LlewellynConsulting | Macro series | Russell Jones and John Llewellyn 14 November 2019
UK fiscal policy – a dangerous change of regime
The wild fiscal policy proposals of the major UK political parties risk sparking a sterling crisis.
The UK general election debate is unedifying. The middle ground has been largely abandoned, and the major political parties are enthusiastically employing the intemperate rhetoric and deceitful tactics of populism.
This is scarcely a surprise. Populism is a global phenomenon, and additionally in the UK the Brexit imbroglio has poisoned the political well. The country is frustrated and riven. Anything that can move the discussion on from Britain’s EU exit, however tenuous its relationship with reality, is gladly embraced. But predicting the electoral outcome is nigh on impossible at this stage: deep divisions cut across traditional party lines, enormously complicating the psephological arithmetic.
Fundamental change of tack
Nowhere is the influence of populism more obvious than in the sphere of fiscal policy. Post-2008 austerity has been consigned to history. The major political parties are frantically trying to trump each other’s promises of budgetary largesse. The rhetoric drives a coach and horses through previous expectations for government deficits and debt. Old fiscal rules have been abandoned, to be replaced with much less constraining alternatives. Any notion of balancing the budget in the foreseeable future has been discarded. And all this at a time when an ageing population will necessitate large increases in current spending on pensions and health care.
Such is the scale of the fiscal expansions being proposed that precise numbers matter little, even if it is clear that Labour’s undertakings are the most fantastical. That said, at least Labour has signalled a willingness to raise taxes to fund its plans, albeit overwhelmingly on business. The Tories, extraordinarily, are actually promising to cut taxes, but have not said by how much.
One way to frame today’s capacious plans is to compare them with the manifestos launched prior to the general elections of 1997 and 2005. Ahead of the former, a Labour Party out of power for 18 years, and determined to establish its macro policy credibility, confined its election pledges to five modest initiatives, and committed itself to the incumbent Tory government’s public spending limits for two years. Ahead of the latter, the Conservatives, out of power for 8 years, promised to hold public spending 1% below the existing Labour government’s plans. How things have changed!
We ourselves have long taken the essentially technocratic view that, with monetary policy having largely run its course, interest rates so low, and public sector budget constraints thereby less onerous, there is a strong case for making greater use of fiscal policy to manage aggregate demand. We also favour higher UK public investment spending to address infrastructure bottlenecks, improve the economy’s supply side, and begin to address climate change.
At the same time, however, we recognise that such policies need to be framed within regular, sound, and transparent assessments of the public sector accounts; sensible guidelines for future deficits and debt; and adequate cost-benefit analysis of projects. They also must be calibrated with available resources; and take due account of the limitations imposed by international capital flows.
The electoral promises of the major UK political parties fall short on all these counts. The Office for Budget Responsibility was prevented from publishing its scheduled November forecast. The more that the fiscal rules are changed, the greater the risk to policy credibility. The larger the number of investment projects, the more the threat that oversight, control, and efficiency fall short.
And all this at a cyclical peak
Perhaps most worrying of all, the UK is running sizeable twin deficits. Ten years into an upswing, its consolidated budgetary shortfall still amounts to 2% of GDP. Even on optimistic growth assumptions, it stands to rise; and the deterioration would be sharp should there be a recession. The external deficit is more troubling still: its historically-high projected value of 5.5% of GDP for this year is well above that of its major competitors, and exceeds the ‘Rule of four’ threshold. 1
And all this comes at a time when the Brexit deal threatens to reduce the UK’s already lowered potential GDP by a further 3½ percentage points of GDP or so over the coming decade. 2 The resources to deliver bountiful spending programmes will not be there. The unavoidable conclusion is that fiscal incontinence risks pushing Britain towards a sterling crisis.
1 Initially proposed by Norges Bank Deputy Governor Jan Qvigstad to provide a simple-to-calculate, easily-understood portent of danger in the OECD economies, ‘The Rule of Four’ focusses on a country’s inflation rate, and its current account and budget deficits expressed as a percentage of GDP. A value of 4 or above for any of these variables is generally a warning signal, while a value of more than 4 for two or more of these variables almost certainly spells serious trouble. Qvigstad. J., Llewellyn. J., Vonen. N.H., and Dharmesena. B. 2012. The ‘Rule of Four’. March. Available on request from Llewellyn Consulting.
2 Hantzsche. A. and Young. G. 2019. The economic impact of prime minister Johnson’s new Brexit deal. NIESR Review. Issue 250. 30 October.
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