A budget for “the next genera(l elec)tion”?

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Credit: www.thisismoney.co.uk

On Wednesday the Chancellor of the Exchequer George Osborne announced the budget for the fiscal year 2016-2017, a “Budget that puts the next generation first”. The content and the form of this speech have been widely debated in the press already. Without repeating what has already been written, here are a few thoughts:

  1. Brexit has definitely taken its toll. This is the first budget speech since the overwhelming Tories victory in last year’s general elections. With the House of Commons under their control, the context was ideal to outline an ambitious budget instead of delaying the bulk of the government budget rebalancing effort to the end of the parliament – we are talking about a £32bn reduction in Public Sector Net Borrowing (PSNB) between 2018-2019 and 2019-2020. An interesting analysis compiled by Torsten Bell for NewStatesman and reproduced below shows that PSNB is only reduced the year after general elections, and tend to soar the year before. And yet, the next general election is planned for… 2020. Unfortunately, Mr. Osborne as well as the rest of the Tories establishment will bet their political future in 3 months’ time. If the UK gets out of the EU, this future will be rather short-lived. As a consequence, this budget speech was partly design with the intention of rallying the Eurosceptics, especially those living outside London – hence the focus on the importance of devolving power to “our nations” and the lengthy discussions on local issues such as “enhanced capital allowances to the enterprise zone in Coleraine” or the “upgrade [of] the A66 and A69”. The Chancellor made use of the carrot but resorted to the stick as well, warning that the Office for Budget Responsibility (OBR)’s growth forecasts, and ultimately the budget equilibrium, were based on the assumption that the ‘Remain’ vote would win in June.
Credit: NewStatesman
Source: NewStatesman.com

2. Raising a fiscal surplus – Mr. Osborne’s self-imposed mantra – is an unpredictable mission, especially when the goal is positioned in a distant future. According to the OBR, by 2019-2020, all the efforts outlined by the Chancellor will only offset the drop in fiscal receipts generated by the latest OBR’s GDP growth forecast reduction (0.5% p.a.).

Changes to public sector net borrowing in 2019-2020
Changes to public sector net borrowing in 2019-2020

Furthermore, there is a very high chance of seeing the forecast revised again multiple times over the next few years, making the target even harder to hit. Finally, history has demonstrated that a higher than expected growth rate does not always lead to lower borrowing.

3. Similarly, the PSNB will largely depend on the uncertain evolution of the Bank of England’s interest rate. Unemployment at a 40-year low and wages growing by 2.1% over the last 12 months could well translate into sustainably higher inflation in the medium-term – the Chancellor indicated that it was forecast to reach 1.6% next year -, which would ultimately force the Bank of England to raise the cost of money. With a debt to GDP ratio approaching 85%, public finances would obviously be significantly impacted by such a change.

4. For the reasons listed above, some aspects of this budget appear as slightly unexpected and Mr. Osborne could well hide a different political agenda. Two options come to mind immediately. The first is that Mr. Osborne will resort to the same tactics towards Brexit as the one he used last year in the aftermath of the general elections, by issuing a revised budget as soon as the vote outcome is known – although this could come at a possibly unbearable political cost. The second option is that, as hinted by George Eaton, Mr. Osborne is actually preparing the ground for an early election which could free his hands to achieve his massive PSNB reduction ambitions in 2019-2020.

You can watch the replay of the Budget Speech below:

On red boxes and helicopters

George Osborne
George Osborne and his case

George Osborne, the Chancellor of the Exchequer, will present the next Government’s budget tomorrow. Although it is not official yet, this year’s Budget has already triggered a general outcry given the various alleged tax increases that have emerged in the press, including an increase in fuel duty, and has raised fears about the return of ‘austerity policies’ – which Mr. Osborne’s interview video below will not alleviate. We will have the opportunity to discuss the key measures once they have been made official. In the meantime this post presents the difficult conundrum Mr. Osborne has to confront.

Firstly, Mr. Osborne bets a large chunk of his political credibility on this budget. After hinting a fiscal surplus – a result that has rarely been achieved in the past -, boosted by promising economic prospects in sight, the Chancellor got caught by the real world and a disappointing economic recovery in the UK, whose 2015 GDP has been revised downwards by £18bn in December 2015. And yet, an apathetic economic activity translates into lower tax receipts for the government – up to £50bn over the course of the parliament. In order to partly offset this unexpected ‘black hole’, Mr. Osborne has to rely on a mix of public spending cuts and tax increases. The first lever will consist of “50p [of cuts] from every £100 the government spends” by 2020. The second lever will be further detailed tomorrow but, beyond the fuel duty increase we mentioned above, tax on insurance premiums and banks are also on the agenda. Mr. Osborne nonetheless proved his political instinct by softening the bitter pill with an announced reduction in income tax – the most visible and universal

Historical UK general government deficit as a percentage of GDP. Source: ONS.
Historical UK general government deficit as a percentage of GDP.
Source: ONS.
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Credits: www.abceconomics.com

Secondly, the looming Brexit threat adds uncertainty to the state of the UK economy at least for the year to come. In the short-term, this uncertainty translates into deferred investment decisions (‘sit and wait’) and ties the hands of the Chancellor, who has been publicly urged by David Cameron not to do anything that could complicate the referendum campaign. This phenomenon would however become marginal if the country decided to leave the EU. In that case, there is little doubt that the road to a fiscal surplus would significantly steepen.

Credits: www.moneymetals.com
Credits: www.moneymetals.com

Lastly, this political stance is challengeable from an economic perspective. Central Banks have struggled to revive inflation despite injecting thousands of billions of pounds/euros/dollars in the economy. The result has been mixed to say the least – inflation in 2015 in the UK will end up close to 0% – and has conducted some economists to bring the notion of ‘helicopter dropback in the spotlight. This measure consists in giving money directly to households in an attempt to encourage private spending. This decision would be a sensible way for the ‘fiscal stimulus’ to reach individuals, given that, as accurately diagnosed by Joseph Stiglitz, banks prefer to leave cheap money sleeping on their accounts – even if it means paying for it – and that companies have benefited from the low interest rates to buy financial assets – including their own shares – instead of investing.

Are helicopter drops the ultimate solution? They could be, provided that households are confident in the future enough to spend part of this gift rather than piling cash in the bank. By putting ‘skin in the game’ itself, the State could facilitate individual decision-making by highlighting trustworthy investments. Higher taxes – leading to lower disposable income – and lower public spending both go in the other direction.

Unfortunately, as we see today, the political agenda is too much focused on short-term deficits to account for longer-term economic benefits. This difficult (and inefficient) trade-off could have been avoided, at least partly, if governments had been bold enough to implement structural cost-cutting reforms in good times. This has not been the case, as the chart below shows. Another thing to think about for the Maastricht Treaty advocates.

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Correlation between UK GDP growth and UK budget deficit as % of GDP. Sources: ONS, World Bank.

To understand what will happen tomorrow you can watch the video below extracted from the UK Parliament website.

Update (16/03): The US banking industry body called for a rate rise yesterday, arguing that the key root cause of the current poor economic conditions was more the lack of business confidence than the availability of funding.