George Osborne cannot possibly know how long austerity will last

The Chancellor's strategy is based on faulty rules and unproven assumptions about the deficit.

Next week George Osborne will hold forth on the size of the underlying deficit and reveal whether austerity will now extend until at least 2018. When he does, he won’t know what he’s talking about – and he’ll be in good company.  Neither will Ed Balls when he responds, nor will the phalanx of city economists who rush to comment, nor indeed will establishment economic institutions such as the IMF and the OECD.

This isn’t because our current crop of politicians and economists are unusually uninformed. Rather it reflects the fact the debate on fiscal policy is being driven in no small part by an economic concept – the structural deficit - that is very close to being unmeasurable. It’s an example of how what sounds like a sensible idea in theory can go wrong in practice.  

The structural deficit is that bit of the deficit that would still exist even if the economy was running at full capacity: the part that can’t be explained away by the fact that the economy is under-performing.  Giving it consideration is sensible and important. Few would disagree that running a deficit when the economy is stuttering along far below its peak capacity is a very different matter to running one when the economy is booming. The trouble arises, however, when we pretend we can decipher exactly how much of a deficit is cyclical and how much is structural.

Estimating the size of the structural deficit is, to put it mildly, something that sensible people can come to sharply different views on. Last week the Social Market Foundation  think-tank (led by former Treasury official Ian Mulheirn who is no fiscal virgin) published a neat bit of work replicating the methodology used by the Office for Budget Responsibility (OBR) to estimate the gap between the economy’s current output and its full potential. They conclude the output gap is pretty modest: under 2%.  If correct, it’s bad news for our economy, as we’ve had a bigger permanent loss in productive capacity than many realise. And it’s bad news for austerity: the return to growth won’t fill the fiscal gap - further painful changes will be needed to meet the objective of eliminating the structural deficit over five years. The SMF estimate that massive extra spending cuts or tax-rises of around £22bn (over and above all of those already planned) would be needed by 2017/18.

Or maybe they won’t be.  Another plausible report – this time by the respected Capital Economics – tells a very different story. It estimates that our flatling economy might be running as much as 6% below its full potential. If that’s the case the structural deficit is far smaller than we are being led to believe – and Osborne may be planning to tighten fiscal policy by too much, way too much – to the tune of around £35bn - in order to meet his own rule.

So that’s all clear then.

In addition to recognising the confusion over the size of the structural deficit it is worth asking whether setting a target that no-one can agree on is likely to result in further economic damage? You’d think so. But the answer depends on whether you believe that the chancellor’s target on eliminating the structural deficit is going to drive new spending and tax decisions that wouldn’t otherwise have been taken.

This question arises because the target is formulated in a way that means, as Jonathan Portes, Director of the National Institute for Economic and Social Research, has highlighted, it never actually bites. Because it is set on a rolling timetable all the chancellor ever needs to do is demonstrate he plans to get rid of the structural deficit five years from a given point in time. He doesn’t actually need to achieve these plans. Each year the date at which the target will be met can just be pushed back by another twelve months (as happened in last year’s autumn statement). Promises rather than delivery will suffice.

Now, a target without a fixed date is clearly a flexible thing. But I doubt this makes it irrelevant to real decisions.  Politics and the chancellor’s craving for ‘credibility’ are likely to result in the target affecting the cuts Osborne actually makes in the here and now.  He won’t want his target to become a joke – the mañana target. Say, for instance, Osborne announces next Wednesday that an extra £15bn of consolidation is needed in 2017/18 - will that really have no impact on the real choices made about the next few years? He may well believe it is vital that he demonstrates additional fiscal resolve –by implementing extra cuts, not just making more promises.  

But in deciding on the timing of any new cuts Osborne faces contradictory pressures. On the one hand, he may well want to bolster credibility as well as build up the size of spending reductions by acting quickly, for instance freezing spending now on aspects of welfare in order that savings accumulate over the forthcoming years.

Alternatively, there are strong arguments for thinking he’d want to push cuts down the road (as his target allows him to do). Most obviously this is because the economy is currently so weak only a fool would contemplate further undermining it.  But there is another subtler reason for playing it long. If the chancellor has a hunch that the true output gap is actually larger than the OBR currently believes he may want to defer cuts – particularly those cuts that he doesn’t actually want to make – in the hope that over the next few years the OBR revises its view. If this hunch turned out to be correct, then at some point the OBR would end up announcing that the output gap is larger (and the structural deficit smaller) than they previously thought.

The result? A return to growth would solve more of our fiscal problems than we currently expect and Osborne (or indeed Balls) would be in the happy position of being able to scale back some of the cuts that have been pencilled in.  Of course, things could turn out worse rather than better than current OBR assumptions. No-one knows. But in an uncertain world one thing is clear: the current target on the structural deficit magnifies rather than minimises the confusion.      

Nor should we forget that the structural deficit isn’t the only fiscal rule in a spot of trouble. The chancellor’s second target – the commitment to reduce debt as a share of GDP by 2015 - is likely to be breached next week (unless a Treasury accounting fiddle is used to avert this). Either way, the rule is highly arbitrary. If the debt to GDP ratio falls marginally in 2015 but grows thereafter then the rule would have been met but the public finances wouldn’t be sustainable.    

Osborne’s fiscal regime is in a state of disrepair.  The finest minds in the Treasury are currently chasing two faulty fiscal lodestars: a deficit rule which is impossible to accurately measure, resulting in starkly different estimates with very different implications for policy and politics; and a debt rule which is highly arbitrary and tells us very little about the nation’s longer term fiscal health.     

All of which would lead you to think that there would be a major debate – not least on the centre-left - about alternatives to Osborne’s rules. After all, fiscal policy is the issue of our times and will define the next Parliament as much as it has this one. To be fair there are indeed those setting out new and interesting thoughts on the type of framework that might better ensure fiscal sustainability whilst taking account of the strength of the economy  and without falling foul of either false precision or arbitrariness. For now this conversation is only happening at the margins. In the meantime we are stuck with fiscal rules that aren’t fit for purpose. That’s likely to remain the case regardless of what George Osborne says in the Autumn Statement.

Chancellor of the Exchequer George Osborne. Source: Getty

Gavin Kelly is a former adviser to Downing Street and the Treasury. He tweets @GavinJKelly1.

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Owen Smith promises to be a "cold-eyed revolutionary" - but tiptoes round Brexit

The Labour leader challenger takes Jeremy Corbyn on at his own anti-austerity game. 

Owen Smith may be challenging Jeremy Corbyn for the Labour leadership but it seems he has learnt a thing or two from his former boss. 

One year on from abstaining from the Tory Welfare Bill - a decision he now says he regrets - Smith attacked the former Chancellor George Osborne’s austerity policies from Orgreave, a former steel plant which was pivotal during the miners’ strike.  

Listing frustrations from library cuts to delayed trains, Smith declared: “Behind all of these frustrations is one cause – austerity.”

Borrowing the rhetoric that served Corbyn so well, he banged the drum about pay, labour rights and fair taxes. 

Indeed, a spokesman from Jeremy for Labour popped up to say as much: “We welcome Owen’s focus on equality of outcome, reindustrialisation and workers' rights - and his support for policies announced in recent months by Jeremy Corbyn and John McDonnell.”

On policy, though, Smith showed a touch of his own. 

His description of the Department for Work and Pensions as “a byword for cruelty and insecurity” resonates with the deep fear many benefit claimants feel for this faceless but all powerful authority. His promise to scrap it will not go unnoticed.

Another promise, to end the public sector pay freeze, is timely given widespread expectations that withdrawing from the EU’s single market will push up prices. 

He also appealed to the unions with a pledge to scrap the “vicious and vindictive” Trade Union Act. 

The policies may be Corbynite, but where Smith stands out is his determination to be specific and practical. He is selling himself as the Corbyn who actually gets things done. Asked about what he would replace zero-hours contracts with, he responded: "Well it could be one [hour]. But it can't be zero."

As he concluded his speech, he promised “revolution” but continued:

“Not some misty eyed romanticism about a revolution to overthrow capitalism.

“But a cold-eyed, practical, socialist revolution, through a radical Labour Government that puts in place the laws and the levers that can genuinely even things up.”

Smith’s speech, though, steered clear of grappling with the big issues of Brexit. He stands in favour of a second referendum on the Brexit deal, which may appease Labour's inner city voters but could frustrate others who voted Leave.

On the free movement of people – widely viewed as a dividing line between Labour’s Corbynite members and the wider voting population - he has been vague. He has previously expressed support for the "progressive case against freedom of movement" and criticised Corbyn for failing to understand patriotism. But this is not the same as drawing up policy. Whether he can come up with strong views on immigration and still appeal to both voter bases will be his biggest challenge of all. 

Owen Smith's 20 policies

1.      A pledge to focus on equality of outcome, not equality of opportunity 
2.      Scrapping the DWP and replacing it with a Ministry for Labour and a Department for Social Security
3.      Introducing modern wages councils for hotel, shop and care workers to strengthen terms and conditions
4.      Banning zero hour contracts
5.      Ending the public sector pay freeze
6.      Extending the right to information and consultation to cover all workplaces with more than 50 employees
7.      Ensuring workers’ representation on remuneration committees
8.      Repealing the Trade Union Act
9.      Increase spending on the NHS by 4 per cent in real-terms in every year of the next parliament
10.  Commit to bringing NHS funding up to the European average within the first term of a Labour Government
11.  Greater spending on schools and libraries
12.  Re-instate the 50p top rate of income tax
13.  Reverse the reductions in Corporation Tax due to take place over the next four years
14.  Reverse cuts to Inheritance Tax announced in the Summer Budget
15.  Reverse cuts to Capital Gains Tax announced in the Summer Budget
16.  Introduce a new wealth Tax on the top 1 per cent earners
17.  A British New Deal unveiling £200bn of investment over five years
18.  A commitment to invest tens of billions in the North of England, and to bring forward High Speed 3
19.  A pledge to build 300,000 homes in every year of the next parliament – 1.5 million over five years
20.  Ending the scandal of fuel poverty by investing in efficient energy