Tuesday 23 April 2013

The deficit is falling..

[Updated 17.00 with HMT response: see end]

The deficit is falling!  Today's figures show that the budget deficit for 2012-13 (public sector net borrowing, excluding some of the more obvious distortions) was £120.6 billion  - £0.3 billion lower than in 2011-12. So maybe the Chancellor's cunning plan - to reduce last year's deficit by not paying some of the UK's bills until this year, also known as "the cheque is in the post" strategy, has worked.  Or, more prosaically, the government has simply cut public investment again - net investment was £2.4 billion lower in March 2013 than in March 2012, while the current deficit was about £1 billion higher.

So is the plan on track? Certainly not measured against the government's original intentions.  The Chancellor's first "benchmark for Britain" was to cut the deficit at a faster rate than that set out in his predecessor's plans. But under those plans the deficit was supposed to be now about 1% of GDP ( £15 billion) lower than today's figures show. Of course that would never have happened - those plans too were far too optimistic, and would have proved undeliverable. But describing them as insufficiently ambitious - indeed as likely to lead to a debt crisis - and then making even less progress than they implied, can hardly be described as policy success. 

But where we are now is more important.  And here the key point is that, as Robert Chote, Chair of the independent Office of Budget Responsibility, has pointed out, deficit reduction "appears to have stalled". Here's his chart:

So what's going on? As I noted earlier, most of the deficit reduction has come from cutting public sector net investment (spending on schools, roads, hospitals, etc) roughly in half. Pretty much all the rest came from tax increases (note that the investment cuts and tax increases were both, to a significant extent, policies inherited from the previous government). And we can see when it happened - between 2009-10 and 2011-12.

But these sources of deficit reduction stopped in 2011-12, because the government belatedly realised that cutting investment was a major mistake and that the economic imperative was actually to do precisely the opposite (not that there was much investment left to cut); and it stopped putting up taxes overall. So we can see also what's happened since - with the impact of the weak economy on tax receipts reducing revenues, the deficit has been flat and is projected to stay flat. As the IFS puts it:

"The bigger picture is the same: the Government has implemented a combination of tax rises, welfare spending cuts and cuts to spending on public services and brought about a reduction in the deficit between 2009–10 and 2011–12. However, while 2012–13 also saw further austerity measures being implemented, weak economic performance has meant that the deficit was largely unchanged from its 2011–12 level. The same is forecast to be true in the current financial year: the OBR's forecast is that borrowing will fall by just £0.9 billion to £120 billion in 2013–14. This would leave the deficit largely unchanged for three years."
Of course, contrary to the rhetoric, there was an alternative. In fact there were (at least) three. 
  • The first would have been to listen to the growing economic consensus - now finally joined unequivocally by the IMF, where economic analysis is finally overriding political expediency - that, with borrowing rates at historic lows, ample spare capacity, creaking infrastructure, and a chronic shortage of housing supply, now is the time to borrow and invest. This might raise borrowing in the short term, but at no great short-term cost and with substantial short-term benefits to growth and longer term benefits to the economy. 
  • The second would have been to follow the example of eurozone policymakers, and react to the lower economic growth and hence weaker public finances that have resulted from premature fiscal consolidation with still more, and more damaging, austerity; the death spiral in which several eurozone countries remain trapped. This option has been tested to destruction in Greece and Spain; it would have been a disaster. 
  • The third would have been to listen to what I describe as the neo-Hayekian approach of cutting taxes, but cutting spending even more. This has the merit of intellectual consistency - and of course it is perfectly legitimate to argue, on either political or economic grounds, for a much smaller state over the medium term - but would again, in my view and that of most mainstream economists, be catastrophic in current circumstances. 
The government has chosen none of these alternative approaches; instead, it is simply muddling through.  A year ago I described the government's refusal to change course as the "Macbeth" approach to policy: well, although the blood is still up to his waist, Macbeth has now decided to pause in the middle of the river.  While this is undoubtedly better than pressing on, or adopting the second or third of the approaches set out above, there is no economic rationale, theoretical or empirical, that I  can think of to justify the particular - very odd looking - trajectory of deficit reduction set out in the chart above (note that the reduction in the cyclically adjusted current deficit, the government's notional target variable, also stalled this year). There's nothing in economic theory that says you pause a third of the way through a deficit reduction programme which has gone way off track; nor does the fiscal framework, now effectively defunct with the abandonment of the debt target, dictate this approach. As Matt O'Brien puts it, austerity - such as it is - is "a policy without a justification." We're here because we're here because we're here. 

So what happens next? Eventually, assuming that reasonably healthy economic growth returns, as both we and the OBR do indeed forecast, deficit reduction resumes at a fairly rapid pace, although this to a large extent depends on what Paul Krugman in the US context describes as "magic asterisks" (that is, future spending reductions that are simply assumed in advance of actually having policies to deliver them). 

One thing we can be reasonably certain of is that the Budget will in itself do little or nothing to boost growth; the OBR has gone through all the significant policy measures in the Budget (Box 3.1) and concluded that while some will have very small positive impacts, and others equally small negative impacts, the overall impact is negligible.   That's not to say we won't get a proper, sustainable recovery at some point; the UK's underlying economic strengths remain, as the current health of the labour market illustrates. But it won't be thanks to macroeconomic policy.

To sum up; an honest and accurate description of the progress on the government's deficit reduction plan would be:
"We reduced the deficit by a third in our first two years in government, mostly by massive cuts to public investment, which we now understand were a big mistake and have damaged the economy. We've also now realised that trying to reduce the deficit further while the economy isn't growing is self-defeating, so we're not even going to try to get back on track until it does grow. We won't miss our fiscal targets, since we no longer really have any. If the IMF understood that we're not really going anywhere, perhaps they would stop telling us to change course."
UPDATE 17.00 23 April. 

The Treasury have been in touch with a response: here it is in full: 
"Given the unprecedented size of the UK's fiscal deficit and the record overhang of private sector debt, the Government's macroeconomic strategy is a combination of fiscal responsibility and monetary activism. The Government has set fiscal policy to meet the fiscal mandate which is to eliminate the structural current budget deficit over a 5 year forecast horizon. In response to slower than forecast growth due to the eurozone crisis and the damage done by the financial crisis, the Government has stuck to announced fiscal plans while allowing the automatic stabilisers to operate freely and has not tightened fiscal policy in order to chase the debt target. This strategy is well understood by economic commentators and financial markets and has maintained fiscal credibility while delivering a gradual and relatively steady reduction in the estimated structural deficit. Since the Government came to office the deficit is down by a third and the structural deficit has been reduced by more than any other G7 country. Over the forecast horizon the reduction in the structural deficit is around 1% of GDP per year, in line with the IMF's recommendation for advanced countries, despite the fact that the UK has one of the largest structural deficits in the developed world."
Readers can largely judge for themselves. I will merely note three points. First, as observed above, and explained more fully here, eliminating the structural current deficit in 5 years - without the debt target - is not a constraint on anything.  The Treasury is well aware of this, because in the 2010 Budget they gave a very clear explanation of the need for the debt target to ensure that there is some binding constraint.  Second, note the unexplained switch in the second half of  the paragraph from the structural current deficit to the structural deficit, which is not the same thing and was never part of the original framework.  As for "relatively steady reduction", we can simply look at table 4.34 of the OBR's Economic and Fiscal Outlook, which shows essentially no reduction in the structural deficit ("cyclically-adjusted PSNB ex. Royal Mail and APF") in 2012-13.  

To repeat, policy could undoubtedly be worse; muddling through is better than some of the alternatives. But I remain of the view that this is not a coherent fiscal strategy.  

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