Showing posts with label Economics. Show all posts
Showing posts with label Economics. Show all posts

Wednesday 5 January 2011

Dealing with the Deficit (5) - Is the Coalition's Plan "Progressive"? Is it Fair?

On being Progressive, distributional impact, fairness, cabbages and Kings (and why the sea is boiling hot and whether pigs have wings - well, not really.)

This article follows on from previous articles outlining the economic arguments around the Coalition's budget plans, introducing the structure of the public finances and the plans for reducing the deficit, looking at the feasibility of closing the deficit by cutting military spending and an analysis of the taxation changes. This is the final article on the distributional impact and fairness of the government's plans.  I've separated them out to try to keep them shorter.

"Progressive", "Fair".

These are undoubtedly the words that have come to define politics in Britain over the last couple of years. Not necessarily in terms of actual policy enacted, but definitely in terms of the language of our political discussion.  We argue about whether policies are wise, whether they are affordable, whether they are right, but more and more we have come to argue about whether policies are fair or progressive. It has been one of the changes wrought by the 13 long years of Labour rule. Today these terms are thrown around like cheap confetti by almost every party and politician of whatever hue or stripe as basically synonymous terms.  This widespread usage by completely opposing politicians to describe contradictory policies may give you the impression that these terms are largely meaningless. And you would be right. But the question is, can we save any precise meaning at all from this avalanche of linguistic abuse?

'Fair' is one of the first words that any child learns, as any parent or child can tell you.  A sense of things be fair or unfair is one of the most basic of human judgements, and arguably the basis of much of our moral sense.  Like all such terms though it has no clear, definable meaning.  We all think we know fair and unfair when we see it.  Roughly, it means equitable, in proportion with what is right.  It is, in other words, a value judgment. In other words, referring to various policies as fair, is little more than declaring you think they are morally right and/or a good idea, i.e. it conveys almost no actual information, since we generally assume that if someone is pushing a policy they think it is good/right.  It would be bloody odd if politicians were pushing policies they personally thought were a load of immoral rubbish. Referring to a policy as 'fair' is generally useless. But what it can do, at best, is to imply a certain, not only efficient but also, moral judgement about the effects of a policy. But beyond that it's pretty empty.

'Progressive' is a slightly different (but equally annoying) kettle of fish. It has become, if anything, even more prominent than 'Fair'as a political descriptive. It sadly lacks 'Fair's basic and understandable connotations.  It is a technical term, just one with a vague definition. For a while after I heard it first it confused me because I had no idea what it meant. From context I could only tell that it seemed to mean 'good' in a vague sense, but I could not at first work out anymore than that. So I spent some time studying it. Taken literally progressive means to to support progress, but that is little more than a tautology. No politician claims to be opposing progress, any more than motherhood or apple pie. So where did this word come from?  The answer is that it came from America, and it became more and more popular first among Labour supporters and politicians in the 1990's to describe themselves, and then among others. As far as I could tell from some study these people seemed to use it to mean Socialism without the state ownership of industries (since that has been discredited since the 1970's). More generally it has come to mean fluffy and friendly and kind and good, and most importantly: us, as opposed to them.  On which basis it was also appropriated by first the Liberal Democrats and then more recently even the Conservatives, and particularly the current Coalition government.

In defence of some of those who use it though. There is one area where the term progressive can be said to have a precise meaning. That is, in reference to fiscal policy.  In particular, taxation.  A tax is progressive if it hits the rich harder than the poor.  This originally could mean just in terms of the amount raised.  these days however it generally means as a proportion of income.  That is, for a tax to be progressive it must take up a higher percentage of the income of the rich than the poor, rather than just a larger cash amount.  The opposite of this is regressive.  To give some examples: Income tax is progressive, because it is charged at higher rates the higher your income is;  VAT is more or less neutral, because rich and poor pay at the same percentage rate; The BBC licence fee is regressive, because it a flat amount charged regardless of income, and thus obviously takes a higher proportion of the income of the poor than the rich.

In extension to this financial system or policy of spending and taxation is progressive if it enhances the opportunity or chances of the least advantaged in society, generally in terms of redistributing money from the rich to the poor in society, or at least hitting the rich harder than the poor in percentage terms.  And is in this sense that we can analyse whether the Coalition's deficit reduction plan is progressive, as the Chancellor claimed, first at the June budget, and then at the CSR. This was an important point, after the Conservatives campaigned claiming Progressive credentials, and also to the Lib Dems

This is a big question.  Is it possible to have  major deficit reduction plan of tax rises and spending cuts that is also progressive, in the sense of hitting the rich proportionately financially harder than the poor?  Or, in other words, how does the government's deficit reduction plan impact people differently across the income distribution.

On the one hand the government has raised taxes on the rich and taken efforts to protect core areas of progressive spending on health, education, welfare and international aid, as well as for children and pensioners.  On these grounds it claims its plan is progressive.  But this has been strongly contested, to say the least, by other groups.  The analysis of the government's plans has been divided into two separate sections.  We have had distributional analyses of the impact of the changes in terms of taxes and benefits, and then separately the estimated impact of the spending cuts.  These can then be combined to give the over-all impact of government's deficit reduction program by income decile of the population (the poorest to richest tenths of the population).

My personal view has always been that the government has tried quite hard to make sure that we are "all in this together" in the sense of the pain of deficit reduction being shared across the population.  But that it would be almost impossible for any significant deficit reduction plan to actually impact the rich harder than the poor, without being mostly consisted of crippling tax rises.  If I had to guess I would say that the government's plan will likely hit the poor two to three times harder than the rich.  Because our system is so progressive anyway, meaning that the least well off benefit more from welfare and rely more on public services, and pay less in tax, pretty much any attempt to reign back what the state does will hit the poor harder in proportion to the rich.  That is, although the rich will contribute more to the deficit reduction plan in terms of cash this will still consist of a smaller portion of their income, due to the disparity in income, and the extent to which government spending is slanted to benefit the less well off, and that raising taxes on the rich is actually quite hard because they pay high taxes already.

Analysis of the distributional impact of the government's spending plans breaks down into two sections: Welfare and Tax changes, i.e. direct cash transfers, and departmental spending cuts i.e. estimated value lost from services received.  The first of these is relatively easy to estimate, as it involves actual cash transfers, whether in terms of welfare or taxes.  The second is somewhat more dubious, as is involves estimating the value people receive from public services in terms of a cash value, and then guessing how spending cuts may have affected this cash value.

The first off the blocks to attack the government's claims of the progressive nature of its deficit plan was the IFS.  The Institute of Fiscal Studies has actually been around for 35 years, but has recently seemed to appear into the media consciousness.  It is a think-tank that produces work looking at the details and effects of the financial and distributive effects of policy.  Since the Coalition took government its pronouncements on the impact of government policy have, for some reason, been received by the media with a degree of trust and authority generally reserved for Holy Writ. This slight oddity to one side though, it is true that the IFS' research is generally very good. And an excellent starting point.

The IFS produced a report on the distributional impact of the Tax and Welfare policy changes by income decile, but not the impact of the public spending changes.  The most relevant graphs is below.  It shows the impact of all the the tax and welfare changes proposed by the government up until the CSR in October, apart from the CGT rise and the Child benefit changes.

That means by income decile from poorest to richest the changes will mean a hit on income of:

DecileImpact (£/year)Impact as % of net income
2 -£750.00-5.0%
3 -£800.00-4.5%
4 -£850.00-4.3%
5 -£800.00-3.5%
6 -£900.00-3.6%
7 -£1,000.00-3.2%
8 -£1,000.00-2.8%
9 -£1,200.00-2.6%

From the graph it is clearly visible that by income decile the changes are somewhat regressive across the income distribution from the 1st-9th deciles, though the richest 10th do take a particularly large hit.  It is solidly progressive in reference to the amounts involved, but not progressive enough to make it progressive in terms of the percentage hit to income.

Sunday 19 December 2010

Dealing with the Deficit (4) - Tax is always bloody taxing.

On Tax Avoidance, Robin Hood, Bashing the Bankers, VAT, cabbages and Kings (and why the sea is boiling hot and whether pigs have wings - well, not really.)

This article follows on from previous articles outlining the economic arguments around the Coalition's budget plans, introducing the structure of the public finances and the plans for reducing the deficit, and looking at the feasibility of closing the deficit by cutting military spending. It's followed by a final article on the distributional impact and fairness and (my) opinion of the government's plans.  I've separated them out to try to keep them shorter.

In dealing with our country's financial problems taxation is the obvious other element of the equation, along with spending and borrowing.  Even if we as a country manage to agree how much and how quickly we should reduce the deficit there is still the question of Tax; how big a contribution it should make to deficit reduction and what taxes should be raised.  The government does not currently get enough money in taxes, at previously agreed rates, to pay all its bills.  It must, hence, tax more, or spend less, or go on borrowing forever.  But no-one really thinks that last one is a viable option. In one form or another this is one of the eternal issues of politics, seeing as it relates to one of the most important things in human society: money.  It is one of the fundamental arguments of the Left and Right in politics.  Pretty much wherever you are, and whatever the precise figures and names involved, those on the right will be arguing that we should be taxed less and those on the left will be arguing we should be taxed more.  And this is one of those occasions, though the exact details are, as always, considerably more complicated.

The first question that must be answered is the extent to which a change in tax policy is required.  Most of the £155 billion deficit the UK currently has exists because tax revenues have collapsed due to the recession at the same time as spending on social services and welfare have dramatically risen due to the increase in unemployment.  Taxation is generally a skimming off the surface of economic activity.  It is the icing on top of the cake.  Things that are taxed strongly are things like profits, employment, income, capital gains, luxury spending, rather than the underlying substance of economic transactions and existing wealth.  Because of this when recession occurs and economic activity falls the decrease in tax revenue is proportionally much larger.

However, this in itself is not necessarily a good reason to increase tax rates, because after the recession economic activity will return to previous levels, and tax revenue accordingly. If this was all that happened then we could just borrow to make up the shortfall in the meantime until economic activity and tax revenues returned to normal and closed the gap. Unfortunately there is more to it than this. A deficit of this type, caused by a temporary fall in economic activity is the cyclical deficit, as it is caused the temporary affects of the economic cycle rather than any intrinsic mismatch between taxation levels and spending commitments. It is estimated that this accounts for around £50 billion of our deficit. The Other part of the deficit is the structural deficit, so called because it is down to the structural feature of our tax and spending system, rather than a transitory effect of the recession. This part of the deficit will not go away when the economy returns to normal. It must be dealt with either by raising tax rates permanently or by cutting spending. This is the serious part, and it is estimated that it is about £100 billion. But where has it come from?

Firstly, we were running a £30 billion deficit even before the recession. Secondly, the realisation that the boom in the housing and banking sectors was in fact an unsustainable bubble. Thus meaning the record tax revenues from these industries were also a bubble that will not be returning, lowering the estimate for the sustainable tax revenues under the current system.  This is about another £30 billion. The final element is the interest payments for all the debt we've built up due to the recession, which even if we eliminate the deficit we have already piled up and hence must pay interest on until we ever pay the debt off (unlikely), and which hence sucks up tax revenue we could otherwise use for services. This spending has increased from about £30 to £60 billion.  I have gone into this all in a bit more detail here. So that is the structural deficit. And it is what we cannot rely on a return to economic growth to remove. We have to cut spending commitments and projects and/or raise tax rates to get this hole filled in future. So what is the current role of Tax rises in the government's deficit reduction plan?

The government plans £110 billion of 'fiscal consolidation' over the next 5 years, of which £29 billion is tax rises and £81 billion is spending cuts.  That is a ratio of 24% tax rises to 76% spending cuts.

These figures are not in nominal money terms (actually figures spent), or in inflation adjusted real terms, but rather in real terms in comparison to current expectations if current policy is not changed.  In terms of the actual figures of pounds and pence the government plans to spend the plan is quite different.  Spending is forecast to rise by £70 billion from today.  Even in real terms this is equivalent to spending falling by only £25 billion, a fall of about 3.5%.  Tax revenue on the other hand is forecast (in nominal terms) to rise by £170 billion.  In other words the plan is to hold overall spending as roughly flat as possible, bringing it down slightly in real terms, while waiting for the economy to recover to bring tax revenues up until the point where they close the gap. This plan seems very different to the position in the popular media understanding, where 'savage cuts' are going to bring down the deficit.  The truth is though, that this plan does require hefty cuts, just to keep spending level, due to the constant upward pressure on government spending from changing demographics, the constant demand for more resources and rising interest payments.  Even under this plan many areas of spending will continue to naturally expand, thus necessitating the deep cut in programs and jobs to hold spending down sufficiently in some areas for it to naturally rise in others.

The Coalition is planning £29 billion of tax rises, which involves taking the £21 billion of tax rises Labour planned and adding £8 billion onto them.  Labour's plan basically involved whacking the rich with various schemes that massively reduced the generosity of pension rebates, removed personal allowances, and brought in a 50% tax rate; and pushing up NI, Labour's tax rise of choice, roughly from 11->12%.  NI is the 2nd largest tax in the UK and is very useful for raising money because it is paid by everyone and, in fact, paid twice for each person, by them and then again by their employer.  Hence raising NI brings in lots of money, and does it without raising the headline rates of income tax or VAT.  To this mix the Coalition kept all Labour's taxes on the rich, but removed part of the NI increase, while adding the increase in VAT (Britain's 3rd biggest Tax), a hike in Capital Gains Tax and a Bank Levy.  On the tax cut side they cut Corporation Tax, NI for businesses outside the South and raised the income tax threshold, giving a net increase of £8 billion on Labour's plans.

Wednesday 13 October 2010

Dealing with the Deficit! (2) - Introduction

Of Public Spending, Budgets, Cuts, Cabbages and Kings (And why the sea is boiling hot and whether pigs have wings - well, not really.)

In the first part of this mini series, I looked at the economic arguments for and against the government's economic policy. Next I turn to the questions of whether the policy outlined in the Budget is 'Fair' and if we accept a broad number for the fiscal squeeze to bring down the deficit then what particular tax rises and spending cuts should be implemented. Since the Emergency Budget numerous suggestions and analyses have emerged, both for various spending cuts and tax rises and also of the expected impact of the fiscal squeeze, particularly the distributional impact, that is how it will proportionately affect the poor and the rich. These analyses and suggestions have branched from the sensible to sheer fantasy and back again. They are also, obviously, possibly as numerous as the amounts involved. There are literally, millions of potential ways of slicing up the spending cuts, and here I will only attempt to discuss a few of the more popular suggestions.

I will first discuss various plans for making up the amounts of spending cuts and tax rises mentioned in the budget before moving onto the question of the relative impact and 'fairness' of the government's own chosen approach. I am doing it this way round because, as you may have guessed from part 1 of this series, I broadly support the Coalition's approach, and I, hence, will explain the reasons for why I believe there is no sensible, substantive alternative, economically, and then move onto the question of, regardless of this practical point, how 'fair' this approach is. In this article I just introduce the problem.  Following this in subsequent parts I will look at proposed ideas of cuts to defence, raising taxes and then after that ring fencing areas of spending such as ID and Health. Followed by a final part about the question of 'fairness'.

The twin issues of the fairness and morality of a deficit reduction plan and which taxes/spending to alter are obviously linked. People's perceptions about what counts as a fair approach to the former will affect their outlook on the latter. There is a risk with this though. What is considered moral, or 'fair' in the immediate term may not be the most economically effective solution on a longer framework. Obviously there are basic standards of what we should and should not accept, but within that framework it is important to remember that in almost all cases greater economic activity and a swifter and better recovery is the surest and most sustainable way to restore the tax and spending levels we enjoyed before the economic crash, and to ensure greater prosperity in the future for all of society and other the long and even medium term in many cases these cumulative affects will significantly outweigh any advantage gained by a slighter higher degree of initial fairness. This, evidently, does not apply in all cases, each case must be considered on its own merits, but it is important to keep in mind when discussing various ideas.

Just to explain slightly how government spending is made up. Government spending can be roughly divided into capital and current government spending. Capital spending is spending on infrastructure, building schools and railways and on constructing buildings and bridges and other things. It is equivalent to the economic category of investment. It comes to about £60 billion. Current spending is everything else. It is itself can be divided into departmental spending and welfare and non-useful spending. Non useful government spending is the money the government spends on interest payments on government debt. This spending is non-useful for obvious reasons. It is mostly paid to foreign investors and is neither targeted nor spent on anything useful or decided by parliament. It is wasted money, money that we must raise in taxes but cannot spend on anything useful like infrastructure or services or welfare or all the other things the government does. In the UK today this amounted to about £30 billion before the recession, and is forecast to rise to about £70 billion by 2015. Departmental spending is all the money government departments spend running all the services the country requires such as the NHS, the Education system, the Armed Forces, the social services, street sweepers, road repairs the government itself, etc, etc. it is equivalent to the economic category of consumption and account for about £400 billion. It is this spending that politicians and commentators talk about when they discuss 25% cuts to departments or whatever. The final category is welfare or, more accurately, transfer payments. Whereas departmental spending involves the government spending money to then run some kind of service we either directly use or indirectly benefit from, transfer payments are when the government spends money just transferring it to citizens under various guises: the dole, the state pension, tax credits, incapacity benefit, etc, etc for various social reasons. This is different from departmental spending because it is a direct money transfer, rather than the government spending money itself on good and services for various purposes. It comes to about £200 billion. So government spending can be divided into the main categories of non-useful spending (debt interest), departmental spending, capital spending, welfare. With the last three being useful government spending, and welfare, departmental and debt-interest being current spending.

The government's plan is based on an 80:20 ratio of cuts in spending to tax rises with spending cuts spread across departmental spending, capital spending and welfare, with only the Health and International Development budgets entirely protected from cuts with DfID (the department for international development) seeing its funding increase significantly. This contrasts with the previous government's plan which was based on a plan of 2:1 ratio of spending cuts to tax rises with 'frontline' spending on schools and hospitals, etc, protected from all cuts, along with International Development and Welfare.

In both cases they diverged slightly from these intentions. Alistair Darling's budget plan involved 70:30 ratio of spending to taxes, whereas George Osbourne's was 77:23, so less divergent than initial impressions may suggest. The main difference in the Coalition's plan is the sheer scale. It involves an extra £40 billion of consolidation in addition to the £73 billion already planned by Labour. Both plans involve approximately halving capital spending for the next 5 years and deep cuts in departmental spending. To this the Coalition adds £11 billion of cuts to welfare, with more possibly coming. Also, although the Coalition is ring-fencing the entire health budget, whereas Labour only ringfenced areas of certain budgets, because they did this across multiple departments they actually managed to ringfence more than the Coalition. Due to this fact and the cuts in welfare, this meant that average cuts on unprotected departments under the Coalition's plans are only marginally higher than Labour's, 25% compared to 20%, despite the considerably higher over-all amount of spending reduction. Further to the complete ringfences for ID and Health, the Coalition has also committed to partially protecting Education and Defence from cuts, planning only 10-15% cuts in these areas. This in turn means that the cuts on those areas not protected at all rise to about 30% on average. It is also worth remembering that Welfare is treated separately to these figures, and although it is possibly losing as much as £15 billion it is the largest area of government spending by far, anyway, and hence this translates to only a 7.5% cut.

Beyond these categories, the actual numbers are that the Labour party planned a £73 billion consolidation consisting of £21 billion of tax rises and £52 billion of spending cuts and the Coalition plans £113 billion of consolidation consisting of £29 billion of tax rises and £83 billion of spending cuts. Just to give one last figure, all in all, these cuts amount to a 12% total cut in useful government expenditure. These are the figures that must be made up somehow, whether in terms of cuts to services people use, or taking money from people in tax rises.

Nominal government spending will actually rise over the next 5 years from just below £700 billion to around £760 billion, capital spending falls, even in cash terms, and current spending and welfare continues to rise. Taking inflation into account in real terms capital spending halves over this period, with current spending declining by 1%. This figure masks the spending cuts, because it includes debt-interest. Stripping this out, useful government spending falls by about £50 billion, with a little more than £20 billion from capital spending and £30 billion from current spending. The remaining number to make up the headline figures from cuts comes from the fact that some government spending naturally rises outside the direct control of government, such as pensions and others, and hence to maintain these levels, spending cuts must be found elsewhere to compensate for this within the over-all given numbers.

The current government's approach to cutting the deficit is to take a broad based attack on the problem, raising some money in taxes, and also taking money from across government departments (apart from ID and Health) as well as capital spending and welfare, at varying rates decided on due to various other considerations. All these choices can and have been questioned, most completely by the Labour party's plans, but also by a range of commentators and public bodies. As Polly Toynbee notes, 'What's your cut?' has become a popular game in the media, with various people suggesting their own swinging cuts of things they just don't care about, or they claim are unimportant, or of raising taxes they claim are painless or intrinsically 'fair' compared to the government's plans. These suggestions can be divided into two classes, those such as the Labour party's, which take a similarly broad approach to the coalition, though differing in detail, and those that take a narrow approach and suggest massively attacking a few narrow areas of policy, believed to be particularly unworthy by the suggester, with the belief that this could mean saving most of the pain elsewhere. (Though of course there's also a range in the middle.) These narrow suggestions seem to be uniformly based on the principle that their proposers believe there to be vast pots of money somewhere either just waiting to be painlessly taken in taxation, or being totally wastefully spent that can just be excised without much harm to our general body politic.

These suggestions seem to be largely motivated by the belief that our financial problems are not complicated, deeply based and systematic issues with our economic and political structure but rather a simple problem with an obvious and largely cosmetic solution. The problem with this idea is that it is total bunk, and with most of these ideas underwritten by faulty logic or data. A common thread with these ideas is that either the tax rises proposed could not easily raise nearly as much money as suggested, or the simple spending cuts would not save nearly as much money as their starry eyed proponents would hope, at least not without causing serious damage. These suggestions can be roughly divided into right-wing ideas and left-wing ideas, though both share similar characteristics, as they do with other similar examples of simplistic, near conspiratorial thinking.

I will look at the three most common areas of these suggestions, from both left and right wings in subsequent articles.  Starting with Defence, and then moving onto tax rises and ring-fenced spending.

Tuesday 7 September 2010

It's the Budget Stupid! - Part 1

Of Balancing Budgets, Spending Cuts, Fiscal Squeezes, Cabbages and Kings (and why the sea is boiling hot, and whether pigs have wings. - Well, not really).

Whatever one may say about the new Coalition government one cannot accuse them of being lazy or timid. They have moved incredibly quickly, within the first two months of entering government announcing reforms and changes of policy on education, criminal justice and policing, civil liberties, constitutional reform, defence, health care, local government, welfare reform and, most importantly, the economy. It has been a long time since British politics has changed so much so quickly. It is weird to think that only earlier this year we were in the dying days of a Labour government, awaiting the long anticipated 2010 budget from Chancellor Alistair Darling, with the announcement of the election, let alone the actual poll, still merely on the horizon. A lot changes in only a few months. The budget, the long awaited dissolution of parliament, the campaign, the election, Brown's resignation, the formation of the coalition, a Tory and Lib Dem cabinet and then a wave of announcements of the first steps along the road to significant reform of almost every major area of government.

Many of these ideas, like the Big Society focus, are Conservative policies dating from before the recession, back in 2008 when David Cameron was still talking about "sharing the proceeds of growth". Some, like education and to a lesser extent health care, are effectively continuations and intensification of Tony Blair's attempted public service reforms. Others have come to prominence due to the dedication of a single cabinet minister, such as welfare reform. Some, like Constitutional Reform, have been added due to the mix by the addition of the Liberal Democrats. Some, like reform of Defence, have come about due to the pressures brought by the credit crunch and the coming spending cuts. And to this mix, financial radicalism has been added due to the need to respond to the affects of the recession and Britain's huge budget deficit.

Without a doubt, amidst the all of these plans for change, the question of the economy looms over everything. It is the big one, the question that most affects the lives of every voter and dictates pretty much everything else the government can do. The government has committed itself to a radical approach to Britain's financial problems, and this will either work or not. Either way it is almost certainly the issue that will determine the government's future. Right or wrong, no one will care what other changes they bring in for better or worse over the next few years. If the Coalition gets this call right, then re-election in 2015 seems almost certain. Get it wrong, and Labour will almost certainly return in 2015, if not earlier, with a working majority. This is the one issue that can't be fudged or ignored, because the effects are so massive and so widely felt.  And so there is no running away or hiding, for the government, from the decisions it has committed itself to now. Considering politicians' usual preference for avoiding blame or any possible chances for negative assessment, it is almost brave.

To be more specific, the question is: How to secure the economic recovery from the 2008-2009 recession and respond to the monumental budget deficit it left the UK with? Or, in other words, Cuts: How much and How soon?

Just for reference at this point so you definitely know what I'm talking about.  (Including minor cuts already made) the Budget deficit currently stands at 11% of GDP, some £156 billion a year, or about 22% of public spending planned for this year.  This is the money the government must borrow from international investors this year alone, in order to meet its spending commitments, and which goes onto the total National Debt we've been building up since 1700, which is currently about £900 billion pounds.

In this regard the 'emergency' budget announced by George Osbourne in June has got to be the most important act of the new government yet, setting the tone of the new government's policy for securing both the recovery and dealing with the deficit, and hence the funds available to other parts of the public sector and the entire tenor of government policy until the next general election. It is a mark of how central this issue is considered that the Coalition went to the effort of producing an entire new budget within less than two months of taken office, and only 3 months after the previous government had released its own budget for the year. It is also remarkable to compare the completely different feel of those two budgets, so close in time but which couldn't be further apart in political thrust. it is a far cry from the 1950-51 Butskellite budgets that cemented the post-war consensus, or the '97-'98 Clarke, Brown budgets that saw the acceptance by Labour of the overwhelming majority of the Thatcherite consensus. This is rather a step change in political intention, if in terms of actual measures only a deepening of the same policy.

The Budget raises a few key questions, most loudly and obviously, was it right? And, was it fair?

Though these themselves raise a whole host of questions about the direction of our politics and nature of our political discussion over the last few and next few years, the main part of these questions breaks down, quite easily, into a few political issues. Firstly, is this the correct decision to deal with the budget and support economic growth over the medium term? (which I shall deal with in this part) Secondly, does the impact of the budget fall fairly across the population? (part 2) And, thirdly, is the ratio of tax rises and cuts, and the choice of tax changes, the correct one? (Part 3)

So, what does the budget actually contain . . .

Answer: A lot.

Real Answer:

RPI, by freezing public sector pay for all workers on over £21,000 and by capping and cutting housing benefit, disability benefit and restricting tax credits to poorer workers. Departmental spending cuts are the equivalent to cutting unprotected departments by an average of 25%, as compared to 20% under labour's plans. The budget also announces extra money for pensioners and poorer children, via old-age pensions and increases to child tax credits. An additional net £8 billion in tax rises. This is a bit more complicated. The big and most controversial change is the rise in VAT from 17.5% to 20%. There will also be rises in Capital Gains Tax (18->28%) and a new tax on the Banks, along with hikes in the allowance for entrepreneurs, cuts in corporation tax (28->24%), cuts in NI for businesses outside the south, a one year freeze on council tax and a large increase on the personal allowance for income tax by £1000. The government also keeps Labour's 50p tax band and the rest of Labour's tax rises announced in March (apart from the NI rise).

That about covers most things. The net result of this is an additional £40 billion of deficit reduction, on top of Labour announced plan to halve the deficit in 4 years. The result of this is that in 2015-2016 Britain is forecasted to eliminate the structural deficit and achieve a (cyclically adjusted) balanced (current) budget for the first time since 2002. Unsurprisingly the budget has released a torrent of commentary on the wisdom of its measures. The Conservatives have welcomed it, Labour have excoriated it, and the LibDems haven't really been entirely sure what to think about it.

The Budget represents a number of dramatic moves by the government. The rise in VAT has proved perhaps the most individually controversial measure, mostly over its supposedly 'regressive' impact, and especially since all 3 major parties effectively denied pre-election that they were going to raise it. The sheer scale of the fiscal tightening announced, though, is the most remarkable thing about it. it was widely expected that the Coalition would aim to cut the deficit faster than Labour, but few expected that they would attempt to balance the budget, even in 5 years time (and only the current budget). The scale of spending cuts, totalling some £99 billion by 2016, is bad enough, a further £32 billion of spending cuts over the first 5 years and £8 billion net of tax rises. But the most eye-watering figure is the fact that this translates into 25% cuts to all government departments outside the NHS and International Development, ring-fenced under the coalition agreement (up from 20% in Labour's plans). To be quite frank, it has never been done before.

This table explains the scale of the cuts and tax rises announced to cut the deficit over the next few years, and also gives the comparison of Labour's plans announced in March with the Coalition's plans.

Total consolidation plans over the forecast period

One things that is important to note though is that these figures for spending reductions are in real-terms and compared to the totals if all departmental, welfare and capital spending was to continue at current real levels, including all plans for future expenditure already agreed and trends in aging population etc. In nominal, cash terms (i.e. the actual numbers of pounds the government will spend), government spending actually rises by £60 billion over this period, going from £697 billion in 2010-2011, up to 700, 711, 722, 738, 758 in the subsequent years. In (forecast) real terms this is equivalent to a 1% fall in current expenditure over the period. An additional £30 billion of this total is expected to be absorbed by interest payments on government debt over the period, International development will rise by around £5 billion in real terms and the NHS probably by a similar amount, an aging population makes up most of the rest of the room between these figures and the totals for cuts given above.  Nor does this mean that the government is cutting spending by 25%.  That is only the average cut in departmental spending in un-protected departments.  With the addition of welfare spending and Health, the two largest items of government expenditure, which aren't facing the same cuts (and ID and capital spending), the cuts are equivalent to a 13% cut in public spending.

So, is the coalition's plan the correct one for dealing with the economy?

One thing that the budget certainly doesn't lack is ambition. It is a remarkable statement of intent, and this intent can be read as a thread that runs through the measures announced by the chancellor. This is an aim to, not only, balance the budget, but also re-balance the UK economy in the direction of the private sector. This can be seen in his reliance on cuts, rather than tax rises to cut the deficit, as well as tax breaks on corporation tax, on allowances for entrepreneurs, on cuts in NI, especially for businesses outside the south. All these tax breaks are counter-intuitive in the context of a purist deficit cutting strategy. The Chancellor is putting his eggs in a basket, so to speak, and cutting back hard at the public sector, while simultaneously trying to incentivise the private sector. It is a 'brave' decision.

There is some evidence that the recovery is gaining strength and that the UK economy does look in increasingly good shape after the recession. Osbourne is betting that his measures will reinforce the private sector recovery just as it is gathering speed, and he can ride the up-tick all the way to a balanced budget and general prosperity for all. Now, obviously, this is a pretty optimistic plan, and if it all does goes to plan then Mr Osbourne should consider himself a very lucky politician. Realistically, though, it is no more optimistic than Alistair Darling's plan of just borrowing loads of money and hiking taxes and hoping everything magically turns out alright. Both these two plans that the respective chancellors unveiled are real commitments to a certain, possibly risky, approach, with the hope this will pay dividends. The difference in the two can be seen by the fact that Darling said that should the economic news be unexpectedly good, and tax revenues higher than expected, he would use any extra money to cut borrowing faster. Osbourne, on the other hand, said that should this occur then he would use any extra money to cut less. Both men knew they were out on a limb, with both probably inwardly praying that this 'extra revenue' would in fact emerge.

The main criticism of the budget is based on the sheer scale of the fiscal tightening planned. This is large. The extent to which it is the budget's main priority can be seen in the above table, which shows that, the above points notwithstanding, over-all the budget not only significantly increases the spending cuts planned but also puts taxes up quite a lot. This heaps more taxes on an, already, quite highly taxed economy, and one would have thought, something that a Conservative chancellor would be loathe to do. The fact that he has brought in more taxes than labour, even with the greater proportional reliance on spending cuts, demonstrates the scale of fiscal tightening. The criticism to this approach is very simple and has been widely adopted by swathes of the left-wing media and labour Party. The policy outlined by the budget involves taking a considerable amount of demand out of the economy over the next 5 years, equivalent to about 8% of GDP. It is deflationary, meaning that it removes money from the economy and reduces the flow of transactions. The risk is that with the recovery fragile and demand weak that this removal of demand will have a magnified affect, potentially tipping the economy back into recession. The counter argument to this is that the deficit itself poses a far greater danger to the economy. This danger includes crowding-out private investment and lending through pushing up interest rates, and more immediately the risk of a collapse of lender confidence, as has most dramatically occurred to Greece, and the sharp rise in the already serious cost of paying the interest on such a large quantity of borrowing.

But will it work?

There is a risk. No-one suggests that removing more than £100 billion of demand from the economy over the next 5 years does not have the possibility of going wrong. The question is, however, how likely is it to go wrong and, how does this compare with the danger of not cutting? The plight of Greece on the continent highlights the real danger of a collapse of lender confidence. In the EU this led to the necessity of the emergency announcement of a colossal €800 billion pot of funds from the EU governments to cover the debt of at risk nations such Greece, Spain, Portugal, Ireland. Partly following on from these events George Osbourne announced his austerity budget with loud cries of his measures being both "inevitable and necessary" and that he had no choice. This is, of course, not true. People always have choices. People only ever say that they has no choice as a cover for the choices they have already made. Is it a necessary choice, though, and is it a justified one? Osbourne is putting all his money (almost literally) on getting the public sector out of the way of the private sector, of balancing the budget, and betting that the boost this gives to business and international confidence, and the pressure this removes from the lending markets, will keep interest rates low and provide the space for higher growth in the long term.

Britain faces continually expanding and higher liabilities, both in terms of the national debt and the wider off-budget sheet liabilities that we are developing. With an aging population and decreasing relative economic importance, borrowing to make up the difference over the long term and even the medium term becomes a less and less sustainable strategy. Over the long term we need to see a commitment to balanced budgets, or at least borrowing below our rate of growth, to keep these liabilities down and ensure we do not drown in our own debt again and again. Furthermore, in economic terms, the less public sector debt the state is burdened with the better for the government and economy in general, all else being equal. Cutting now means that we are not reliant in the long term on higher taxes to maintain the level of spending we are engaging in until growth entirely eats away the deficit. There is also international evidence to suggest that fiscal consolidations that rely on spending cuts are healthier for the economy than those relying on tax hikes, and by supporting confidence can even be expansionary in the short term. This is due to the general, dispersed depressionary affect of tax rises during a weak economic period braking the momentum to economic recovery, whereas the benefit for maintaining spending is concentrated in only a few points. Also, the less debt, the less money we waste on interest payments, the less the government crowds out private investment by placing upward, the more room the government has to manoeuvre in any future crisis.

The question is how quickly this can be done without causing too much collateral damage to growth in an economy recovering from the recession. There are, however, other possible arguments against accelerated deficit plan the chancellor introduced. Obviously tax hikes cut very directly into people's standard of living, at a time when so many people are already suffering wage cuts, reductions in working hours or lower investment incomes. Spending cuts impact on vital services, health, education, welfare, defence, etc and undeniably impact on the poorest and most vulnerable the hardest. There is also the affect on the labour market. At a time when jobs are few, spending cuts will lead to hundreds of thousands of job losses, risking more knock on social damage and suffering in a weak job market. There is hence an argument for keeping consolidation down to an absolute minimum necessary and waiting for growth to cover the deficit, without the cuts in living standards that greater fiscal consolidation will inevitably entail.

However, it honestly does not seem that the minimum realistically necessary over the next 5 years, to avoid the serious risk of a decline in lender confidence and higher interest rates, among wider detrimental effects on the recovery, which would outweigh the benefits of marginally higher spending, is very much less than the target the coalition has set. There are a number of reasons for this.

One of the effects of the experience of Greece has been to scare numerous other countries and unease the markets, leading various other nations, including those in considerably better shape than the UK, to announce stronger action to cut their own deficits. For the UK to bring itself into a position whereby it does not stand out as a particular liability among international investors, has become harder than it was at the start of the year, and hence the need for considerably stronger action is magnified. This wider trend is an unfortunate one.

Part of the problem that caused the credit crunch and the collapse of Greece was a world economy whereby some countries were running large consistent trade surpluses and some countries large consistent trade deficits. The way this was continuing was for the surplus countries, such as China, to lend ever increasing amounts of money to the deficit countries, like the USA or the UK. This has occurred in a smaller way in Europe with Germany and Greece. Part of the reason why Greece got in so much debt was because Germany was lending them money at cheap rates, so they could then purchase German products. One of the remedies the world economy needs is for this situation to be reduced, so surplus nations, such as Germany, buy more of their own products and deficit nations such as the UK sell more products. The situation we have now though, is that the more prudent nations are continuing their prudence and slashing their own much smaller budget deficits, in a similar proportion as the more indebted nations. This means that aggregate demand is being cut across Europe, increasing the risk that cutting demand by so much within the UK will cause economic problems. Ideally, the nations that can afford to would increase, or at least maintain, their smaller deficits in order to help prop up demand to help cover the gap caused by more indebted nations slashing theirs. Behind Portugal, Ireland, Greece and Spain the UK is in the worst financial position of any European nation and, hence, it is right that it should be engaging in the greater fiscal consolidation. There is little the government can do about the fact that other countries are also slashing deficits when they do not, in fact, need to, and thus increasing the danger for us, as well as the relative need for us to take action, so as to not appear a particular liability.

Current estimate put the structural deficit at £85 billion a year. This is the part of the deficit not due to the temporary effect of the recession and which will not disappear with post-recovery growth. Any deficit reduction plan must, over the long term, entirely eliminate this figure, at the very least. Arguably this amount should be eliminated entirely through spending cuts as well, as because this is a structural problem rather than a temporary recession provoked problem, any taxes raised to help fill it will need to remain permanently as an addition to the tax burden to cover this figure. Of course this is not to suggest that there is not an argument for raising taxes generally. But if we regard any of the tax rises since 2008 as a temporary measure due to the recession we cannot use them to fill this portion of the deficit. This figure is so high for a number of reasons. Even in the boom years from 2002-2007 Labour was running a deficit that averaged about £30 billion a year, sticking a total of £160 billion extra onto the national debt. This action goes totally against Keynesian policy and doubtlessly had a role in stoking up the credit bubble and boom that led to the recession. Obviously the actions of the banks had a larger role, but it is interesting that very same people who are now claiming that withdrawing £20 billion of demand from the economy a year will cause economic disaster seem intent on claiming that £30 billion of effective stimulus a year had no serious role in pumping up the boom in the first place. Obviously this, roughly, £30 billion will not go away after the recovery from recession, as it was there before the recession. Another factor is that on top of this is that tax revenue before the crash was artificially buoyed by corporation tax from the financial sector due to the banking bubble and stamp duty from the housing bubble, as well as the wider economic affects of these. We cannot assume that this tax revenue will re-appear, and indeed it would be a dangerous sign that we were merely reflating the same bubble if it did. Quite simply, Government pre-crash was a junkie spending big on pro-cyclical borrowing and asset bubble tax receipts, in direct contravention to Keynesian policies. The last factor is the obvious fact that since the recession broke we have already borrowed some £300 billion pushing the interest we must already pay up considerably, by about another £30 billion. And all these are before we even get onto the subject that the economy has shrunk by 6% thus reducing the tax basis. For these three reasons we cannot just hope to return to the status quo ante.

These factors together contribute to the £85 billion structural deficit and the fact that it would require a considerably larger proportional tax hike than many people may think to even remotely cover the deficit. Even if we raised the tax level by 7%, to cover the 6% fall in the tax base, this would only raise around £37 billion a year, and the Coalition is almost but not quite doing this, raising taxes £29 billion a year. Though this itself takes no notice of the negative economic impact, mentioned before, of raising taxes during a period of weak economic activity. It is also not the case tax were not raised by 'New' Labour to cover increased spending (which would presumably then leave plenty of room to raise it now) though they were obviously not raised enough to cover their plans. Compared to the plans left by the Conservatives in 1997, Labour raised an extra £1 trillion in tax over the decade between 1999 and 2008, meaning that although the UK is certainly not the highest taxed economy in the world, especially after the changes announced and confirmed in the budget it is not a low tax economy at all, meaning there is comparatively little space to raises yet further.

There is also a good argument here for the necessity, in the long term, of governments pursuing a balanced budget, if not a surplus in the good times. This is not just good Keynesian policy but also because governments trying to push spending as high as possible are incapable of deflating a bubble because, as in this case, they are reliant on the taxes that bubble brings, and the borrowing it makes cheaper, in order to fund their spending plans, which means they are incapable, or at least strongly incentivised, to not look at where that bubble revenue is coming from, nor take any move to restrict it over the medium term, i.e. the period they are likely to be in office. Only a government committed to maintaining a balanced budget has the possible ability, and will, to react to control a bubble because they are not staking their reputation on raising spending as fast as possible under their tenure, as Labour was after 1999.

One way of analysing the feasibility of the various deficit plans as a course of action is to look at the end results of those plans. Under Labour's plans, outlined above, we would have £52 of cuts starting next year and spaced over the 4 years after that, with the intent of halving the deficit. Their plan marginally over-achieves this, but, including forecasts for growth, still leaves the UK with a 4% deficit in 2015. This means at the completion of the deficit reduction plan we would still be borrowing £60 billion a year. This figure is one which, in any other situation, would have been considered as cause for serious worry, and is certainly not sustainable in the long term when growth is expected to be 2.5%. Even after cuts had been completed, under this plan, it would have been necessary for public spending to be frozen (in real terms) for years more for growth to bring the deficit down to a level where it would be acceptable to start increasing public sector spending again (in real terms), possibly for an entire further 5 year parliament. Something that would have prolonged the pain of public services already smarting from the £53 billion of cuts planned by Labour. In the long term 4 years of cuts, followed by 5 years of real term freezes, followed by annual rises of 2% (or so) would probably feel like a lot more austerity than 5 years of deeper cuts followed straight away by a return to (hopefully slightly higher) real-term increases.

This is itself assuming several generous assumptions. Mainly, that such borrowing would not cause any decline in business confidence, would not place undue upward pressure on interest rates over the next few years, and would not lead to any decline in lender confidence, causing a hike in the interest costs on such borrowing, as occurred to Greece. Realistically, this is unlikely. Partially, because there is reason to doubt that the figures that the treasury based their predictions on, under this model, would have held out if labour had actually won the election and implemented this plan. Quite simply put, the interest rate on government debt and associated business confidence was partially based on the assumption that labour would lose the election and whoever won (probably the conservatives) would implement a tougher deficit reduction plan. The treasury could only base their projections on the interest rate on government debt as was in March, but there is every reason to think that this interest rate was artificially lowered by the market factoring in that a tougher deficit reduction plan was the one that would actually be implemented, and indeed when this expectation became a reality this has led to a fall in the interest rate on government debt, as well as an increase in confidence in the UK economy, shown by a rise in the pound against the euro and dollar. If Labour had managed to scrape home it seems likely that they would have been unable to implement this less ambitious plan and would have been forced into stronger action.

On the other hand, confidence in their commitment to implement even this weaker plan is questionable. The trove of post-defeat revelations by senior New labour figures have revealed, among other things, that Gordon Brown was essentially forced into this deficit plan by Alistair Darling, his less tribal chancellor, and that he himself did not believe in it. Something that can be seen by his previous insistence of lines of 'Labour investment vs Tory cuts', long after it became apparent that all parties would have to cut, the ludicrous spectacle of announcing 0% increase in departmental budgets in the House of Commons, and the fact that Ed Balls, Gordon Brown's mini-me, has now repudiated this plan as part of his pitch for labour leader. He would presumably have favoured a plan that would have left us with, perhaps, £80 billion of deficit after 5 years and would almost have certainly led to another economic crisis, or if we were really lucky just crippling long-term interest payments.

This possible idea of slowing deficit reduction down over 7 or even 10 years has a further danger, in addition to all those mentioned previously. Financial crises and recessions, of one sort or another, have a habit of coming along every ten years or so, though obviously this isn't a physical law. Between the 1976 and 1980 recessions there was only 4 years, between coming out of recession in 1982 and the next crisis in 1991 there was only 9 years. A deficit reduction plan that still has debt rising as a percentage of GDP almost a decade from now risks not having stopped paying for this crisis when the next one hits. This would inevitably leave the government at that point with very little space to further stimulate the economy, should it be needed, and could be deeply damaging by removing a future government's room to manoeuvre in a crisis, especially considering the likely very high interest payments.

Neither is it the case that there is any real evidence that increased fiscal consolidation is likely to tip us back into recession. The official response to the budget has seen cuts in expectations for growth over the current parliament, but of a few tenths of a percent, they still forecast growth of on average around 1.9% a year. The cuts are forecast to cost some 1.3 million jobs over the next 5 years, but the private sector is forecast to produce 2.5 million jobs over the same period leading to a net decrease in unemployment of 1.2 million. Now you can quibble with that figure. But even if the picture is not quite that good, it is still considerably less than a disaster. Growth over the first three quarters since leaving recession has been reasonable, totalling 1.9%. A figure boosted by the extremely good news for the recent quarter of 1.2% growth. What is more this figure came almost entirely from growth in the private sector, including a sizable figure for the construction industry, but also good performances for manufacturing and various other areas of the economy. In other good news, the money supply is growing steadily, dispersing any fears of deflation, and both banks and large businesses are well stocked with cash, making any further major bankruptcies unlikely. Also there is evidence that the government's policy has had a positive effect on international confidence in the UK economy. The Interest rate on government debt has fallen from 4% before the election to 3% now, and the pound has risen against the dollar and the euro. There has even been talk of the UK as a safe haven for investors after the troubles encountered by both the EU and the USA, talk unthinkable at the start of the year.

What is more, the package of consolidation announced is, as previously said, spread over the next 5 years. This year only a very small fiscal tightening is to occur, cancelling some of the more unfunded and unnecessary spending commitments of the previous government. The arguments about this depressingly dominated much of the election, and were generally tendentious. The argument that cutting £6 billion from a £700 billion budget, about 0.8%, would cast the economy into the abyss was always ridiculous. Not that the conservative insistence that a £6 billion national insurance hike would destroy the recovery was much more sensible. It will be 18 months after exiting recession that the fiscal squeeze really begins, giving the economy more time to get onto a stable footing. Even then, as can be seen from the above table, the majority of cuts occur during the latter stages of the parliament. Up until 2013, 3 years from now, only £42 billion of cuts are to be made, taking demand equivalent to 3% of GDP out of the economy, and the most the cuts reach in one year is £21 billion, or 1.5% of GDP in 2013. Cuts for next year are planned as £18 billion or 1.3% of GDP.

The degree of consolidation, though undoubtedly large, is also proportionately smaller than that announced for countries in even worse financial situations, though larger than that in countries in better situations. Greece has and is enacting a consolidation about twice the relative size. In Ireland, another country in a poor fiscal situation, and just across the sea, they removed 10% of GDP (worth of demand) in 3 years, including starting while still in recession and removing 6% of GDP in a single year. This is a truly extreme plan, brought on by the sheer desperation of their circumstances, whereas we are removing a relatively modest 8% of demand over 6 years, almost all starting 18 months after leaving recession, and not totally more than 1.5% of GDP in a single year.

It must be noted that removing 1.5% of GDP worth of demand from the economy does not cut GDP growth by 1.5%. Supply to a degree creates its own demand, and the balance of reduced demand is filled by lower inflation, by other purchasers who have a space due to easier borrowing, lower interest rates, lower prices etc. It is also important to remember that these are just forecasts, they can be changed as things go on, should it appear that they were unnecessarily pessimistic about the economy or the recovery is weaker than hoped, though in fairness this was also true about Labour's plan. In a way they are more like 5 day weather forecasts than necessary facts about the future. Anyone who doubts this, and feels like a laugh, should try taking a look at the 5 year forecasts of treasury plans from 2006 or 2007, and see just how precisely they panned out. What is significant about them is rather the intent and direction of policy they represent rather than the precise numbers.

There is also another interesting comparison. As the recession got going in 2008 labour introduced a deliberate stimulus package, on top of the automatic stimulus caused by rising welfare payments and falling tax receipts. This was only short-term though and wound down in early 2010, around the same time as the debate over the initial £6 billion of cuts, and in fact was one of the main reasons why that argument was so ridiculous. In other words, the Labour government effectively withdrew £23 billion of demand from the economy in early 2010, just as the economy came out of recession. This was VAT going back up to 17.5%, this was the 50% tax rate, this was a £1.2 billion hike in fuel duty. And this actually counts as a slightly larger withdrawal of demand than in any single year in the Coalition's plan. And, did fiscal Armageddon ensue? No, of course it did not, since then we have seen 1.5% growth in the following 6 months. And, this withdrawal of demand took place at the point where, arguably, the recovery was at its weakest.

One of the sublime/ridiculous aspects of this whole debate around the time of the election was the fact that the political dynamics meant that both sides had reason to hope for/fear good and bad statistics as to economic growth immediately coming out of the recession. For the Conservatives good growth meant that, on the one hand, the case was stronger for the economy being able to stand earlier spending cuts, but on the other hand it obviously made Labour's handling of the recession look better, which was bad for them. On the other side, good growth figures undermined Labour's case that it was too risky to chance early cuts, but also vindicated their handling of the recession. A heads you win, I win, you lose and I lose situation. What it came down to then was obviously who won the wider battle for public credibility for their position, which was mostly won by the Conservatives. They also seemed to get the luck on the economic growth figures though, as the first two quarters out of recession were both announced as anemic 0.1% growth, before being later revised up, the 2nd quarter on the very day that Gordon Brown resigned, precisely too late for Labour to benefit, and then the next quarter came through with significant growth figures, from a period that Labour were in charge, just in time to help support George Osbourne's case for deeper cuts. Thus Labour got the opprobrium heaped on them from the announcement of low growth under their tenure, and the Conservatives seem to have the benefit of their position being reinforced by the better than expected revised and later growth figures, almost a perfect storm. As one commentator said, maybe God is a Tory after all.

What will be likely is that over this period these measures will produce lower headline growth figures than perhaps would otherwise be projected, and since the budgets announcement we have seen a number of growth forecasts for the UK downgraded for the next few years. This is the other main argument against the economic benefit of quicker attack on the deficit and it is a serious risk. The likely affect of the accelerated cuts program is lower headline growth for the next few years. These forecasts are dependent on the above possible negative externalities on economic performance not emerging, however, that these economic bodies cannot necessarily take into account in their calculations. There is also little argument that over the longer term the potential for growth for the UK economy is enhanced by lower levels of borrowing, and the costs associated with it, which I have repeated ad naueseum above. Furthermore, like treasury forecasts, these predictions are certainly not infallible, these bodies fail to see things coming as much as anyone. Their glorious failure to see the credit crunch itself coming, for example. Another point is more subtle: Assuming these bodies are correct, for the public finances we are faced with a trade-off between the lower debt interest we are racking up with the tax income gained through higher growth. Obviously though, this does not include the wider economic benefits of higher growth, nor the social benefits of higher government spending, but neither does it include the negative possibility of the previously mentioned financial and economic externalities. Nor the fact that these figures are crude measures. They can take into account the reduction in government spending (reducing GDP) but not the underlying increase to the health of the private sector this may be supporting, which in the end supports the private and public sectors.

All this is not to claim though that the plan that the Chancellor announced is itself necessary for the economy.  It may, as it turns out, be the best plan to secure long term growth and financial health for the UK, and furthermore he may have read the financial runes perfectly and timed it with a recovering economy.  Possibly.  Like I said though, if this is the case then he will be a very lucky politician.  However, I believe there to be clear risks associated with Labour's considerably more gentle deficit reduction program, especially after both the Greek crisis and wider drive to prudence that this has launched.  An approach that would probably take ten years or so to get the UK's public finances under real order, if everything else goes as plan, just seems completely insufficient.  This is not to ignore, however, the difficulty faced with introducing large real term cuts in public spending and the difficulty this will cause many individuals and communities.

Considering all these factors I believe it is possible to consider an alternative fiscal plan that hopefully goes someway to combine these elements, or less diplomatically, just takes the middle ground between the various alternatives.  I hope to introduce and explain this idea in the final part of this little mini-series.

Friday 30 July 2010


Now there's a phrase I never thought I'd write.
One of the more remarkable phenomena of the discussion around the budget has been the emergence of, what can only be called, Pop-Keynesianism among the left-wing media.  Now there's a phrase I never thought I would ever say.  The financial crisis in general was widely reported to have brought about a resurgence of interest in and influence of Keynesian policies.  At least nominal adherence to keynesianism was the principle mark of economical policy-making from the 2nd World War until the end of the 1970's.  Now, Keynes was a genius, and one of the very few most important figures in the history of economics.  His great insight was to argue that governments could have role to support economic activity by borrowing and spending in times of recession to boost the economy, by boosting general demand, and thus easing the effects of recession and supporting growth by combating the generally deflationary spiral of recessions.  But too often, though, keynesianism was used as merely an ideological cover for ever higher state spending, and this, among other things led to its discrediting as a driver for policy in the neo-liberal reforms of the 1980's.  With the coming of the recession, though, we have experienced a supposed revival of keynesianism, as governments turned to fiscal stimulus to combat the effects of recession.

More recently still, the banner of Keynesianism has been seized by those opposing the austerity plans of the Coalition and the Conservatives particularly.  In a way it is good to see debate on public policy being supported by appeal to scientific principles, rather than vague emotion as is far too common.  However, recently this has reached the stage of the ridiculous.  Indeed, there was a period shortly following the budget, when, for a few weeks, the Independent and Guardian seemed to be running a rent-a-keynesian contest to see if between them they could manage to have at least one commentator a day accusing the Coalition of forgetting the lessons of Keynes and reverting to what was variously called pre-keynesian barbarism, a reversion to the economics of the 1930's, and various other mindless insults.  All with the intention of insinuating that the fiscal hawks were seemingly just naively unaware of the great Keynes' achievements, the poor, simple dears, and were certainly going to tip us back into economic Armageddon.  Suddenly, every half-baked leftist political commentator was an economics major (for example).

But the credibility of these new experts as invaluable fonts of economic theory would be considerably greater were it not for two niggling issues.  The first problem is the repeated claim, by a number of smug commentators, about the madness and ignorance of seeking to enact savage cuts whilst in a recession.  This criticism, if true, would be pretty decisive. But it has just one small problem, which hopefully you can spot:  we are not actually in recession.  For me, personally, the ability to totally miss this basic fact about our economy shakes my faith in their pronouncements on policy.  No one has suggested cutting during a recession, and not only are we not in a recession (and have not been for 9 months), but these commentators have equally seemed to miss the fact that the coalition's plans for balancing the budget are not all coming into effect now.  They represent the plan for the next 5 years, and, the fiscal tightening does not begin in earnest for another year, at which point we will have not been in recession for 21 months.  One of the more irritating episodes of this problem came with the initial announcement of £6 billion of cuts by Osbourne and Laws.  The papers were full of commentators quoting economists to the effect that what was necessary was a gentle start to any deficit reduction plan, seemingly oblivious to the fact that this is exactly what £6 billion is; whether you call it 6 out of £160 billion, 4% of the deficit, 6 out of £700 billion of public spending, or a 0.8% cut in public spending, this is a gradual start.  These people seem to suffer from a lack of awareness of economics and history and what Keynes was actually dealing with.  In the 1930's he was arguing against an economic approach of seeking to balance the budget during a recession, while the economy was still shrinking.  For someone to refer to a plan to balance a country's budget 5 years after a recession ends as "a return to pre-Keynesian history" suggest an ignorance of economics and history.

The second major hit to their credibility as Keynesians is the fact that pretty much to a man these are the same commentators who loudly demanded ever increasing public spending in the years leading up to the crisis, even though the government was running a deficit of around £30 billion before disaster struck, in direct contradiction to actual Keynesian theory.  Keynes sought to use governmental fiscal policy to smooth out the business cycle, by running a surplus in the good times, and thus cooling demand and the emergence of bubbles, so governments could afford to run a deficit in bad times, in order to help support growth and recovery.  He did not just advocate the idea that never-ending deficit spending on its own was a magical solution to all economics problems.  These commentators supported higher public spending and deficits in the good economic times and the bad economic times.  There seems to be literally no economic circumstance that they believe would not be helped by a healthy dose of central government spending more money and running a deficit.  The fact that these people do not seem to understand what keynesianism actually is, while being quite happy to act as its advocates, is the reason for labelling this Pop-Keynesianism.  What it really is, is a convenient scientific fig-leaf for their real aim, ever higher and more unsustainable public spending.  An ideological colour donned now it is convenient and presumably to be abandoned when it no longer is.  If these people were real Keynesians then they would argue for maintaining public spending for now while outlining their belief and awareness that once the economy has recovered public spending must be restrained and a budgetary surplus run to avoid us getting into this situation again.  Needless to say, they do not do this.    

If these people were real Keynesians then they would have supported the Conservative economic proposals at the 2005 election.  The Conservatives proposed £35 billion a year less public spending than Labour over the period of 2005-2010.  This smaller increase in public spending was shamefully labelled a plan for cuts, and widely shouted down in the media.  This figure is coincidentally just higher than the deficit labour ran until the recession.  Assuming the Conservatives would have followed a similar tax policy to Labour they would have run a near balanced budget, meaning that when the recession came we would have entered it with more than £100 billion less debt, having not artificially inflated the debt bubble further through government stimulus over the last few years, and with considerably more room to manoeuvre to stimulate the economy during the actual crisis.  Not to mention the fact that when the bubble popped that would have been £35 billion less cuts we now have to make.  In retrospect, it is clear that the Michael Howard's spending policy in 2005 was correct and Labour's was wrong, and all the media commentators who slammed the Conservatives were wrong too.

Sunday 18 July 2010

Possibly the Most Un-Sexy topic in the world: The true scale of our national debt. - Just how screwed are we?

The topic of our national debt and deficit has become in recent years one of the most important political issues our country faces. On a party political level it has been and continues to be the battleground of a consistent war between Labour, on one hand, and the Conservatives (and lately the Lib Dems), on the other.  It is an argument motivated by the explosion in the UK government deficit as a result of the recession of 08-09, and the crisis of confidence in government debt that has swept Europe and, to date, most dramatically affected Greece.  It is this issue that has motivated the recent government's emergency budget and the dramatic  package of cuts that will so define British political life over the next few years.

The basic problem is this. Like private individuals governments have to pay interest on their debts, which then sucks up revenue, forevermore, that could be spent on more useful things like public services.  Also, in a situation where market confidence begins to fall the interest rate we pay can start to rise sharply, which means that the costs of debt goes up sharply.  Further, as we are permanently running a deficit and our "loans" are only for about 15 years each, we are reliant on the markets not only to lend us more money (the deficit), but also to re-lend us all our current debt on a constant basis as those 15 year time limits runs out, and if the international market refuses to lend us more money except at a ruinous rate of interest then we could suffer what is basically a cash flow crisis, sending us bankrupt.  This is what happened to Greece before the EU stepped in to save them.  Other problems with ever increasing debts include that, for the above reasons, there is a practical limit on how much debt we can get in, and the more we borrow now the less room this gives us to borrow in any future crisis; and various externalities caused by the state borrowing so much, and hence effectively crowding out the private sector from credit, which then impacts the whole economy negatively.

All these are the reasons why more and more borrowing at the rate we are now, which in 2009-2010 will amount to £160 billion, is unsustainable in the long term.  One important measure of how sustainable this is in the short term, however, is, obviously, how much debt we already have.  You would think that this would be a simple question.  Surely we keep track of a figure as important as this?  The answer is, sadly, more complicated.  There is a figure commonly quoted as our national debt.  This is the figure for Public Sector Net Debt (PSND).  This is the amount of government bonds that have been issued, how much straight government debt is held by outside investors or governments.  However, there are other things to consider as well.  The last 20 years have seen the dramatic increase of what is known as "off balance sheet" liabilities, financial obligations run up that the government will have to pay in future years, but which aren't debt already issued.  Previously, though, there has been no official effort to properly calculate how much these off-balance sheet liabilities come to, until now.

In crude party political terms, the question is: did Labour take a responsible approach during their 13 years in power and leave us with a responsible level of debt, until the recession came along and sadly kiboshed all their plans?  Or, were they, as the Coalition accuses, wildly profligate, relying on fantasies of eternal growth and accounting tricks to avoid people noticing the debt, all to effectively bribe the voters with shiny new schools'n'hospitals in their years in power, but that would leave economic pain down the line?

A few days ago the Office of National Statistics (ONS) released their first attempt to calculate these liabilities (as well as the government's assets) and attempt to construct a full public sector balance sheet, revealing just how large these liabilities are.  This concluded that while the PSND is some £900 billion, the government also bears further off-balance sheet liabilities, previously un-collated, of some £3,800 billion. More than 4 times as much, a truly terrifying total, giving, with the actual 'National Debt', a total for public liabilities of £4.5 to £5.5 trillion.

The Independent ran with the story, with this headline, showing their usual love of pretty pictorial depictions of topics.  I remain amused by the Independent's love of of graphs and pictures. I still can't tell, though, whether these representations are merely a colourful attempt to grab people's attention on the newspaper stands, or whether the staff of the Independent just think their audience are actually stupid, and in fact can't really read.

Either way, the ONS' estimates for our national liabilities break down into:

- Future payments for the state old age pension: £1.1trn to £1.4trn
- Unfunded public sector pensions for teachers, NHS staff and civil servants: £770bn to £1.2trn
- Payments under private finance initiative contracts: £200bn
- Contingent liabilities (e.g. bank deposit guarantees): £500bn
- Nuclear power plant decommissioning: £45bn
- Impact of financial sector interventions: £1trn to £1.5trn
- The PSND: £900 billion (forecast to rise to £1.2 trillion over the next 4 years).

Which figure to go with then?  The relatively acceptable £900 billion, represented by the small coin, or the large, threatening £5 trillion, represented in the Independent's helpful picture by the big coin?  (Though they seem to have failed to add the PSND, making their entire headline semi-nonsense)

The Independent has gone with the most simplistic explanation of the ONS' findings, claiming the report reveals that the National Debt itself is 4 times what we previously thought.  However, in reality the situation is more complicated.  We are dealing with a number of different types of financial commitment that are more or less like the traditional national debt, and are hence less significant for the national finances.  These issues sound subtle but the difference they make is one of trillions of pounds. Sums that are not small beer, not even in the ridiculously bloated terms of bailouts and public sector budgets and national GDP.

The first and broadest issue is the difference between debt and a liability, which if you're anything like me is not something you are at all familiar with.  Basically, a debt is a type of liability. In accounting terms a liability is any financial commitment to pay out money in the future, which you enter into.  Examples include, purchasing from suppliers, debt repayments, taxes, pensions etc.  A debt is a particular type of liability.  A company's balance sheet is a comparison of their liabilities and their assets, which are stuff they own or people's commitments to pay them money in various forms.  A company is considered solvent if they have more assets than liabilities, i.e. if you ran through all the payments they had signed up for they would have any cash at the end.  It is in this broad sense of liability that the ONS has calculated we have £4.7 trillion of them.  This is not the same thing as a debt, though, and this can be seen by taking a quick look through the categories that make up this figure.

1. The PSND = £900 billion.

This is definitely actual debt.  It mostly consists of bonds held by foreign investors.  It has a well-documented rate of interest and strict limit on its maturity.

2. Unfunded Public Sector Pension (teachers, NHS staff, civil servants etc.) = £1 trillion

This is not actual debt held now.  But it is a legally binding commitment to hand over money at a future date.  The government cannot welsh on these promises without serious difficulties.  Mostly consists of the generous final salary schemes that continue to exist in the public sector but have practically disappeared elsewhere.  Government only requires relatively small contributions from its staff, the rest to be made up from general taxation.  This amount has ballooned from £450 billion in the early 2000's to around £1 trillion today, mainly due to the considerable expansion of the public sector.  This, combined with considerable pay rises, both of which push up pensions, has widened the gap between employee contributions and the actual financial commitments.

3. PFI contracts = £200 billion.

Another unavoidable and legally binding contractual commitment.  It doesn't come under the national debt, because it is only a commitment to pay various amounts of money, not an actual debt held by someone else.  In all practical terms, though, the equivalent of a mortgage, and so quite clearly debt.  PFI, the private finance initiative, was one of the  last government's favourite swindles (though in service of impartiality I'm ashamed to admit it began in the dying days of John Major's government).  It effectively meant getting a private company to build a school/hospital/other piece of infrastructure, and then the public sector renting it from them for a number of years, at the end of which, the piece of infrastructure would pass over to belonging to the government.  In practice, this meant the government could commission lots of shiny schools and hospitals now, for minimal cash outlay, only with the string that instead of shelling out £10 million for a school, now, the public sector would pay £30 million over the next 30 years.  This meant that the last government got to wow the electorate with all the shiny things they were building for them, the private contractors got a big wodge of guaranteed income, and the only people who lost were following governments and taxpayers who pay out the vastly inflated costs over the following years and decades.    

4. Nuclear Power Plant Decommissioning = £45 billion.

Again, not debt, but a real unavoidable future financial commitment.  Why the figure is so high, considering how few nuclear power plants we have, though, is anyone's guess.

5. Future payments for the state old age pension = £1.1trn to £1.4trn

This is where it all gets a bit dubious.  Yes, we do have a liability for future state pension commitments.  But, in reality, these are paid out of current government income (taxes).  Ignoring, for a moment, the wisdom of running a general state pension like a Ponzi scheme, in a time of ageing population, these commitments are no different, really, to any other area of state spending.  As Stephanie Flanders, BBC economics editor, said, you could just as easily produce eye-watering figures for the liabilities the UK government is accepting for the commitment of providing everyone with free healthcare into the future.  The difference between the state pension commitment and the public sector pension commitments (or the PFI), though, is that whereas the public sector pensions are legally binding contractual employment commitments, which the government cannot easily get out of, the state pension is effectively a welfare benefit, if a universal one.  This means that the government can increase it, decrease it, postpone the age people receive it, or, theoretically, even abolish it, all as ways of keeping expenses down, at will.  All they have to do is stick the necessary clause in the annual budget.  The same is not true for public sector pension commitments.  Calling the state pension commitments debt is like saying I have a debt for all the food I need to buy in the future.  Realistically I can eat more or less, not eat for a while, or eat cheaper food, depending on my income.  It is a liability in the technical sense, but it is not really the same as actual debt.  If they mean the old-age pension is going to be more and more difficult to fund as the proportion of pensioners in the population rises, then that would be correct.  It's different to saying it is a debt obligation now though.

6&7. Bank Bailouts, deposit guarantees etc, etc. = £1.5 - £2 trillion.

This is even more dubious.  This is the remaining financial risk the taxpayers are exposed to due to the financial crisis interventions.  It is mostly the possible cost of paying out deposit guarantees on banks, and the notional loss currently held by the government holding vast quantities of shares in banks that are currently worth less than the government paid for them.  However, there's no reason to think that the vast majority of this money spent nationalising/propping up banks won't be reclaimed. It's only a risk if the banks are going to default (not likely as that's what the bailouts avoided) or the shares are never going to get back to the price the taxpayer paid for them, and hence the money reclaimed.  Neither of these are likely, assuming the recovery ever actually happens.  Similarly, it's unlikely at this point that the government is going to have to shell out much more on deposit protection.  The ONS is right to say that it does have these as liabilities: commitments to pay money on certain conditions.  But they are not debt, and they will probably never become so.  These liabilities will, in fact, hopefully disappear entirely painlessly in the next year or so.

Out of these 7 categories and the £4.7 trillion of liabilities we started with, only the PSND, PFI, Nuclear decommissioning, and unfunded public sector pension liabilities are really debt in a significant way.  The rest are liabilities in a vague technical sense but not the same as debt at all, like the future old age pension.

Even only including these figures, though, gives us the following amount:
£900 billion PSND + £200 billion PFI + £40 billion nuclear decommissioning + £1 trillion unfunded public sector pension commitments + £200 billion (perhaps) of financial sector commitments we're never likely to get back.
............................... = £2.3 trillion      

This is obviously considerably lower than the original figure, but it is still enough to scare anyone without coming up with the type of bogus figures that the Independent splashed all over its front page.

It is possible to be more discriminating still, though.  It is fair to point out that even though I have added some £1.4 trillion of "debt-like" liabilities onto the PSND, they are not actually the same.

Our national debt, as traditionally considered, is money held and owed by outside investors that we must pay a stated rate of interest on, and on which the interest rate may vary with market conditions.  It is the cost of this £900 billion that may sharply rise should the finance markets start to get Greece-like worries about us.  There is no prospect of this happening with PFI payments, for example.  They are set in stone.  It is possible, then, to give three categories of government indebtedness, reflecting this core public debt, the PSND, wider 'off-balance sheet' debt-like liabilities, and wider more general liabilities.  By all means we should have a proper, full cross-public sector balance sheet as well as the traditional 'national debt', more facts never hurt anyone.  But we should still distinguish between, at one end, the broad liabilities we have, at the other end, the current debt we have issued in bonds, and in the middle what is, arguably, really our actual national debt.  These three categories would break down as follows:

Public Sector Net Debt = £900 billion
Wider 'National Debt' = £2,300 billion
General Public Sector Liabilities = £5 trillion.

This approach allows us to have a more realistic debate about the scale of financial problems we are storing up for future generations instead of merely referring to the traditional figure for national debt (£900 billion), which leaves huge financial commitments conveniently out of view, or just referring to all public future liabilities as our 'debt'.  The barmy-ness of this second method is illustrated by the ONS' conclusion that the public sector is solvent.  We have more assets than liabilities (schools, hospitals, aircraft carriers, things like that). This doesn't mean we don't have to worry about the national debt, though, just as these daft inflated liability figures don't mean the end of the world anytime soon.