The Case for Being Boring – or Why Fiscal Policy Doesn’t Need a Reset
So far, so good.
The long term economic impact of Brexit is unlikely to be clear for decades. If politicians work hard to ensure it doesn’t hurt Britain’s levels of competition and trade, examine regulation and work to expose domestic markets to competition, it is likely to be broadly neutral or even positive. If instead, politicians chose to pick up on the anti-globalisation mood, and take it as an opportunity to create a ‘Fortress Britain’ with high tariffs and expensively supported national champions it will be very bad
The consequences of Brexit turn on policy. Good policy that improves the supply performance of the economy will be rewarded with higher living standards and, as ever, erroneous policy will be punished. The choice will be Britain’s control. The Prime Minister’s recent call for Britain to be a ‘global champion of free trade’ suggests we are no danger yet of pursuing the sort of potentially clumsy autarky that would damage the performance of the UK economy. As long as Britain remains an open, liberal and meritocratic economic, it should thrive in future decades.
In truth though, despite the focus on the economy during the referendum campaign, the political and sovereignty arguments over Brexit were always arguably much more important. Positive or negative, Brexit is unlikely to matter anywhere nearly as much to the future of the economy as deeper factors shaping advanced modern economies. These include a potential secular slowing in the trend rate of growth, the digitalisation of the economy, or figuring whether it is really true that monetary policy is either running out of power or causing more problems than it solves.
The Short Term Impact of Brexit
In any case, what really matters for this Wednesday’s Autumn Statement is the short term economic prospects, and as important, the OBR’s guess about it. At the start of this year, when implied betting odds gave Leave only a one in three a chance of winning the referendum, independent forecasters on average expected growth to average 2.3% in 2016. Eleven months and one referendum later, their prediction is little changed, on 2%. Unemployment remains low at 4.9%, household spending has continued to grow, consumer confidence remains strong and both the FTSE 100 and FTSE 250 remain above their June 24th level. Britain looks to have avoided a technical recession – with the worst fears of a vicious cycle of falling confidence and demand proving overly pessimistic.
What happens next year is less certain. Average forecasts have rebounded substantially here too July – but they remain around 1% of GDP down on pre referendum forecasts, and remain around 0.5% down through the rest of the forecast period. Sterling’s 20% depreciation is likely to have created a substantial stimulus, and particular so for the exporters who would be hit by any tariff. (For reference, the average WTO tariff is only 9%.) However, many forecasters worry that this will be more than offset by heightened uncertainty slowing business investment and higher domestic inflation hurting real incomes and consumer spending. Given that the OBR has tended to stick close to mainstream economic thought, even if it proves ultimately overly pessimistic, that is likely the envelope the Chancellor will have to work in.
Do we need a ‘reset’ of fiscal policy?
How then should the Chancellor react to these downgrades?
The first thing to say, is that if this year has taught us anything, it is that forecasts are unreliable at the best of times. Before the referendum, most estimates suggested that the economy was largely running at full capacity, and given the unemployment numbers, a large output gap has yet to open up. If anything, the economy may have already received too much stimulus from the depreciation in sterling, leaving the Bank of England fighting inflationary pressures. While we may face a short turn in demand next year, that is far from certain – adding more fiscal stimulus now could easily make matters worse.
Similarly, while the UK’s infrastructure does show some weaknesses compared to infrastructure in other countries, the barriers to improving it are as much political and regulatory as financial. The UK’s planning system is at the heart of much of the practical constraint on timely and cost effective progress in developing this dimension of the economy’s capital stock. Few ‘shovel ready’ projects exist. Equally, while the theoretical multiplier may be high, in practice infrastructure spending is a poor of economic stimulus. The best types of stimulus are timely, temporary and targeted, while infrastructure spending can take years to get going, is almost impossible to reverse and has a record of significantly over optimistic forecasts. Improving infrastructure is a long term patient project, not something to be accelerated in a few months.
In other words, Britain neither seems to need a discretionary fiscal stimulus, and nor even if it did, would infrastructure spending be the best way to do it. There is no harm in small additions to the Government’s capital budget that amount to a few billion pounds of higher spending on roads or R&D, provided the right projects can be found that will incrementally raise the productivity of the economy. There is unlikely to be the kind of step change in infrastructure that some people have been hoping for.
Do we need a new fiscal rule?
On the other hand, we are at least in spirit if not word, in ‘non normal times’. Given the greater uncertainty we face, from the geopolitical situation to the future of monetary policy, there is a good case for seeking additional flexibility in the short term. Fiscal rules are as much a political as economic device, and given the massive changed circumstances, right now what matters is not giving up on the existing strategy rather than adding a further challenge to an already overstretched Whitehall. While a balanced budget should remain the appropriate long term rule of thumb – given our experience of over optimistic forecasts and unexpected shocks, running a small deficit is unlikely to see debt fall fast enough for comfort – the Government is right to be pragmatic in letting the date for achieving a surplus slip another year or two.
If the consensus forecast for growth is right, the underling fiscal situation is likely to have deteriorated by £20 to £30 billion. While not great, this not a disaster – the deficit would still only be around 0.6% of GDP – or at least it will be as long as the Government does not allow itself to get distracted from the more important long term goal of increasing long term fiscal sustainability through public sector reform and efficiency improvements.
What really matters for the long term sustainability of the public finances, however, is not so much the year to year deficit that most fiscal rules have tended to focus on, but the long run picture for debt and the size of the state. Leaving the state at 45% of GDP, the position the Coalition inherited it in, may have avoid some difficult short term decisions, but would have led to a long term slowdown in growth and reduction in living standards. Taxation both has a direct cost, and creates the economy through deadweight costs.
Unfortunately, while the last Government made real progress – spending is now back to 40% of GDP – much more still remains to be done. Unless public sector productivity can be raised closer to the private sector, the state is likely to inflate back to 45% or still higher in the 2020s, significantly slowing income growth.
One of the Coalition’s genuinely impressive achievements was that after thirteen years of flatlining, public sector productivity finally started to improve – the challenge for a future government is to show that this can be achieved at a time of plenty as well as through cruder cutbacks. The next twenty years offers the potentially to transform the public sector through new digital technology, institutional models and redesigned welfare, but this will not happen if we simply throw money at every problem.
Planning for the Long Term
Despite the many changes in fiscal rule or target year for the deficit, the last Chancellor followed a relatively consistent strategy: allowing monetary policy to take the lead in managing demand, pursuing gradual reform of the public services, encouraging marginally greater infrastructure spending and not chasing any disappointment in tax revenues. You might call it a ‘long term economic plan’.
Given the high uncertainty we face now, this remains a good strategy. This Autumn Statement should dare to be boring, adopting a wait and see attitude on the economy. While there is little harm in small boosts to infrastructure spending or help for those likely to lose out from high inflation, now is not the time for a significant surplus – and the focus should be on pursuing long term reform in day to day spending and identifying genuinely valuable infrastructure investments.
In other words, the Autumn Statement should not seek to be one to be remembered – indeed, if anything, there is not a bad case in future years for abolishing it altogether.