The Conservative Party has offered the tale that Gordon Brown did not prepare the UK economy well for economic downturn - failed to "mend the roof whilst the sun was shining". As I have written before, I think that as an overall story that's right. I even think that there is something right about the story in the specific area to which it is often applied - namely government borrowing - though in that area I think it overstates the situation. Now, because this has worked so well for us politically, because the press has bought the narrative hook, line and sinker, and (most importantly) because it is correct as a general story, even if not completely correct in respect of government borrowing, I've not complained too much. There didn't seem much point in being pedantic when the consequence would be rocking the boat.
David Cameron has, alas!, gone beyond the "roof-sun-shining" to declare something further: that "the cupboard is bare." But that's just wrong, I'm afraid. It does not follow from the fact that Brown has failed to prepare us as well as he should have done that we therefore are totally unprepared and unable to do anything. Unfortunately, the way the economy is going, in recent months I've felt unable to ignore the distinction. Today, I'm going to go further than I have before, and urge that our "cupboard is bare" line needs to be abandonned in the fiscal policy area. For the sake of the economy, we need to find a different way to tell our "didn't mend the roof whilst the sun was shining" tale - and, my goodness, there are plenty of other areas in which is certainly is correct - but free the government to do what will shortly be necessary on fiscal policy, indeed preferably (I submit) urging the government (probably against Gordon Brown's instincts and against Labour's lack of collective imagination) to much bolder fiscal action.
I shall explain.
First, even though I think fiscal policy is far from the worst of Gordon Brown's failings, I agree that there is a sense in which the government has failed to prepare us well on government borrowing. See the two Figures (click to enlarge).
In 1990, as the UK entered economic downturn, UK government debt on Eurostat definitions was about 34% of GDP, with public sector net debt on UK government definitions at just above 26% of GDP. Addressing recession and into the first phase of the upturn, the government ran fairly large deficits of 6.4% (1992), 7.9% (1993), 6.8% (1994) and 5.9% (1995). As a consequence, UK general government debt rose to peak at 51.3% in 1996, and we see a similar tale with public sector net debt peaking at 43.3%.
Note that the 1990 position was achieved through rapid and consistent falls in debt during the 1980s boom (at the time called the "Thatcher economic miracle"). In contrast, these charts illustrate that although during the 1990s boom debt fell similarly, from 2002 onwards, Gordon Brown's budgets systematically raised debt as a proportion of GDP instead of cutting it.
This is the important and under-rated truth in the Cameron-Osborne formula of "sharing the proceeds of growth." For, in contrast, in the boom times Gordon Brown took all of the proceeds of growth and more for spending rises. If the rate of debt reduction of the period 1997 to 2002 had been sustained, government debt as a proportion of GDP would have been more like 25% in 2007, instead of the 43.8% it actually was. Perhaps such rapid debt reduction would have been excessive, but a figure of 30% would have been by no means unrealistic, and might have been the sort of figure achieved through the "sharing the proceeds of growth" formula.
So, arguably we enter probable recession with debt at least 10% higher, as a proportion of GDP, than might really have been reasonably achievable. On the side of the annual government deficit, as opposed to government debt, there is a broadly similar tale, and we now have been running an annual general government deficit of around 3% or more on Eurostat definitions for several years. There is a material structural problem in our deficit.
Fine. Let's say that the government failed to "mend the roof whilst the sun was shining." Doesn't that mean that now "the cupboard is bare"? No! "Not as well prepared as we should have been" does not equal "impotent". The only reason for thinking that would be if one accepted Gordon Brown's daft "fiscal rules", in particular the rule constraining debt, as the last word in fiscal rectitude. But we should not. I can see that it is cute politics to see Brown hoist by his own petard. And if it didn't really matter, economically, whether the government felt constrained to limit its embarrassment by doing as little on fiscal policy as possible, then perhaps we would be best to leave it at that. But it does matter. For we are approaching a moment at which it might well be very useful, economically, to attempt something quite bold on fiscal policy, and the "cupboard is bare" narrative stands in our way. Good politics or not, I believe we need to modify our line - the fiscal policy needs of good or even a bit patchy times are not the same as the fiscal policy needs of credit-crunch-exacerbated recession.
First, let us understand that although I have illustrated that we have not been prepared as well as we might have been, the cupboard is not "bare". At the most direct level, 2007's 43.8% debt to GDP ratio is not 1996's 51.3%. But that difference significantly understates the scope for fiscal action. The EU27 average government debt to GDP was 58.7% in 2007, having been 68.5% in 1997. The Eurozone average is 66.4%, having been 73.6% in 1997. Belgium's debt to GDP was 84.9% in 2007, having been 122.3% in 1997, and in 2007 Italy's debt to GDP was still 104%.
Obviously we don't want to duplicate the much higher levels of debt in many parts of Europe. But the question of whether the "cupboard is bare" is that of whether some kind of fiscal policy action is possible, not whether it is a good idea. What would make it impossible would be if it became impractical for the UK government to service its debts if it were to borrow more. But Italy, Belgium, the Eurozone, the EU27 all service very much larger government debt that does the UK, and the UK itself serviced much larger debts only a decade ago. The cupboard is not bare. It isn't true. The constraint on fiscal policy action is not whether it is possible. It is merely, as at all normal times, whether it is a good idea.
Next, let's see why it might be useful to deny that the cupboard is bare, and instead do something quite dramatic on fiscal policy. Attempts to use fiscal policy to manage the macroeconomy have become unpopular. There were four important reasons for this:
- Fiscal policy boosts (say, cutting taxes funded by borrowing) tended to be ineffective. They simply crowded out private activity. In particular, government borrowing must be serviced with interest payments and eventually, one day, paid back through taxation. The private sector, anticipating this, would typically take much or all of any borrowing-funded boost and save it so as to pay these higher future taxes. (This save-to-pay-the-tax effect is often described as a "Ricardian effect", and when the argument is made that it does not matter whether current expenditure is funded by taxes or by borrowing the theory is called "Ricardian equivalence".)
- Next, fiscal policy boosts in the past tended to be difficult to reverse, and ultimately tended to lead to a sustained long-term rise in government debt. The cost of servicing this was a burden on future taxpayers, bearing down on economic growth - at higher tax levels, the negative effects of tax distortions are greater.
- High levels of debt create a temptation for the government to create or allow inflation, so as to inflate away the real value of their debts. This increased inflation risk meant that higher interest rates had to be paid on debt at higher levels, increasing the cost.
- Most importantly of all, ways were devised to use monetary policy to manage the economy much more effectively and precisely than had been possible through fiscal policy.
Has anything changed? Well, perhaps. For it is quite plausible that recent financial turmoil has left credit markets damaged. A consequence might be that, apart from the lowest risk borrowers, most people are having to pay inefficiently high interest rates if they want to borrow anything. Further, impaired credit markets might mean that interest rate changes have become relative ineffective instruments, temporarily, for managing the macroeconomy.
The government, because of its power to tax, has higher creditworthiness than almost any private individual. Sometimes in the past it has been suggested that this higher creditworthiness provides a rationale for a large public sector. That is a significant mistake, for the inefficiencies of public sector organisation far outweigh the risk aggregation gains. At present, many people urge that the government should use its greater creditworthiness so as to act as a guarantor of specific sectors - e.g. by giving government backing to mortgages. This seems to me to be precisely the wrong way to make use, if any, of government creditworthiness.
In my view, a better use of greater government creditworthiness would be to make up the private borrowing that isn't occuring, because of impaired credit market functioning, by public borrowing. Why might that do anything? Well, remember the Ricardian equivalence claim. The idea there was that if the government were to, say, cut taxes today funded by extra borrowing, then that would have no positive effect on the economy because people would just save their tax cuts so that they could pay the higher taxes necessary tomorrow. But if, at present, people would prefer to be borrowing a little more than is available because of credit market malfunction, Ricardian equivalence won't apply. If people are currently credit impaired then if, say, there were to be a temporary borrowing-funded tax cut of the sort Bush has introduced in the US, people might spend their tax breaks rather than saving them.
Of course, current economic slowdown might be nothing to do with any credit crunch. It could be all a matter of readjusting debt levels after an irrational borrowing binge and of adjusting wealth expectations to more realistic levels as house prices cease to rise and of forming a more accurate assessment of future systematic risks in the economy. But, to the extent that economic slowdown is really the consequence of a credit crunch, as opposed to these other factors, a Bush-style tax rebate might have a material effect here - as it appears to have had in the US.
On the other hand, suppose that there is no credit market malfunction. People just aren't borrowing at the moment because they want to hold less debt. Would a tax-funded rebate be damaging? Well, let's think. On the tale now before us, people are reducing their debt levels and so they would not spend their tax rebate, but instead save it. Reducing private debt levels can be a costly process, and is not always smooth. By providing a tax rebate, it is possible that we in fact smooth that process, reducing what would otherwise be real transitional costs during deleveraging.
If people are going to save their tax rebates, then that might also smooth transition in the banking sector, allowing banks to obtain deposits more rapidly to replace the wholesale money market loans that were common until mid 2007.
Suppose, in contrast, that there are no real economic costs to deleveraging and no bank liquidity gains, so that the tax rebate would not smooth anything, but would be simply saved. Well, then we didn't gain anything, but we've not lost much either.
So, in summary, it seems very plausible to me that it would be worth a try, running a very large temporary budget deficit funded by tax cuts. I would probably suggest something like a temporary large rise in the personal allowance for income tax and a temporary cut in corporation tax. To emphasize the temporary nature of the personal taxation changes, I would suggest not changing the PAYE arrangements, but, instead, literally sending people tax rebate cheques at a pre-announced date. I have in mind something of the order of £30bn, in 2008/9 and 2009/10. I would recommend the measure be announced shortly after inflation has peaked and is starting to fall - so, probably in the Budget of 2009, with the 2008/9 cheques being based on a rebate allocated at the end of the financial year, and similarly for the 2009/10 cheques. The measures would be automatically reversed, without the need for further tax-raising votes in later years.
One argument against the approach I suggest is the danger that, in later years (say, perhaps, from 2011/12), the economy risks falling into deflation. In that event, more dramatic action still might be worth a try. However, I believe that the figures available would be adequate for action both now and later, if necessary.
The Conservative government of the early 1990s ran deficits of up to 8% of GDP. Contrary to many of the now-clearly-ridiculous comments of Gordon Brown, there was nothing "irresponsible" about our running deficits of that level at that time. Similarly, over the next few years there will be nothing "irresponsible" about our running a deficit of up to 8-10% of GDP. It might even be a good idea. Gordon Brown will find this very difficult to do, given where he has positioned himself. With his "cupboard is bare" line Cameron has not placed us in the best position to respond to Brown. In my view, our story should not be that the cupboard is bare. Rather it should be that Brown did not prepare us well, but we are where we are, and we should not let Gordon Brown's pride, his past hubris and his silly attempts to smear us, to stand in the way of the bold fiscal action that is now appropriate. Brown's fiscal rules need to be consigned to the dustbin where they belong, and with them the whole fiscal policy paradigm of the past eleven years. Fiscal policy action isn't usually the thing to try in managing the macroeconomy. It just happens to be the right thing on this occasion.