UK Chancellor makes a shrewd fist of flying blind

The Covid shock has presented the British economy with an unprecedented challenge. The huge fall in output has come on top of a decade of economic stagnation across advanced economies, following the banking crisis and Great Recession.

The Chancellor has rightly responded to the Covid shock with unprecedented relief and help for people and businesses. The Chancellor has been right to allow government borrowing to take the strain in an environment of low interest rates and inflation. In a context where monetary policy cannot be a source of effective stimulus, the Government has stepped up to the plate with a powerful fiscal response. The ratio of public spending has increased to 54 per cent of GDP and borrowing has risen to over 16 per cent of GDP in 2020-21.

The Government has recognised that to limit the damage of unemployment a swift programme of active labour market measures was needed to help people and the long-term unemployed to remain in touch with the labour market and the opportunities it offers. It is rightly prepared to experiment with training, skills, work creation and enterprise schemes.

The Chancellor and the Secretary of State for Work and Pensions are fully seized of the lessons of the 1980s, that an ambitious programme of active labour market measures – paying benefits, testing benefits, and helping people into work and economic activity – is needed to prevent the creation of permanent structural unemployment or hysteresis. This labour market agenda, moreover, has been supported by macro-economic fiscal policy which maintained demand in the economy. One big difference between now and the 1980s is a flexible labour market with realistic pay bargaining that can adjust to the shock.

The scale of the UK policy response has been huge and greater than that of any other advanced economy apart from the USA. This has reflected the public health challenge – infection, morbidity, and mortality that the UK has faced and a recognition of what needed to be done. Only the US government has deployed a greater policy response. This partly reflects the different social safety nets and the differing role and scale of automatic stabilisers in the two economies.

Policy makers should not be afraid of allowing public debt to take the strain. Historically low nominal and real interest rates; integrated global capital markets where the scope for an individual government to crowd out private sector borrowing is limited, and a liquid and sophisticated gilt market provide UK policy makers with an enviable macro-economic tool. The UK is moreover unusually well placed to use it because the maturity of its debt, at fourteen years, is close to twice as long as that of the other G7 economies, something that UK Treasury officials are rightly very proud of.

The Budget statement is accompanied with detailed economic and revenue forecasts. Normally these invite almost biblical exegesis among economists and commentators. In the present context it is important to recognise that analysts and policy makers are flying blind. The normal economic data used are incomplete and distorted. The weights used in index numbers are made redundant due to changes in consumer behaviour that result from the lockdown. Measures taken to support people, such as the furlough scheme have distorted labour market statistics. The Labour Force Survey data on employment and unemployment in the present context are misleading.

Better guides to the state of the labour market and the amount of spare capacity are provided by the HMRC claimant count and measures of the number of hours worked. The deflators used to measure real output of the public sector have made it difficult to make reliable real international comparisons given that national accountants in other jurisdictions are not as rigorous as the UK’s ONS in applying international national accounting conventions. Additionally, the events of the last year are outside the parameters of conventional economic forecasting models.

An economic forecast laying out a formal model run of values over a six-year horizon in the present context will exhibit some arresting and potentially misleading features. These arise from the yo-yoing effect of falls and rises in output arising from the private sector contribution to national accounts. The 10 per cent fall in GDP last year will be followed by a 4 per cent rise this year and a 7.3 per cent rise in 2022. The forecast is driven by a recovery in consumption, which increases by 11 per cent in in 2022. This is necessary for recovery to take place, given the weight of consumption in UK GDP, and assumes that the savings ratio falls by almost two-thirds over the forecast period from 16.8 per cent in 2020.

Even greater than the increase in consumption, as a percentage change, is the forecast increase in business investment of 16.6 per cent. This is apparently predicated on the time limited enhanced capital allowances that are expected to spur investment. Experienced tax practitioners are sceptical about this. Their judgement is that investment plans and particularly investment plans that are confined to new rather than second-hand capital assets, are unlikely to be influenced by the time limited tax relief.  A feature of the forecast is the way public investment rises and then falls sharply as a ratio of GDP despite increased Government capital investment. This is an artifact of the fall and then the recovery of the denominator of GDP.

If an approximation of the OBR forecast were to be realised it would be a tribute to the decisive fiscal action of the Chancellor at the start of the crisis and an artifact of the extraordinary stability of output in the face of extreme shocks – war, revolution, natural disasters, banking strikes. Whatever happens to advanced market economies, they possess enormous capacity to adjust and recover.

The immediate direction of the economy remains, however, unclear. Policy makers will have to be nimble in either providing more support or tightening policy if inflation emerges as a problem. Policy makers in the UK, in the same way that their international counterparts understand its importance, should make full use of the tools of macro-economic policy and fiscal policy. If further stimulus is needed it will fall to active fiscal policy and if a policy tightening is required, then the instrument to be used should be monetary policy.

Before the Covid crisis the British economy, in common with other advanced economies, experienced a decade of disappointing productivity and economic growth. It approached the sort of stationary state that classical economists explored. Once the economy has recovered from the Covid shock, future productivity and the trend rate of growth will depend on an ambitious agenda of future tax reform and supply side reform to improve the functioning of the economy. This should involve removing the Manhattan Skyline of income disincentives, a simpler and less complex tax structure, a focus on capacity to pay and the recognition that a total tax burden rising to a historic high not seen since the late 1960s is not a road map to economic dynamism.

You might also like

This website uses cookies to improve your experience. We'll assume you're OK with this, but you can opt-out if you wish. Accept Read More