angry people looks like, know how disorienting a fiscal crisis can be for social democrats.
Osborne's original rebalancing plan had both a political and a fiscal advantage: it would kickstart a new kind of growth not based on property speculation and maxed out credit cards; and it would rapidly refill the Treasury's coffers with private sector tax revenues. At a stroke of the statistician's pen, this was made impossible yesterday - or at least impossible in the short term. And all this is premised on the non-implosion of the eurozone.
George Osborne revealed yesterday the Treasury is contingency planning for a euro breakup; the OBR revealed it was not part of that contingency planning. Maybe it should at the very least model what the options would be for a flatlining UK economy faced with a second credit crunch and a sharp slowdown in world growth. Economist Andrew Lilico on Newsnight last night predicted it would bring a 10% contraction in UK GDP.
"Contingency plan" sounds in a way safe, remote. We have to hope the actions of Mrs Merkel and President Sarkozy do not turn today's secret contingency plan into March 2012's Budget Statement.