Sunday, 10 February 2013

Reflections on the Green Budget

The IFS Green Budget - the 2013 version of which was published last week - is as ever essential reading for anyone interested in UK macroeconomic and fiscal policy.  Catching up with it a little after the event, the following passages jumped out at me:
"Domestic demand is now rising. Although this is not the first time that "green shoots" have been observed, it nevertheless remains likely that the economy will begin to recover this year...The main threat to this outcome is the recession in continental Europe, where German monetary influences are still forcing policy to be unsuitably tight for domestic purposes.  A substantial portion of Britain's trade is with this bloc, and we could still suffer an unpleasant backwash from Europe's problems."
"The public finances are in a substantially worse state than anyone expected this year. This was because GDP growth did not emerge, leaving the economy smaller than it was expected to be.  We anticipate borrowing for this year will be about 7 per cent of GDP. .."
Since the government has already announced its public spending plans, and since it is likely to have considerable difficulties in hitting these plans, most of this budgetary tightening will almost certainly have to come from higher taxation...Our view is that significant tax increases will be necessary if the public finances are to be brought under control."
A table shows projections for borrowing under "optimistic", "baseline" and "pessmistic" assumptions about the growth of the economy, assuming no further tax increases. Under the "baseline" one, borrowing is still 6 per cent of GDP in four years time; even under the "optimistic" one - which assumes a quick recovery followed by rapid growth - it is still more than 2 per cent.

And so on.  The document rightly points to the sensitivities of these analyses to the "output gap", or amount of spare capacity in the economy; but the overall impression is pretty dismal. The UK remains in a big fiscal hole, the result of over-optimism about the economy's growth potential, deflated by a major financial crisis that was in turn followed by very slow (or no) growth. Only eye-wateringly tight restraint on public spending, combined with substantial new tax increases, can possibly fill the gap.  And this broad analysis was very much the message of the media reporting of last week's Green Budget.

So what should we conclude from this?  Well, perhaps, in order to assess its credibility, we should first check the identity of the authors of this particular Green Budget:  They are Gavyn Davies, Evan Davis, Andrew Dilnot, Andrew Lilico, my old colleague Harold Freeman, and of course the current IFS Director, Paul Johnson. An illustrious bunch. Although most were not quite as well  known in 1993, when it was published. Some have gone on to greater things; Paul, of course, left IFS for government and then returned as Director.

OK, so I've made my point: plus ca change, we've been here before, economic forecasts aren't worth much, and so on.  But I think we can learn more from it than that.   In the 1993 Budget, the Chancellor (Norman Lamont) did (some of) what the IFS recommended: he announced some future tax increases, although not nearly as much as the IFS would have liked or thought necessary to get the public finances back on a sustainable path.  But, as I explain here, the IFS and the Chancellor got the macroeconomic policy judgement precisely right. The IFS argued that fiscal tightening should be delayed until there was a clear recovery in domestic demand; that's what the Chancellor did.

And what happened to the public finances? Well, unknown to the Chancellor and the IFS, recovery was already well underway in February 1993. Over the next few years, the economy and even more so the public finances far outperformed even the IFS' "optimistic" scenario (described as "at the extreme end of what might happen").  And so did the public finances - by 1997-98 the current budget deficit had been eliminated:

What should we conclude from this?  I would highlight the following points:

  • First, on forecasts, I would emphasise that I'm not criticising the IFS then or now: I'm sure NIESR's 1993 forecast was well off the mark too; forecasting the public finances over the medium term is at least as difficult as forecasting the wider path of the economy. And of course this year's Green Budget, like the 1993 one, fully recognises the uncertainties.   But the point is what you use the forecasts for; I would argue that we should not take them as a given on which policy should be based, but rather as one scenario, which policy - and many other factors - can and will change, for better or worse. 
  • Second, on fiscal policy, I've said this before, but it bears repeating. There is a simple, absolutely standard prescription for dealing with unsustainable deficit resulting from a recession.  It is the following. Announce, and commit clearly to, tax and spending measures to deal with the deficit.  But ensure implementation follows recovery, not precedes it. That's what the IFS recommended, and exactly what Norman Lamont and Ken Clarke did in the early 1990s; it's not what this government had done, although, as the IFS rightly points out, the Chancellor has very sensibly decided not to tighten policy further, even at the cost of abandoning his fiscal targets.  
  • Third, and most importantly, growth, rather than specific tax or spending measures, is the prerequisite for restoring the public finances to a clearly sustainable track. A few years of 3 percent growth - and given the amount of spare capacity in the UK economy, there is no reason that should be infeasible, given good policy both here and in the eurozone - and much of the problem will simply vanish, as tax revenues rise and some spending falls. Moreover, to the extent that tax rises and spending cuts will indeed be necessary - and they will, just as they were in the 1990s - it will be much easier , both politically and economically, to deliver them in an environment where jobs are plentiful, real incomes are rising, and companies are investing.  By contrast, if growth doesn't get out of the 1-2 per cent range, then we will indeed face the problems this year's Green Budget identifies.  
So the government - and the rest of us - should worry a lot less about the, highly speculative and uncertain, implications of the IFS's 2013 projections for future tax and spending; and much more about what policy actions are required now to generate growth, both immediately and in the medium term.  There are lots of good ideas out there; notably, the Green Budget itself includes a proposal for an extra £20 billion of public investment, financed by borrowing; which is of course precisely what I've been arguing for the last year.  In addition, we have the LSE Growth Commission's emphasis on long-term planning for infrastructure, human capital and innovation: Adam Posen's set of proposals for boosting both private and public investment; and the Fabian Society's "Great Rebalancing" collection (including mine on immigration).   All these programmes have much in common, in particular an emphasis on investment, broadly defined, and making a reality of the slogan that the UK should be "open for business".  Those should be the Chancellor's priorities for the "real" Budget. 

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