Sunday, October 18, 2015
How Osborne's dreams of a surplus could backfire
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Outside the narrow confines of what is sometimes called the Westminster village, most people will have been getting on with life, rather than following the progress of the government’s Charter for Budget Responsibility; its new set of fiscal rules.

To sum up, for those who missed it, Labour decided that the charter was a very obvious political trap set by George Osborne to demonstrate that the opposition could not be trusted with the public finances. Then, having identified this very obvious trap, the party’s new leadership tried to get all its MPs to hold hands and jump into it. Some sensibly resisted by abstaining on the vote.

John McDonnell, the new shadow chancellor, has made a fool of himself. There was something very odd about his interview with The Guardian on September 25, when he said he would support the charter – which commits the government to an overall budget surplus – while also saying Labour would borrow to fund investment; the party’s position under Ed Miliband.

It looks like he did not understand what he was saying and the illogicality of his position was pointed out to him. That is more convicing than his story, that he had a Damascene conversion when visiting the families of steelworkers in Redcar, should be taken too seriously.

I hope this is the last time McDonnell will feature here for a while. Ed Balls, for all his faults, was 10 times more suited to the job of chancellor than his successor and I did not devote many column inches to him during the last parliament. It would have been very different if the general election had turned out differently for Labour and for Balls.

Just because the new shadow chancellor has been a fool does not, of course, mean Osborne is a genius. The fiscal charter is not, as its opponents suggest, a stunt – he means it - but the highly political way in which it has been used makes it easy to make that claim. Sometimes the chancellor can be too political for his own good. You might have needed a fiscal charter vote to convince voters that a Miliband-Balls Labour party lacked fiscal credibility. You do not need it with a Labour party led by Corbyn; people know that already.

This should be a golden time for Osborne. Though he got on reasonably well with Danny Alexander, the Liberal Democrat Treasury chief secretary, during the coalition, those days are over. The Treasury these days is peopled by like-minded Tory ministers, including Alexander’s successor, Greg Hands.

The economy is doing well. Though there is evidence of a slight slowdown in the third quarter, Osborne can bask in the glory of an economy growing faster than G7 competitors, and the recent upward revisions in gross domestic product which have vindicated his approach.

The labour market is doing extraordinarily well, a recent pause in employment growth giving way to another good rise. In the latest three months employment has grown by 140.000; in the last year by 359,000, and overwhelmingly traditional full-time employee jobs. The unemployment rate has dropped to 5.4%, its lowest since May 2008, and could soon threaten to drop below its lowest point during the long upswing from the early 1990s to the global financial crisis.

Average earnings are growing by 3% - 3.4% in the private sector – at a time when inflation has turned marginally negative, by 0.1%, again. Real wages are rising strongly and, though the path will be bumpy, productivity should also recover. The economy is in a sweet spot.

Instead of basking in this, and the political gift of a chaotic and divided opposition, the Tories are in danger of creating rods for their own backs. The fiscal charter is badly designed and hard to defend, and the cuts in tax credits, which have become the lightning conductor for austerity in this parliament, are being badly handled.

The problem for the charter is not that it aims for an overall budget surplus, and then to keep it there, although Osborne could easily find, like most of his predecessors, that this is a triumph of hope over experience. He came up with his surplus ambition only after his deficit targets had slipped.

After a big increase in government debt before, during and after the financial crisis, it is reasonable to aim to reduce it, if only slowly. Treasury projections produced at the time of the budget showed that, even assuming an economic shock every eight years that pushes public sector debt up by 10% of gross domestic product, a rule that required a small surplus would reduce it from just over 80% of GDP now to just over 50% of GDP by the mid-2030s. Borrowing to invest – running an overall budget deficit - would leave debt close to current high levels.

Nor is it the case that running a small overall surplus means starving means starving the country of much-needed public investment, as is sometimes claimed. There have been times when budget surpluses coincided with near-record lows for public investment, as under Gordon Brown from 1988-99 to 2000-01. But there have also been times when surpluses ran alongside very strong public investment, as in 1969-70 and 1970-71, when public investment averaged well over 6% of GDP, more than four times current levels.

The problem is the way the charter is designed. It aims for an overall budget surplus by 2019-20, which would be the first for nearly two decades, and a reduction in debt as a percentage of GDP each year until then. That overall surplus would then be maintained each year “in normal times”, the requirement only being abandoned if there is a “significant negative shock” hitting the economy, defined as an assessment from the Office for Budget Responsibility (OBR) either that growth has dropped below 1%, or that its forecasts show it doing so.

The problem with this, as Jonathan Portes, former director of the National Institute of Economic and Social Research points out, is that it could lead to mistakenly tight fiscal policy. If growth averaged 1.5% a year rather than 2.5% over a four-year period, the cumulative loss of GDP, and tax revenues, would be considerable but the charter’s get-out clause would not be triggered. Osborne, or his successor, would be required to target a budget surplus even in a period of slow growth.

This would deprive Osborne of flexibility he himself has taken advantage of. The OBR, in its latest forecast evaluation report, just published, looked at why borrowing last year, 2014-15, was more than £50bn more than it predicted in 2010. The problem was a shortfall in economic growth, and the weakness of wages, which meant tax revenues came in £60bn lower than expected. But we now know that growth never fell below 1% during the last parliament. Had the charter applied, Osborne would have had to cut spending more deeply, or raise taxes, to compensate for the shortfall in revenues. It is a problematical piece of legislation.

The government is also getting itself into an unnecessary bind over tax credits. There are plenty of things that need fixing about tax credits. Everybody talks about their positive effects on work incentives but they also operate in the opposite direction. I recently quoted a Low Pay Commission report which found that many lone parents were unwilling to work more than 16 hours a week, and single adults more than 30, because it affected their entitlement to tax credits and other in-work benefits.

What you do not want in any reform are large numbers of seemingly deserving cases, who will lose out significantly from the tax credit changes, in some cases reducing or removing their incentive to work. Chancellors are at their best when following the dictum of Jean-Baptiste Colbert, Louis XIV’s finance minister, of plucking the largest amount of money from the goose “with the smallest possible amount of hissing”.

There is plenty of hissing over the tax credit changes, which strongly suggests they could be done in a better and fairer way.