Black holes and doom-loops

The long march to economic ‘credibility’. Fiscal policy debates are heating up in the run up to the Autumn Statement on the 17th November. Treasury sources have been briefing journalists the gory details of the rumoured ‘black hole’ in the public finances and dropping hints about measures being considered to fill it. The latest estimates report that Chancellor Jeremy Hunt is planning cuts and tax rises totalling £60bn (at least half is expected to come from spending cuts) as he attempts to restore the Conservative party’s reputation for economic credibility. (Be warned: there is a large amount of expectation management going on from the Treasury, so take all reports of figures or policy options with a pinch of salt).

• A comprehensive explainer of fiscal responsibility. But what is fiscal space, how much does the government have, and what determines the options available to the Chancellor? Spending and Stability, a timely briefing by IPPR’s Carys Roberts and Carsten Jung, outlines the macroeconomic situation after the mini-budget and clarifies what the real constraints on tax and spending decisions are going forward.
• Inflation and sustainability are the only constraints. The authors explain there is little justification for the government narrative of a multi-billion pound ‘black hole’ which must be filled immediately to avoid economic calamity. In fact, the primary short-term constraint is the risk that any tax and spending decisions further stoke inflation (which they argue was the main driver behind the mini-budget “market turmoil” - read our analysis of the mini-budget’s contents and reaction) and the only medium-term constraint is the Chancellor’s choice of fiscal rules (a self-defined measure of sustainability).
• Room for additional spending. In the short term, IPPR argues that there is room for the government to raise spending to combat the cost of living crisis and invest in policies that will lead to economic growth, as long as inflation pressures are controlled. In the medium term, even the governments’ own fiscal rules do not prescribe spending cuts. Instead, a mix of policies (such as public investment) that increase growth (and thus lead to higher tax receipts and lower public spending) combined with some tax increases, would provide a credible fiscal strategy. This kind of countercyclical fiscal policy would be a more normal response to an impending recession, as the BBC’s Andy Verity explains. 

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Debt sustainability and fiscal rules. At the heart of this debate is the UK’s framework of fiscal rules. Fiscal rules are chosen by the Chancellor: they are a commitment to certain debt management policies to assure investors in UK public debt that there is a plan to ensure debt levels remain manageable - violating this can lead to higher risk premiums, leading investors to charge more interest on the debt. There are multiple fiscal rules, but the important one for this debate is the commitment to ensure the UK’s debt-to-GDP ratio is falling by the third year of the OBR forecast (i.e. by the end of 2025). This is a rolling target, so in some ways it can never be reached, but it does oblige the government to attempt to set out policies to meet it, which the Office for Budget Responsibility assesses. The ‘black hole’ is the anticipation of how far the government is away from meeting this self-imposed rule. 

• Debt-to-GDP ratios. Media commentary is estimating different sizes of the ‘fiscal black hole’ (from £10bn to £70bn) because it is based on different forecasts of GDP growth in three years time - or over five years if they assume the Chancellor will relax his fiscal rules and give himself more time to have debt falling as a % of GDP. The anticipated growth rate makes a huge difference to the estimated size of the ‘hole’, which is why policies that can raise the growth rate are also effective fiscal management policies. 
• The ‘moron premium’ and market reaction to the mini-budget. IPPR clarify that the market turmoil caused by the tax-cuts in the Truss government’s mini-budget was not due to a lack of faith from investors about the ability to repay the debt. They suggest that actually, it was caused by the lack of evidence about the effect of tax cuts to generate economic growth, citing recent analysis by the IMF (NB there is now a long-standing breadth of evidence that trickle-down economics - particularly via tax cuts - fails to generate growth), and that they might be inflationary which “combined with the fact that policies announced did not credibly address key upcoming challenges caused by the cost of living crisis.” 
• The market reaction to the Energy Price Guarantee. The tax cuts in the mini-budget were originally calculated to cost £45bn, however, the much larger Energy Price Guarantee was predicted to cost £150bn, but the latter didn’t provoke the same response from investors in UK government debt. IPPR explain that if public borrowing is used in ways that are much more likely to increase GDP growth, such as public investment to protect incomes, spending and demand, then this is more sustainable for the public finances in the long term. Further, there was good evidence that the energy support package would reduce inflationary pressure.

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Reducing the debt-to-GDP ratio through contractionary policy is self-defeating. IPPR’s point is that the size of the hole in public finances changes depending upon the policies chosen to fill it. George Osborne (in)famously tried to reduce the government’s debt-to-GDP ratio in the 2010s by heavily focusing on cuts to public spending. This approach has been roundly criticised by major economic institutions as a failure; across 32 of 32 advanced economies, reduced government spending led to slower economic growth. Contractionary fiscal policy, such as certain tax rises and spending cuts reduce spending in the economy and therefore negatively impact growth, making the hole in the public finances larger. In other words, if you want to meet a debt-to-GDP target, then the GDP is as important as the debt.

• This recession could be worse than the 2010s. The Guardian’s Larry Elliot explains that attempting austerity again now will be worse than in the 2010s because, unlike in the 2010s, the Bank of England is now also tightening its monetary policy; the Bank predicted last week that “higher interest rates would push the economy into the longest recession since the 1930s…Hunt’s fiscal squeeze is likely to worsen the forecasts, and the Bank said the economy was already contracting and would continue to shrink for eight consecutive quarters to the summer of 2024.” 
• Failure to learn the mistakes of austerity. The Institute for Government warned that £40bn of departmental spending cuts would require budgets to fall by 7.8% in real terms - the same severity of austerity as in 2010-2015 - but public services are already more fragile than they were in 2010 and “the methods used in 2010 are no longer politically or practically viable.” The UN’s envoy on extreme poverty also warned Rishi Sunak that a new wave of austerity could violate the UK’s international human rights obligations by increasing hunger and malnutrition: “This is the worst time to impose such cuts. You do not impose austerity measures when the whole population is facing a cost of living crisis. What you do is you raise taxes on the rich, you raise taxes on corporations.”

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Avoiding the “doom-loop”. The CBI’s Tony Danker, head of the UK’s largest business lobby group, warned PM Rishi Sunak against repeating the mistakes of the Cameron-Osborne years and creating a contractionary ‘doom-loop’; where tax increases and spending cuts harm growth so “the country could end up in a similar doom loop where all you have to do is keep coming back every year to find more tax rises and more spending cuts because you’ve got no growth.” The rumoured Treasury calculations admit the risk of this ‘doom-loop’ taking hold where estimates of the initial fiscal hole rose from ~£30-40bn to £50bn because more tax rises or spending cuts “will worsen the economic outlook, which will in turn hit future tax revenues”.

• Counter-cyclical approaches for economic growth. The PM has recently appointed Onward’s Director, Will Tanner, as his deputy chief of staff. Onward have a published a new paper by Tim Pitt (previously special adviser to Conservative chancellor’s Philip Hammond and Sajid Javid) calling on Chancellor Hunt to “loosen the interpretation of fiscal rules” to enable more investment in human capital, infrastructure and R&D. Pitt recently argued that Conservative economics must adopt a more pragmatic approach to fiscal policy, where they are “prepared to use it aggressively in downturns, esp when monetary policy is at ZLB, while accepting need for debt to fall materially in good times to build space for that”.
• Alternative fiscal rules. IPPR explain that debt-to-GDP fiscal rules have significant drawbacks as they limit borrowing to invest, even when this could be growth-enhancing and ultimately reduce debt in the long term. They propose instead a debt-interest-to-GDP rule or a net worth rule. NEF propose replacing fiscal rules with a Fiscal Policy Committee housed at the OBR and given a mandate based on resource constraints, full capacity utilisation, the private sector balance sheet position, and public sector net worth. 

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Achieving debt sustainability through growth. IPPR criticise the IFS’s estimate that £25bn of spending cuts are needed to meet the government’s current debt-to-GDP rule because this is based on near 0% growth in the medium term and 1% rise in interest on public debt. They argue that if the UK returns to pre-pandemic growth and interest rates closer to 2%, then the UK can afford to run a deficit of £49bn until 2025 and still be stabilising its debt - with £74bn more fiscal space than the IFS’s estimate.

• So how do we achieve growth? Fresh forecasts from the Bank of England last week predicted no or negative GDP growth until mid-2024. This can be broken with careful targeted measures to protect incomes and demand, in areas that don’t stoke inflation. IPPR’s paper outlines a strategy to tackle the cost of living crisis while ensuring sustainable growth and sound finances in the future; they give options for raising taxes that dampen inflation risk while also improving efficiency, equity and behaviour change. Carys Roberts outlines this approach in the New Statesman: “The fiscally responsible approach is to build a strong economy through public investment and tax increases on the wealthy.”  (Reminder: the UK is still a low-tax nation compared to Western standards.)
• Fiscally responsible policy options for 2023. The Telegraph reports that the Chancellor is looking at changes to the headline rate, reliefs and allowances on Capital Gains Tax and considering raising taxes on dividends. There is also speculation about whether the government will abolish non-dom status and the shape of a redesigned windfall tax. (The IMF ranks the UK’s oil and gas tax rate as the lowest amongst major producers.) The Guardian also reports that Labour are working on a “big policy intervention that will be a major overhaul of the tax system”, looking at taxing wealth in particular. Tax Justice UK have outlined 5 changes to wealth taxes that can raise £37bn a year. (Check out Economist Arun Advani’s Wealth Tax Reform Calculator for different revenue-raising options.)  

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No public appetite for austerity. Another consideration in this debate is how politically deliverable a programme of fiscal restraint would be in practice. Public attitudes on the economy have shifted since the 2010s. Deficit management is much less salient in the public's judgments about economic performance than it was in 2013; voters are now “most likely to be influenced by information concerning inflation/increases in prices”. NatCen’s latest British Social Attitudes survey shows “Appetite for government intervention in the economy is rising, as is concern about inequality, and enthusiasm for redistribution of income from the better-off to the poorer”. Those who want to increase taxes and spend more on health, education and social benefits was at its nadir at 31% in 2010, but has been climbing since - since 2017 more of the public want the government to “increase taxes and spend more” than those who want it to “keep taxes and spending at the same level as now”. 62% of 2019 Conservative voters think wealthy people should pay more tax.

• The pandemic changed people's views on welfare. Pollster Sir John Curtis argues that the public is much more sympathetic to working age people in need and more tolerant of welfare spending than in the Cameron-Osborne years. More than two-thirds now believe that ordinary working people do not get their fair share of the nation’s wealth - the most since 1991 and 10% more than in 2019. There is also growing support for redistributing income from the better-off to those with less (+10% since 2019). 71% of 2019 Conservative voters think the minimum wage and social security system don’t provide enough to live on.