Sunday, July 24, 2005
Cyclical trickery only buys time
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Until last week, a question had been nagging away at me. Politically, another big rise in taxes was always a no-no for Gordon Brown, as I wrote immediately after the March budget. As long as he remained chancellor, Labour could not whack taxpayers with another hike, not least because of the way it would colour attitudes to his hoped-for transition from 11 to 10 Downing Street.

But in economic terms, it seemed, he was in a cleft stick. His precious golden rule — borrowing only to fund investment over the economic cycle — was under serious threat. On one side stood the risk to his political reputation, on the other the credibility of his fiscal rules. Which would he choose?

My question has been answered and it was, to use the expression identified by readers as the most irritating jargon, a no-brainer. Kenneth Clarke, Brown’s predecessor, liked to refer to what the regulars talked about in the Dog & Duck. It is hard to imagine them discussing the fiscal rules. Higher taxes, on the other hand, would feature. Politically, the imperative was to avoid tax rises, even at the expense of the rules.

Until last week Brown’s fiscal rules had little salience among the public. Now they have little relevance, or credibility, in the City. Since they were designed to underline the government’s prudence for the financial markets’ benefit, that is not good news, though so far the damage has been limited.

What happened last week? Invited by the Commons Treasury committee to talk about the G8, Brown used the occasion to make an important statement about domestic economic policy. The statement, that new official figures justified a rethink about the economic cycle, so it is now thought to have started in 1997 rather than 1999, kicked tax hikes into the very long grass. A bit of cyclical trickery can work wonders.

The reason is simple enough. To meet the golden rule, the chancellor has to balance surpluses and deficits on current spending and tax receipts over the economic cycle. By putting back the start of the cycle a couple of years he gains the benefit of the healthier public finances when he was first in charge at the Treasury, and genuinely was prudent.

As is characteristic of the Brown Treasury, the announcement was accompanied by a lot of paperwork. Just as last year’s “no” decision on euro entry required 18 technical studies and an assessment, this one had a 58-page document on the theory and practice of economic cycles.

This is not the place to go into the details of that paper, and whether the Treasury has made its case convincingly or not. Plenty of independent economists say not.

But Brown insists the change was fully justified. The Treasury’s previous belief, that there was a mini economic cycle between 1997 and 1999, always looked odd and the new growth figures confirmed that, though they also suggest that the cycle ended a couple of years ago.

The point is that if it looks like a fudge and tastes like a fudge, it probably is one. Appearances matter, and this change was just too convenient. Last week’s shenanigans in effect buried the golden rule.

Policy rules must be simple and easily understood. If they require that Treasury mandarins have to burrow deep into statistical history to determine whether they have been met or not, they are worse than useless.

Brown has another rule, the sustainable investment rule, to keep government debt below 40% of gross domestic product, compared with 35.3% now. On the face of it, this is being met comfortably but the government’s use of off-balance sheet funding, notably through the private finance initiative (PFI), means that this, too, has to be questioned. The Office for National Statistics is examining the way it treats PFI spending.

All this sounds arcane. The Treasury, however, has always insisted the fiscal rules are as important as Bank of England independence. That was never a very plausible claim; now it looks ridiculous. The Tories have promised an independent committee to monitor the fiscal rules. They should first devise new rules.

The irony is that if Brown tries to stick to his golden rule, there is still no guarantee it will be met. The Treasury had expected the economic cycle to end this year but that depends on its strong (3%-3.5%) growth forecast. The chancellor is still upbeat about prospects. If he is wrong, the cycle could last another two to three years, during which time borrowing would remain high.

No matter how it is finessed with fancy rules, there are eternal verities associated with fiscal policy. If you spend more than you raise in taxes, there will be a budget deficit. Mr Micawber understood this; many chancellors try to avoid it.

Brown’s early prudence was replaced by strong growth in spending, with the assumption that tax revenues would keep up. They haven’t. Figures last week showed government borrowing was rising, not falling, and in the first three months of this fiscal year was significantly up on the same period of 2004-5. The current budget deficit was £13.1 billion, compared with £11 billion.

That puts the onus on spending, assuming Brown wants to make good use of the time he has bought himself on tax. The other announcement from the Treasury last week was that the government is to hold a “second” comprehensive spending review, to be concluded in 2007, which will set out priorities for the next 10 years, the first having been in 1997.

I had naively thought, looking at the documents on my desk entitled “comprehensive spending review”, that the government had had a few of these, in 2000, 2002 and 2004. But apparently only the first, actually published in 1998, really mattered, as will the one coming up. It does not take much detective work to conclude that the first was intended to cover the Blair era, while the next one will set priorities for Brown’s intended long reign.

What will it come up with? The biggest priority has to be much slower growth in spending, to bring it back into line with tax receipts and allow the public services to digest the big rises they have already had. If not, then while Brown’s manoeuvres last week may have headed off tax hikes while he is chancellor, they won’t stop them if he manages to become prime minister.

PS At least one aspect of policy is straightforward. The Bank of England’s monetary policy committee (MPC) can do one of three things: put interest rates up, cut them, or leave them alone. This month, for the 11th in a row, it chose the last course, though it was a close-run thing, 5-4. David Walton, the committee’s newest member, marked his debut by voting for a cut, against Mervyn King, the governor.

After a knife-edge vote, can anything stop an August cut? A 5-4 vote one month does not necessarily mean a change the following month. Five years ago the committee had two successive knife-edge votes of this size — in those cases for a rise in rates from 6% — only for the moment to pass without a change. More recently, however, 5-4 has been a precursor of a move.

Last month’s retail-sales figures, up 1.3% in volume, surprised on the upside but one month’s figures do not change the picture dramatically. The value of sales, up only 0.4% in the latest three months compared with a year earlier, was still noticeably weak. Some MPC members may be concerned about the weakness of sterling but that would be circular thinking: the pound has weakened on the expectation of lower interest rates.

So a cut from 4.75% to 4.5% is on the cards for August 4. Friday’s growth figures, showing a rise of just 1.7% on a year earlier, should have been the clincher. More interesting, perhaps, is what the Bank’s inflation report will say about future rate prospects a few days later.

From The Sunday Times, July 24 2005

Comments

The MPC has the best of both worlds at the moment. Talk of a rate cut has depressed the pound’s effective exchange rate by 4.4% since the end of April, helping exporters, but the MPC hasn’t actually made borrowing easier for consumers.

Even so, consumer borrowing is on the rise again (according to the BBA) – a case for holding current interest rates.

But the CBI says firms are losing confidence - while export orders are rising. Perhaps holding interest rates will stiffen their resolve to export. It doesn’t seem likely the pound will recover that 4.4% very quickly under present circumstances.

Also, the MPC must be aware the US seems likely to keep raising their interest rates for the rest of this year. That will increse the value of the dollar and the cost to the UK of commodities priced in dollars.

It'll take more than crunching the numbers through a model to get this one right.

Posted by: David Sandiford at July 27, 2005 11:02 AM

Its going to get really interesting if and when Brown takes over as Prime Minister.

I am wondering if Brown will become another Eden or Major - i.e. cuckold who doesn't really shine after a really successful leader.

If the economy slides into recession and the public finances are in disarray then Brown is scuppered. His political credibility will wane. He will be an easy target on his supposed strong area - the economy. And he is unproven at managing any other brief. I am beginning to think that there is a good risk of him becoming a liability. Does Tony know that?!

I see too much tinkering by Brown and too many unrealistic assumptions. Unrealistic about UK growth and unrealistic about the pace and scale of reform, cost cutting and head-chopping in the public sector and civil service.

I think when the Chancellor starts to get one of the bread and butter items wrong (taxes, public finances, inflation, or interest rates) then he is starting to wobble.

Posted by: Angry Economist at August 12, 2005 04:19 PM