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Less austerity will always mean more tax

Less austerity will always mean more tax

There is a great deal of discussion, following the election, of relaxing or even abandoning austerity.

There is an equal amount of confusion about this, because the same word is being used to describe two quite separate concepts.

The consequences of the government changing its policy on austerity are dramatically different, depending on which one it is.

One meaning of the word is what we might call “social austerity”. From any given pot of money available to a government, its supporters believe that, in general, tax cuts should be promoted rather than public spending increased. Opponents argue that public spending as a result has become underfunded. Local councils, education, and the NHS all need more money.

Social austerity can be relieved, as even the DUP and some Conservatives argue, by increasing spending appropriately, and funding it by increases in taxation. This was an important aspect of Labour’s manifesto, and the tragedy at Grenfell Tower has intensified the discussion around it.

The main risk is purely political. Are voters really and truly willing to pay more tax, rather than just wanting someone else to pay it?

There are some potential adverse economic consequences if the policy of higher taxation is pushed too far. Former French President Francois Hollande’s 75 per cent tax rate led to several hundred thousand skilled young people leaving France, mainly for the UK. If companies are taxed too heavily, they may choose to locate to another country. Both skilled labour and capital are geographically mobile.

But, within reason, social austerity could be relaxed without perhaps too many fears in this direction.

“Economic austerity” is quite a different matter. Opponents of this want to increase the gap between government spending and tax receipts – the so-called fiscal deficit. This is funded by issuing government bonds. So the deficit in any given year goes up, and the outstanding stock of government debt also rises.

Any relaxation of social austerity is paid for by higher taxes now. Any relaxation of economic austerity is paid for by borrowing more now.

But the debt has to be repaid at some point, and the interest payments on it must be met. So taxes in the future will be higher. Either way, less austerity means more tax.

John Maynard Keynes himself made it very clear that increasing public spending at a time of full employment would simply lead to more inflation. There are areas of the country where there probably are people registered as unemployed who genuinely do want to work – the Welsh Valleys, for example. But the rest of the UK is at full employment.

The number of people in employment is at an all-time high, at 32m. This has risen by 2.8m since 2010. Meanwhile the unemployment rate has fallen from 7.9 per cent in 2010 to just 4.6 per cent today.

Any major fiscal stimulus to the economy now would simply bid up wages, leading to higher costs and higher inflation.

The public mood on social austerity may have shifted. But the case for economic austerity is stronger than it has ever been.

As published in City AM Wednesday 21st June 2017

Image: People’s assembly by Peter Damian is licensed under CC by 2.0
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Brexit was the final straw: it’s time to scrap the IMF

Brexit was the final straw: it’s time to scrap the IMF

Sports fans will all be familiar with the commentator who almost always gets things wrong. “Arsenal are very much on top here” he – it is invariably a “he” – will pronounce, or “Root is looking very settled”, only for the opposition to score a goal immediately and for the Yorkshireman to be clean bowled. In economics, a similar role is played by the International Monetary Fund (IMF).

In the middle of July, Remain fanatics had a field day. “The IMF has slashed its forecasts for the UK economy for next year after Brexit”, crowed the Financial Times. Maurice Obstfeld, the Fund’s chief economist, claimed that Brexit “has thrown a spanner in the works”. Global growth projections for 2017 were cut back, but most of all for the UK.

But on the first day of September, the IMF was forced to admit that growth in Britain had, in a splendidly bureaucratic phrase, “surprised on the upside”. On the same day came the news that manufacturing activity in August had posted its biggest monthly rise in 25 years. On Monday this week, the Markit purchasing managers’ index for the service sector registered the biggest monthly increase in its 20 year history.

The IMF has real form. In 1998, East Asia was experiencing a major economic crisis. Yet in May 1997, the IMF was predicting a continuation of very strong growth in most countries for the year ahead: 7 per cent for Thailand, 8 per cent for Indonesia and 8 per cent for Malaysia. They revised the projections down by December, but even these proved wildly optimistic, as the economies collapsed during 1998, registering a fall in output of over 15 per cent in Indonesia, for example, worse than America in the Great Depression of the 1930s.

Macroeconomics is the study of variables such as GDP which describe the economy at the aggregate level. Since the 1980s, it has been dominated by the concept of equilibrium. Highly mathematical models have been developed, resting on the premise that the economy can correct itself and absorb any shocks. Olivier Blanchard, the IMF’s previous chief economist, was a great enthusiast for this project. In August 2008, he published a paper which concluded with the claim “the state of macroeconomics is good”. Three weeks later, Lehman Brothers collapsed.

Apart from the European Commission itself, the IMF has been probably the biggest cheerleader for the euro. Since the inception of the single currency in 1999, a whole series of statements and technical articles from the IMF has eulogised its mystical benefits. At the end of July this year, the IMF’s own Independent Evaluation Office (IEO) was totally scathing of the Fund’s record on this. The top staff became impervious to other points of view and ignored warning signs of the financial crisis. In their view of the world, it simply could not happen.

The IMF exercises enormous influence and power. Yet its persistent ineptness makes England football managers look like world beaters. To add insult to injury, its staff enjoy tax free salaries. It’s time to close the Fund down and go back to the drawing board.

As published in CITY AM on Wednesday 7th September 2016

Image: Valsts kanceleja/ State Chancellery is licensed under CC BY 2.0

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Corbyn is completely out of touch with the real debate about UK austerity

Corbyn is completely out of touch with the real debate about UK austerity

Following the Brexit vote, normal service seems to have resumed. A key question in economic policy since the General Election of 2010 has moved centre stage once again: should the government abandon austerity?

At one level, the question has an easy answer. Interest rates are now so low that the UK government can borrow for 30 years at a rate of not much more than 1 per cent, so some relaxation in terms of infrastructure spending does seem sensible. It is essential that the projects are not motivated by purely short-term political expediency, but in principle they are a good idea.

For Jeremy Corbyn, the answer is even easier. He would carry out no less than £500bn of extra public spending. How would this be paid for? Even easier, just grow the economy, stupid! Extra taxes generated by economic growth will fund whatever we like.

This is not a spoof, it is what Corbyn and his shadow chancellor John McDonnell actually believe. Taxes are currently about 40 per cent of the economy, so to pay for £500bn of extra spending, the economy needs to grow by something like £1.25 trillion. Its total size at the moment is just under £2 trillion. This stupendous growth will take place like something out of Harry Potter, once Jeremy waves his wand.

The real task of political economy facing the chancellor is a much more difficult one. At one level, there is no need to relax the policy of austerity and the simple reason is that the UK is at full employment. The unemployment rate from April to June, the latest data available, was just 4.9 per cent. This is well below the average of 7.3 per cent during the period since the major oil price shock in 1973. Record numbers of people are in work, no less than 31.75m of them, up by 600,000 on the same period a year ago. The labour market is essentially in equilibrium, and almost anyone who wants a job can get one.

But a key reason for full employment is that labour has priced itself back into work. Following the recession in 2008, earnings after allowing for inflation fell every single year until 2014. Only last year was this trend halted and a modest increase registered. Workers have become cheaper to employ.

The downside is that many people in work have experienced falling living standards. If real earnings rose by 5 to 10 per cent to make up the lost ground, on the one hand there would be less incentive for an individual employer to hire someone. But on the other hand, the “price” of labour is the wage, and higher wages mean more money to spend, and higher demand for goods and services. So more workers would be needed by firms to satisfy this demand.

In principle, full employment can exist with higher earnings. The risk, however, is that we become trapped in a relatively low wage full employment situation.

If the government were to relax austerity to do something about this, it would be a very difficult balancing act to pull off. But the political rewards could be huge.

As published in City AM on Wednesday 31st August 2016

Image: Anti Austerity March London by bjpcorp licensed under CC BY 2.0

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Why austerity must be the order of the day for May’s chancellor

Why austerity must be the order of the day for May’s chancellor

On the face of it, the Brexiteers have a bit of explaining to do.

A week before the vote, Boris Johnson dismissed fears about the value of sterling, and accused the governor of the Bank of England of “talking the economy down”.

Yet the economy does seem to have stalled, property funds have had to suspend redemptions, and the pound has collapsed. So what is to be done? The chancellor – whoever Theresa May chooses for the job – faces something of a challenge to kick-start the economy and restore confidence. Fortunately, economic history provides some very clear guidelines.

In 1949, the post-war Labour government devalued the pound by 30 per cent, from a rate of $4.03 to $2.80. The latter rate held until 1967, when the Labour government of Harold Wilson reduced it further to $2.40, a fall of 14 per cent.

By the time of Margaret Thatcher’s first government, the world had moved away from fixed exchange rates to a floating system. Against the dollar, sterling fell by 13 per cent in 1981 compared to the previous year, and by further 14 per cent in 1982.

In each case, the devaluation was followed by periods of strong economic growth. In the five years after the devaluation of the late 1940s, GDP grew by an average of 3.7 per cent a year. Following the Wilson devaluation, the five year average was 3.6 per cent, and the corresponding figure in the 1980s was 3.9 per cent.

These compare to the average over the post-war period of just 2.5 per cent. Obviously, a fall in the value of the pound makes our exports more competitive and enables British goods and services to compete more effectively against imports in our domestic markets. But there was an additional factor which was necessary to take advantage of the devaluations.

In both the late 1940s and mid to late 1960s, the economy was at full employment. There was a bit more slack in the early 1980s, but this was almost entirely in the old industrial areas. In the current situation, we are effectively at full employment. The unemployment rate is only 5 per cent, and a record 74.2 per cent of the working age population are in work. Space had to be created to enable net exports to expand.

In each of the three historical episodes, the then chancellors did so by tightening the fiscal stance. In other words, by implementing austerity.

Under the left-wing government of the 1940s, the policy was dramatic. A budget deficit of over 6 per cent of GDP (over £100bn at today’s prices) was transformed to surpluses of 4.6 per cent in 1949 and 3.4 per cent in 1950. Roy Jenkins changed the 1967 deficit of 3.9 per cent of GDP to a surplus of 1.8 per cent in 1969. And Geoffrey Howe provoked the notorious letter signed by 364 economists by cutting public spending in the early 1980s. In each case, devaluation combined with drastic fiscal tightening worked wonders.

The lesson is clear.

As published in City AM on Wednesday 13th May

Image: Numbers and Finance by reynermedia licensed under CC by 2.0

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Is Britain on the edge of recession? History is an unreliable guide

Is Britain on the edge of recession? History is an unreliable guide

Concerns are growing about a marked slowdown in the UK economy. The Lloyds Bank purchasing managers’ index, for example, fell to 52.1 in April, its lowest point since 2013. The initial estimate for GDP, total output, in the first quarter of this year shows an increase of just 0.4 per cent on the final quarter of 2015.

Growth since the start of 2015 has been only 2.1 per cent, a rate which is a rough benchmark as to whether employment rises or falls. Indeed, in February, the latest month for which we have data, the Labour Force Survey showed that the total number of jobs in the UK was unchanged since December.

On the positive side, the economy has definitely grown since the recession, with output being up by 7.3 per cent on its previous peak value just before the recession in the first quarter of 2008. And these are the official estimates, which may not be able to cope with measuring accurately activity in the new cyber economy.

But economic slowdowns and recessions do happen. Indeed, they are a fact of life. The upsurge in inflation in the 1970s, when it reached 25 per cent, captured the mind-sets of policy-makers and prevented them from realising that low inflation, which we have now had for over 20 years, is normal. In the same way, the long period of continuous expansion during the 1990s and 2000s distorted expectations about what is normal. This period, which economists dub the Great Moderation, during which Gordon Brown claimed he had abolished boom and bust, makes people think, incorrectly, that recessions are very unusual.

We have quarterly GDP data in the UK going back to 1955. Economists have a fairly arbitrary definition of a recession as being at least two successive quarters of negative growth. Since 1955, we have had eight such periods. So, on average, we have a recession once every seven or eight years. We had one in 2008-09, and we might think that, on the law of averages, one is due now.

Things are not so simple. Economists write about the “business cycle”, as though the fluctuations in economic growth were regular. But this is a piece of jargon. The Nobel Laureate Robert Lucas pointed out 40 years ago that the key feature about economic ups and downs is that most sectors of the economy tend to move together, so we can presume there are general factors driving the economy. Specific factors will influence specific industries, but these do not cause the economy as a whole to boom or shrink.

The gaps between recessions are in fact pretty irregular. For example, there was one in 1956 and another in 1957. The recession of 1973 was followed quickly by the one in 1975. In contrast, there was a gap of 17 years between the 1990-91 contraction and the financial crisis.

Decision-makers do not like uncertainty, and Brexit is certainly creating this. Capital spending by companies stopped growing in the late summer of 2015. So it might all bounce back after 23 June.

Paul Ormerod

As Published in City AM on Wednesday 12th May 2016

Image: Pound Coin by Andrew Writer licensed under CC by 2.0

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No more whingeing, please. The recovery is solid.

No more whingeing, please.  The recovery is solid.

Last month saw some very positive economic news. The US Federal Reserve raised interest rates for the first time in over seven years.  The Bank of England reported on the major stress test of UK banks which it launched in March 2015.  It concluded that “the banking system is capitalised to support the real economy in a severe global stress scenario”.

Yet much of the discussion on the economy remains tinged with various hues of gloom.  We expect John McDonnell, the Shadow Chancellor, to be living in the past.  So it is not surprising that he has launched a “fight against austerity” with Yanis Varoufakis, the former Greek finance minister.  But many commentators seem to find it hard to believe that the recession in the UK is well and truly over.

Some argue that the recovery has taken place, but that it is somehow “unbalanced”.   True, manufacturing is struggling, with highly publicised plant closures in what have become effectively commodity industries, like steel.  But the data from the Office for National Statistics suggests a virtually textbook example of a sustainable recovery.

The depth of the crisis was reached in the spring and summer of 2009, and we now have the initial estimates for the economy for the same period in 2015.  GDP as a whole increased by £100 billion, after allowing for inflation, a rise of nearly 13 per cent.  Companies spent an additional £32 billion on new investment in 2015 compare to the same period six years ago.  In percentage terms, this was by far the fastest growing sector of the economy, up by 26 per cent.   In contrast, consumer spending grew by only 10 per cent, less than the economy as a whole.  It has been an investment-led recovery, with the role of public spending being negligible.

From a historical perspective, the recovery profile is better than it was in the 1930s, the previous time there was a major financial crisis on a world scale.  The economic historian Angus Maddison devoted his life to constructing the annual national accounts of the developed economies going back to the late 19th century, and his work has widespread academic credibility.  Peak output prior to the Great Depression was in 1929.  In his sample of countries, only just over a half had regained this level by 1937.   This time round, taking the same group of economies, 80 per cent of them had a higher GDP than in 2007.

The only area which really continues to struggle is the Mediterranean economies in the EU.  In Spain, output is 4 per cent lower than in 2007, in Portugal it is 6 per cent down, in Italy 9 per cent and Greece has seen a drop of no less than 26 per cent.  The crisis exposed deep structural problems with these economies.

In contrast, GDP in the G20 economies has risen by 24 per cent since 2007, the last year before the recession began.  And they account around 85 per cent of world output.  The economic discourse has become disconnected from reality.

As published in CITY AM on Wednesday 6th January

Image:Yanis Varoufakis by Marc Lozano licensed under CC BY 2.0

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