How Osborne's Budget can increase confidence

The state must have more faith in its own power to tame recession.

The state must have more faith in its own power to tame recession.

This week's Budget will reflect whether George Osborne's team has learned some economics over the last few months. If not, here is a last minute crash course, focusing on the need to increase "confidence" (the government's buzz word). But whose confidence?

1. Market confidence

Low interest rates in the UK aren't a reflection of "market" confidence, but of the fact that the economy is not growing. As in most stagnant economies, interest rates remain low - as does also inflation, which is only rising due to international commodity prices. The fact that the UK has its own currency, with an active central bank, partly explains why the bond markets are not fearful of a default and why Britain's AAA credit rating has not been downgraded, yet.

But the increasingly low growth forecasts for the UK, and the recent warnings by ratings agencies (including Fitch last week), show that the markets know that one of the world's most "austere" nations is in trouble because austerity does not generate growth.

Lesson: In your speech, don't use the "market'"and low interest rates as the reason that you need to continue austerity. Remember that savers are punished by low interest rates and life insurers - an important UK industry and a source of finance for recovery - could be seriously undermined by them. And if you think that the fixed rate on 100 year bonds is the solution, this will only make markets less confident. It demonstrates that you think rates of return will remain very low for an extended period. If not, it's unclear why anyone would invest in these.

2. Business confidence

Private business investment is not driven by tweaks in taxes, but by expectations about future technological and market opportunities. This is what Keynes meant by investment being driven by "animal spirits" and is the reason why there is too little investment in downturns and too much in booms.. It is also the reason why even in booms, there is little investment in countries, or particular regions, with low future growth opportunities. Weak private business investment in the UK and the fact that various companies are picking up and leaving (Pfizer, GSK, Sanofi) , is not due to their high taxes, but the lack of positive expectations about future growth in the UK.

Lesson: Don't try to increase investment by decreasing corporate taxes. Evidence is that these "savings" will not be reinvested back into production. Likewise reduction of the 50p rate will not "trickle down" to the rest of the economy, it will only increase inequality as all such measures, especially in the USA and the UK, have in the last decades. To increase investment, government must invest in those areas that create high expectations about technological and market growth: education, research in emerging technologies, modern infrastructure, and constructing a financial system that can nurture long-run, innovative investments.

3. Confidence in competition

When competition is strong, businesses feel the need to differentiate themselves to increase market share, whether via advertising or innovation. This is why there is rarely dynamism in sectors where competition is lacking. Competition policy should nurture those types of businesses that are most interested in growing via new products, processes, or new markets for existing products -- and in so doing create jobs. One way to invest in such opportunities is to properly fund the whole 'eco-system' of innovation, promoting broad technological areas rather than trying to pick winners within them.

In doing so it is important not to mythologise some of the actors, especially those with strong lobbies (e.g. small/medium enterprises, venture capital). It is not true, for example, that the SME sector as a whole is being starved of funds. Indeed UK SMEs get somewhere between £7-8 billion pounds a year in direct and indirect government support - more than either universities or the police. It is the high-growth, innovative SMEs (about 6 per cent of the total) that need support, which must be tailored towards their precise needs. And it is not true that the problem in the UK is commercialisation, the target of the new Catapult Centres. The lower amount of market relevant research is the UK's the problem; so setting up Catapult Centres, without investing in public R&D and stimulating business to do the same, is like pushing on a string. The UK's R&D/GDP ratio is 1.3 per cent, compared to 2.6 per cent in Germany and the USA. Unlike Britain, the former has increased its spending since the crisis.

Lesson: Invest in measures that can help generate the company strategies and structures that enable UK companies to produce products and services that the world wants to buy. Only in this way will UK companies win procurement contracts in their own country (it is hardly surprising that Siemens' won the Thameslink train deal, with its very high R&D spending, and investment in green technology). And don't focus so much on new vehicles like Catapult Centres, which will have all the force of a pea-shooter if the research base remains underfunded.

4. Bank confidence

Quantitative easing (QE) by the Bank of England has not resulted in higher growth because this injection of money has simply ended up in the coffers and bonus pools of banks, which are not lending. They are scared because they, like business, do not believe there are growth opportunities in a country that has problems with both demand (consumer spending) and supply (new business output). Banks' complaint that they are not receiving enough demand for new loans highlights the slump in demand afflicting the economy. Thus ironically, post-crisis QE has benefited only the actors that have been most responsible for the crisis, letting them recapitalise on the cheap without reducing business finance costs.

Lesson: To increase lending, the government should create a National Investment Bank that could offer the kind of "patient capital" needed by businesses investing for the long run. As private investment banking will not be viable on the past scale after banking reforms, this could be constructed from the skeleton of RBS. At present there is £500 billion of net financial surplus hoarded in the UK (and $1.1. trillion in the USA), mainly in pension funds; government can play a greater role in releasing these funds, which also have a public dimension, in particular directions like "green" investments with high future returns (see Nick Stern's recommendations).

5. Consumer confidence

Four types of demand drive GDP. Demand by government, by private business investment, by consumers and by what other nations demand from us (exports) minus what we demand from them (imports). Of these, consumer demand is the largest, and the most stable component, about 65 per cent of our GDP. It is much more predictable than private investment, as it is largely a function of disposable income. Thus even if you get all the policies above right, if you cut down on disposable income during a recession, you'll turn it into a depression. This is indeed the real current risk. And falling household incomes (from the rise in VAT, freeze in public sector pay, cuts to fundamental social services, and general downturn of the economy) will be made only worse with the further cuts that will be needed as a consequence of the 50p rate reduction.

Lesson: Consider reducing VAT, and releasing the public sector pay freeze, both of which are damaging to demand. While marginal rates have little effect on top earners they do deter effort and initiative at very low rates of pay (see Mirrlees Report). So what is needed is to decrease the marginal rate on very low earners - sometimes 100 per cent or more - not worrying about a 50 per cent rate at the top. Do whatever you can to steer councils away from spending cuts in areas that sustain the social fabric, including after-school clubs that allow women to work more and youth clubs that allow young people to feel valued members of society.

Perhaps the biggest lesson around confidence is that government must be more confident of its own powers. It should use the ability to tame recessions through monetary and fiscal policy, and invest in the future by funding the knowledge base that is the source of new waves of growth. The new green revolution is just beginning and, like all technological revolutions, will not happen without government playing a lead role, absorbing most of the uncertainty before the private sector dares to enter. This entrepreneurial role must lead the vision in next week's Budget if the UK is to play a meaningful role in the world economy.

Mariana Mazzucato is Professor of Economics and RM Phillips Chair in Science and Technology Policy at the University of Sussex. She is the author of The Entrepreneurial State.

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What is the EU customs union and will Brexit make us leave?

International trade secretary Liam Fox's job makes more sense if we leave the customs union. 

Brexiteers and Remoaners alike have spent the winter months talking of leaving the "customs union", and how this should be weighed up against the benefits of controlling immigration. But what does it actually mean, and how is it different from the EU single market?

Imagine a medieval town, with a busy marketplace where traders are buying and selling wares. Now imagine that the town is also protected by a city wall, with guards ready to slap charges on any outside traders who want to come in. That's how the customs union works.  

In essence, a customs union is an agreement between countries not to impose tariffs on imports from within the club, and at the same time impose common tariffs on goods coming in from outsiders. In other words, the countries decide to trade collectively with each other, and bargain collectively with everyone else. 

The EU isn't the only customs union, or even the first in Europe. In the 19th century, German-speaking states organised the Zollverein, or German Customs Union, which in turn paved the way for the unification of Germany. Other customs unions today include the Eurasian Economic Union of central Asian states and Russia. The EU also has a customs union with Turkey.

What is special about the EU customs union is the level of co-operation, with member states sharing commercial policies, and the size. So how would leaving it affect the UK post-Brexit?

The EU customs union in practice

The EU, acting on behalf of the UK and other member states, has negotiated trade deals with countries around the world which take years to complete. The EU is still mired in talks to try to pull off the controversial Transatlantic Trade and Investment Partnership (TTIP) with the US, and a similar EU-Japan trade deal. These two deals alone would cover a third of all EU trade.

The point of these deals is to make it easier for the EU's exporters to sell abroad, keep imports relatively cheap and at the same time protect the member states' own businesses and consumers as much as possible. 

The rules of the customs union require member states to let the EU negotiate on their behalf, rather than trying to cut their own deals. In theory, if the UK walks away from the customs union, we walk away from all these trade deals, but we also get a chance to strike our own. 

What are the UK's options?

The UK could perhaps come to an agreement with the EU where it continues to remain inside the customs union. But some analysts believe that door has already shut. 

One of Theresa May’s first acts as Prime Minister was to appoint Liam Fox, the Brexiteer, as the secretary of state for international trade. Why would she appoint him, so the logic goes, if there were no international trade deals to talk about? And Fox can only do this if the UK is outside the customs union. 

(Conversely, former Lib Dem leader Nick Clegg argues May will realise the customs union is too valuable and Fox will be gone within two years).

Fox has himself said the UK should leave the customs union but later seemed to backtrack, saying it is "important to have continuity in trade".

If the UK does leave the customs union, it will have the freedom to negotiate, but will it fare better or worse than the EU bloc?

On the one hand, the UK, as a single voice, can make speedy decisions, whereas the EU has a lengthy consultative process (the Belgian region of Wallonia recently blocked the entire EU-Canada trade deal). Incoming US President Donald Trump has already said he will try to come to a deal quickly

On the other, the UK economy is far smaller, and trade negotiators may discover they have far less leverage acting alone. 

Unintended consequences

There is also the question of the UK’s membership of the World Trade Organisation, which is currently governed by its membership of the customs union. According to the Institute for Government: “Many countries will want to be clear about the UK’s membership of the WTO before they open negotiations.”

And then there is the question of policing trade outside of the customs union. For example, if it was significantly cheaper to import goods from China into Ireland, a customs union member, than Northern Ireland, a smuggling network might emerge.

 

Julia Rampen is the editor of The Staggers, The New Statesman's online rolling politics blog. She was previously deputy editor at Mirror Money Online and has worked as a financial journalist for several trade magazines.