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

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.
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.

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.

Million Dollar Baby

Note: This post had been in my ‘draft’ basket for a while, but Michael Skapinker’s remarkable column in yesterday’s Financial Times put it back at the top of my pile.

Housing has become a real issue for British inhabitants in general, and Londoners in particular. LSE Professor Paul Cheshire has made a new contribution in this debate through a widely echoed report which concludes that one of four London homes will cost more than £1m by 2020, with the Financial Times concluding in the same article that “‘not just having a mum and dad who bought a house, but a grandparent too’ would be needed to get on the [property] ladder in the future”. So far, the latest data seem to prove him right.

The fact that owner occupiers and renters are not in the same boat is not news. The latest English Housing Survey supports that assertion in many respects. The share of overcrowded dwellings is almost four times higher in rented places (5-6% compared with 1-2%) and the gap is increasing. Conversely, the share of owned dwellings which are under-occupied has been soaring over the last two decades and now concerns more than 50% of the properties – partly due to the fact that almost all houses larger than 110 sq. m. are owned – compared with 9% and 13% for socially and privately rented dwellings, respectively. The share of non-decent homes has been decreasing across all types of occupations, but more than one out of four privately rented dwellings is still affected by ‘decency’ issues, primarily damp. For all those reasons, owner occupiers understandably report a higher satisfaction level than all types of renters (both social & private).

Share of non-decent homes, by tenure. Source: English Housing Survey 2014-15.
Share of non-decent homes, by tenure.
Source: English Housing Survey 2014-15.

Although the benefit of home ownership in terms of life satisfaction is indisputable, and despite the low interest rates and the numerous government schemes aimed at favouring ‘prime ownership’, UK inhabitants remain negative about their chances to ever get on the property ladder. Only 60% of private renters expect to buy one day, although the age for first time buyers has been continuously rising. For the youngest (25 to 34 years old), the mirage of ownership is vanishing at fast pace.

Split of households with a HRP aged 25-34, by tenure. Source: English Housing Survey 2014-15.
Split of households with a HRP aged 25-34, by tenure.
Source: English Housing Survey 2014-15.

In his report, Prof. Cheshire adds to the pessimism. Analysing the historical evolution of house prices in the UK, Prof. Cheshire concludes that “the key variables we have found have influenced house prices are real incomes, changes in population and house construction and interest rates”, with the former being “by far the most influential”. That being said, the relationship is clearly not 1:1, since real incomes have gone up by a factor of more than 3 since the early 1950s and the price of houses in London has been multiplied by 10 in half the time according to the Halifax House Price Index.

Quarterly evolution of house prices in London. Indexed at 100 for the average of 1983 prices. Source: Halifax House Price Index.

Government schemes or massive foreign capital inflows are not part of the list. In one hand, this is reassuring, as this means that house prices are directly linked to the income UK workers receive. On the other hand, this also means that an increase in inequalities between the richest and the poorest will leave more and more people on the side of the property ladder.

Source: http://thecrownblogspot.blogspot.co.uk/.
Source: http://thecrownblogspot.blogspot.co.uk/.

Prof. Cheshire’s quantitative forecast adds further colour. His econometric model, calibrated using historical data, forecasts an average house price increase of 23% by 2020 and 97% by 2030, with significant disparities between areas. London will be most heavily hit, with 25% of houses being priced at £1m or more by 2030 and the price of a house in the lowest quartile of all prices representing 17 times the income of a person earning the lowest quartile wage at that time, compared with 11.5 times today.

House Prices Observed and Predicted 1961 to 2030 – in logs. Source: Future Britain: Housing Millionaires and housing paupers.
House Prices Observed and Predicted 1961 to 2030 – in logs.
Source: Future Britain: Housing Millionaires and housing paupers.

Experts agree to say that the price surge we have been witnessing is also due to an imbalance between supply and demand. On that front, the Financial Times recently highlighted that new house building was still apathetic, leading the government’s ‘1m homes built by 2020’ target to be considered as increasingly unrealistic. The root causes of this supply shortage are subject to debate, but the UK regulatory and planning systems surrounding the building industry are often pointed out as major roadblocks – at least this is an area where the British and the French converge. There is however an urgent need for action: as rightly pointed out by Skapinker, at that pace, London will become unaffordable for the next wave of young talents it used to attract.