Mervyn King has famously said that the tax increases and spending cuts that would be needed to plug the UK's budgetary hole would be so unpopular that they will keep the party that introduces them "out of power for a whole generation". Aside from the point that this is just the latest in a long line of communications incompetence and political-meddling from the Bank of England's Governor (yes, I'd sack you, Merv!), does he have a point?
The real question here is "what is the impact upon growth and employment of a significant fiscal consolidation?". The widespread and off-the-cuff answer to this is usually "well, obviously growth is going to collapse and unemployment is going to sky-rocket". Nearly thirty years have past since "Thatcher's cuts" of the early-80s, and the political, economic and media narrative appears to treat the early-80s as being a single event caused by "Thatcher's cuts". As a result, it is commonly accepted that fiscal contractions are terrible for growth, employment and, by extension, government popularity. Indeed, many cite the deep unpopularity of the Conservative government in 1981 - the time when the Lib/Lab Alliance was posting approval ratings in the 50%+ range. Again, the common parlance is that the Falklands War was the only reason that Thatcher was re-elected. The latter point may well be valid, but an analysis of why the Conservative government was so unpopular in 1981 is instructive.
As with most things I rant about, this is a case of conventional wisdom not getting the facts right. The below chart shows quarterly GDP around the 1979-81 recession. The red line is where Geoffrey Howe announced his austerity budget (in March 1981) and the 1980s fiscal consolidation began. So if the government was deeply unpopular in 1980-81, it was clearly not as a result of Howe's austerity budget.
But what about the effect of fiscal tightening itself? Goldman Sachs have put together an excellent paper (Global Economics Paper No:195 - "Limiting the Fall-Out from Fiscal Adjustment", Ben Broadbent & Kevin Daly) that looks at 24 OECD countries' fiscal consolidations over the past 35yrs. The common criticisms of such studies are that conclusions drawn from them may be reflecting other factors, such as FX depreciation, falls in interest rates/bond yields and the stage in the economic cycle (the more cynical view is that Keynesians and politicians have an interest in fiscal easing and prefer to criticise any policy that withdraws stimulus early on in a recovery - Krugman, Stiglitz, and the LSE fall under this bracket!). Goldman Sachs have attempted to control for these effects, and came to some pretty striking conclusions:
These are pretty remarkable conclusions, supported by a recent OECD paper and also by a recent UK Treasury paper. They conclude that the optimum fiscal consolidation program is 80% expenditure-driven and 20% tax-driven. This is the stance held by the Conservative party (Labour plan 67/33), if only articulated to a "fluffy cloud" degree for political expediency. Given the above evidence (as well as that of above-trend growth in the UK from 1981-87), it is likely that many will be surprised by just how little growth is affected by these austerity plans.
Back to business investment point. When there are severe fiscal imbalances, evidence suggests that the both consumers and businesses save on a precautionary basis, expecting future tax rises in a form of Ricardian Equivalence. It is therefore plausible that if a government cuts spending, then the probability of such tax rises in the future falls, and thus pent-up demand from consumers and businesses is released, driving the recovery. This is a form of "crowding in". Such moves may also loosen monetary conditions by reduced fiscal premia on long term debt or via FX depreciation (as the government is no longer spending on domestic "stuff" and workers, system-wide unit labour costs fall, lowering the Real Exchange Rate, and increasing the competitiveness of the private sector). On this point, it is important to remember that a government deficit is the mirror of the private sector's (including the external sector) surplus. For the UK, the external sector is zero (the Current Account is currently balanced - this is a KEY DIFFERENCE with the PIGS, all of whom run Current Account deficits and rely on external financing), and therefore, by equivalence, the private sector is saving at an unsustainable rate. The below chart shows UK Business Investment at an historic low of -23.5% y/y (ignore the 2005/6 spike which was a one-off accounting issue) and also clearly shows a very large bounce in business investment during the years of Howe's fiscal consolidation. Given that there is much uncertainty regarding the election and sovereign credit rating, it is very possible that corporates are in a state of "wait and see" until there is clarity post-election. It is also worth remembering that business investment in both the UK and US has been subdued since the DotCom boom, and a notable feature of the current US recovery has been that businesses have been ramping up investment. Post-election, it is highly likely that this will occur in the UK, in tandem with fiscal consolidation in the manner demonstrated in the GS study above.
The final point I want to address is the view that fiscal consolidation implies a weaker FX rate and that post-1981 the Pound depreciated significantly. As discussed above, this economic phenomena operates via unit labour costs cheapening the REER. The below chart shows General Government Consumption as a share of GDP (white line), and the Bank of England's Calculated Effective Exchange Rate (Orange/Green - two overlapping series) lagged by six months. It is clear that over time there is a broad relationship between the two: as the government's share of the economy increases, it pushes up labour costs and crowds out the private sector (thereby increasing the Real Exchange Rate), and as its share fall, the opposite effect occurs. Obviously, the relationship is not completely tight over time (and far from the only driver of the exchange rate), but broadly speaking this effect has been observable, especially in the 1980s. More recently, it appears that Sterling anticipated this effect in 1996-7 as it became more likely that Labour would be elected. I think the large disconnect since 2008 is a combination of the bank bailouts not representing actual expenditure, but instead loans, and the market already pricing in the likelyhood of a significant fiscal contraction in the coming years. On this basis, therefore, it is hard to argue that GBP should weaken further as the UK tightens fiscal policy. As a corollary, it is remarkable that Gordon Brown's Statism makes the 1970s look pretty tame by comparison, with Government consumption as a share of GDP the highest on record (since 1960).
As an aside, was the fiscal effect the only phenomena in the 1978-85 period? The below chart shows the BoE Calculated Effective Exchange Rate (orange), and the white line below shows the spread of the BoE Base Rate to the IMF Special Drawing Rights interest rate (which is an average interest rate for IMF shareholders) lagged by 6months. From 1978-80, the UK boasted a spread of as high as 930bps over the SDR-average, and as a result the Pound appreciated significantly, reversing all of its losses on this CEER-basis since 1974. Over the first half of 1981, as the recession crimped inflation, policy was loosened (as it was globally). For the next few years, this spread oscillated around +/-200bps. Perhaps one of the main reasons that the Pound fell from 1983-84 was that the Fed tightened policy by 313bps, but UK inflation remained relatively benign in that period. To conclude here, it's possible to see the fiscally-driven weakening, but it is arguable that this was not necessarily the entire reason why GBP traded weakly during this period.
I digress...
The point of this piece is to demonstrate that fiscal consolidation is not necessarily ball-crunching and, if enacted in a sensible way (i.e. the 80/20 rule), can actually act to crowd-in private sector investment - which will invariably create new, more economically useful jobs than those that are lost in the public sector. The misconceptions around the early-80s "Thatcher cuts" have served to create the impression that fiscal consolidation is only a bad thing, and the anti-Tory narrative of the Left over the past 30yrs has encouraged this perception. But the real pain in the early-80s was in response to the very significant monetary tightening from 1979-80, and in the mid-80s in the North as a result of Thatcher's war with the National Union of Miners. Neither of these two events is going to occur this time around because the BoE has inflation-fighting credibility (though, Mervyn King is doing his best to wreck this!) and there aren't any miners to fight. Of course, this is not to say that public sector unions will not fight these cuts, but provided growth in aggregate is not hurt, it is unlikely to harm the government's approval ratings too much (c.f. 1987 election on this point).
So, to conclude, I think Merv is wrong (though, I think he's wrong about a lot of things...!).
The real question here is "what is the impact upon growth and employment of a significant fiscal consolidation?". The widespread and off-the-cuff answer to this is usually "well, obviously growth is going to collapse and unemployment is going to sky-rocket". Nearly thirty years have past since "Thatcher's cuts" of the early-80s, and the political, economic and media narrative appears to treat the early-80s as being a single event caused by "Thatcher's cuts". As a result, it is commonly accepted that fiscal contractions are terrible for growth, employment and, by extension, government popularity. Indeed, many cite the deep unpopularity of the Conservative government in 1981 - the time when the Lib/Lab Alliance was posting approval ratings in the 50%+ range. Again, the common parlance is that the Falklands War was the only reason that Thatcher was re-elected. The latter point may well be valid, but an analysis of why the Conservative government was so unpopular in 1981 is instructive.
As with most things I rant about, this is a case of conventional wisdom not getting the facts right. The below chart shows quarterly GDP around the 1979-81 recession. The red line is where Geoffrey Howe announced his austerity budget (in March 1981) and the 1980s fiscal consolidation began. So if the government was deeply unpopular in 1980-81, it was clearly not as a result of Howe's austerity budget.
But what about the effect of fiscal tightening itself? Goldman Sachs have put together an excellent paper (Global Economics Paper No:195 - "Limiting the Fall-Out from Fiscal Adjustment", Ben Broadbent & Kevin Daly) that looks at 24 OECD countries' fiscal consolidations over the past 35yrs. The common criticisms of such studies are that conclusions drawn from them may be reflecting other factors, such as FX depreciation, falls in interest rates/bond yields and the stage in the economic cycle (the more cynical view is that Keynesians and politicians have an interest in fiscal easing and prefer to criticise any policy that withdraws stimulus early on in a recovery - Krugman, Stiglitz, and the LSE fall under this bracket!). Goldman Sachs have attempted to control for these effects, and came to some pretty striking conclusions:- Expenditure-driven plans are much more successful in reducing debt levels (see first chart below).
- Tax-driven plans have hit growth hard (with a 1% increase in the cyclically-adjusted tax-to-GDP ratio taking an average 0.9% off GDP per year).
- Expenditure-driven plans actually boosted growth [no, that is not a typo!] (with a 1% cut in the cyclically-adjusted expenditure balance adding an average 0.6% to GDP per year).
- Business investment recovered very strongly, and was much more important in the growth rebound than exports (see second chart below). More on this very important point below.
These are pretty remarkable conclusions, supported by a recent OECD paper and also by a recent UK Treasury paper. They conclude that the optimum fiscal consolidation program is 80% expenditure-driven and 20% tax-driven. This is the stance held by the Conservative party (Labour plan 67/33), if only articulated to a "fluffy cloud" degree for political expediency. Given the above evidence (as well as that of above-trend growth in the UK from 1981-87), it is likely that many will be surprised by just how little growth is affected by these austerity plans.
Back to business investment point. When there are severe fiscal imbalances, evidence suggests that the both consumers and businesses save on a precautionary basis, expecting future tax rises in a form of Ricardian Equivalence. It is therefore plausible that if a government cuts spending, then the probability of such tax rises in the future falls, and thus pent-up demand from consumers and businesses is released, driving the recovery. This is a form of "crowding in". Such moves may also loosen monetary conditions by reduced fiscal premia on long term debt or via FX depreciation (as the government is no longer spending on domestic "stuff" and workers, system-wide unit labour costs fall, lowering the Real Exchange Rate, and increasing the competitiveness of the private sector). On this point, it is important to remember that a government deficit is the mirror of the private sector's (including the external sector) surplus. For the UK, the external sector is zero (the Current Account is currently balanced - this is a KEY DIFFERENCE with the PIGS, all of whom run Current Account deficits and rely on external financing), and therefore, by equivalence, the private sector is saving at an unsustainable rate. The below chart shows UK Business Investment at an historic low of -23.5% y/y (ignore the 2005/6 spike which was a one-off accounting issue) and also clearly shows a very large bounce in business investment during the years of Howe's fiscal consolidation. Given that there is much uncertainty regarding the election and sovereign credit rating, it is very possible that corporates are in a state of "wait and see" until there is clarity post-election. It is also worth remembering that business investment in both the UK and US has been subdued since the DotCom boom, and a notable feature of the current US recovery has been that businesses have been ramping up investment. Post-election, it is highly likely that this will occur in the UK, in tandem with fiscal consolidation in the manner demonstrated in the GS study above.
The final point I want to address is the view that fiscal consolidation implies a weaker FX rate and that post-1981 the Pound depreciated significantly. As discussed above, this economic phenomena operates via unit labour costs cheapening the REER. The below chart shows General Government Consumption as a share of GDP (white line), and the Bank of England's Calculated Effective Exchange Rate (Orange/Green - two overlapping series) lagged by six months. It is clear that over time there is a broad relationship between the two: as the government's share of the economy increases, it pushes up labour costs and crowds out the private sector (thereby increasing the Real Exchange Rate), and as its share fall, the opposite effect occurs. Obviously, the relationship is not completely tight over time (and far from the only driver of the exchange rate), but broadly speaking this effect has been observable, especially in the 1980s. More recently, it appears that Sterling anticipated this effect in 1996-7 as it became more likely that Labour would be elected. I think the large disconnect since 2008 is a combination of the bank bailouts not representing actual expenditure, but instead loans, and the market already pricing in the likelyhood of a significant fiscal contraction in the coming years. On this basis, therefore, it is hard to argue that GBP should weaken further as the UK tightens fiscal policy. As a corollary, it is remarkable that Gordon Brown's Statism makes the 1970s look pretty tame by comparison, with Government consumption as a share of GDP the highest on record (since 1960).As an aside, was the fiscal effect the only phenomena in the 1978-85 period? The below chart shows the BoE Calculated Effective Exchange Rate (orange), and the white line below shows the spread of the BoE Base Rate to the IMF Special Drawing Rights interest rate (which is an average interest rate for IMF shareholders) lagged by 6months. From 1978-80, the UK boasted a spread of as high as 930bps over the SDR-average, and as a result the Pound appreciated significantly, reversing all of its losses on this CEER-basis since 1974. Over the first half of 1981, as the recession crimped inflation, policy was loosened (as it was globally). For the next few years, this spread oscillated around +/-200bps. Perhaps one of the main reasons that the Pound fell from 1983-84 was that the Fed tightened policy by 313bps, but UK inflation remained relatively benign in that period. To conclude here, it's possible to see the fiscally-driven weakening, but it is arguable that this was not necessarily the entire reason why GBP traded weakly during this period.
I digress...
The point of this piece is to demonstrate that fiscal consolidation is not necessarily ball-crunching and, if enacted in a sensible way (i.e. the 80/20 rule), can actually act to crowd-in private sector investment - which will invariably create new, more economically useful jobs than those that are lost in the public sector. The misconceptions around the early-80s "Thatcher cuts" have served to create the impression that fiscal consolidation is only a bad thing, and the anti-Tory narrative of the Left over the past 30yrs has encouraged this perception. But the real pain in the early-80s was in response to the very significant monetary tightening from 1979-80, and in the mid-80s in the North as a result of Thatcher's war with the National Union of Miners. Neither of these two events is going to occur this time around because the BoE has inflation-fighting credibility (though, Mervyn King is doing his best to wreck this!) and there aren't any miners to fight. Of course, this is not to say that public sector unions will not fight these cuts, but provided growth in aggregate is not hurt, it is unlikely to harm the government's approval ratings too much (c.f. 1987 election on this point).
So, to conclude, I think Merv is wrong (though, I think he's wrong about a lot of things...!).
