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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Lord Empey: Northern Ireland likely to be without government for a year

The former UUP leader says Gerry Adams is now in "complete control" of Sinn Fein and no longer wants to be "trapped" by the Good Friday Agreement

The death of Martin McGuinness has made a devolution settlement in Northern Ireland even more unlikely and has left Gerry Adams in "complete control" of Sinn Fein, the former Ulster Unionist leader Reg Empey has said.

In a wide-ranging interview with the New Statesman on the day of McGuinness’ death, the UUP peer claimed his absence would leave a vacuum that would allow Adams, the Sinn Fein president, to consolidate his hold over the party and dictate the trajectory of the crucial negotiations to come. Sinn Fein have since pulled out of power-sharing talks, leaving Northern Ireland facing the prospect of direct rule from Westminster or a third election in the space of a year. 

Empey, who led the UUP between and 2005 and 2010 and was briefly acting first minister in 2001, went on to suggest that, “as things stand”, Northern Ireland is unlikely to see a return to fully devolved government before the inquiry into the Renewable Heat Incentive scheme is complete -  a process which could take up to a year to complete.

“Adams is now in complete control of Sinn Fein,” he said, adding that it remained unclear whether McGuinness’ successor Michelle O’Neill would be “allowed to plough an independent furrow”. “He has no equal within the organisation. He is in total command of Sinn Fein, and that is the way it is. I think he’s even more powerful today than he was before Martin died – by virtue of there just being nobody there.”

Asked what impact the passing of McGuinness, the former deputy first minister and leader of Sinn Fein in the north, would have on the chances of a devolution settlement, Empey, a member of the UUP’s Good Friday Agreement negotiating delegation, said: “I don’t think it’ll be positive – because, for all his faults, Martin was committed to making the institutions work. I don’t think Gerry Adams is as committed.

Empey added that he believed Adams did not want to work within the constitutional framework of the Good Friday Agreement. In a rebuke to nationalist claims that neither Northern Ireland secretary James Brokenshire nor Theresa May can act as honest or neutral brokers in power-sharing negotiations given their reliance on the DUP’s eight MPs, he said: “They’re not neutral. And they’re not supposed to be neutral.

“I don’t expect a prime minister or a secretary of state to be neutral. Brokenshire isn’t sitting wearing a hat with ostrich feathers – he’s not a governor, he’s a party politician who believes in the union. The language Sinn Fein uses makes it sound like they’re running a UN mandate... Gerry can go and shout at the British government all he likes. He doesn’t want to be trapped in the constitutional framework of the Belfast Agreement. He wants to move the debate outside those parameters, and he sees Brexit as a chance to mobilise opinion in the republic, and to be seen standing up for Irish interests.”

Empey went on to suggest that Adams, who he suggested exerted a “disruptive” influence on power-sharing talks, “might very well say” Sinn Fein were “’[taking a hard line] for Martin’s memory’” and added that he had been “hypocritical” in his approach.

“He’ll use all of that,” he said. “Republicans have always used people’s deaths to move the cause forward. The hunger strikers are the obvious example. They were effectively sacrificed to build up the base and energise people. But he still has to come to terms with the rest of us.”

Empey’s frank assessment of Sinn Fein’s likely approach to negotiations will cast yet more doubt on the prospect that devolved government might be salvaged before Monday’s deadline. Though he admitted Adams had demanded nothing unionists “should die in a ditch for”, he suggested neither party was likely to cede ground. “If Sinn Fein were to back down they would get hammered,” he said. “If Foster backs down the DUP would get hammered. So I think we’ve got ourselves a catch 22: they’ve both painted themselves into their respective corners.”

In addition, Empey accused DUP leader Arlene Foster of squandering the “dream scenario” unionist parties won at last year’s assembly election with a “disastrous” campaign, but added he did not believe she would resign despite repeated Sinn Fein demands for her to do so.

 “It’s very difficult to see how she’s turned that from being at the top of Mount Everest to being under five miles of water – because that’s where she is,” he said. “She no longer controls the institutions. Martin McGuinness effectively wrote her resignation letter for her. And it’s very difficult to see a way forward. The idea that she could stand down as first minister candidate and stay on as party leader is one option. But she could’ve done that for a few weeks before Christmas and we wouldn’t be here! She’s basically taken unionism from the top to the bottom – in less than a year”.

Though Foster has expressed regret over the tone of the DUP’s much-criticised election campaign and has been widely praised for her decision to attend Martin McGuinness’ funeral yesterday, she remains unlikely to step down, despite coded invitations for her to do so from several members of her own party.

The historically poor result for unionism she oversaw has led to calls from leading loyalists for the DUP and UUP – who lost 10 and eight seats respectively – to pursue a merger or electoral alliance, which Empey dismissed outright.

“The idea that you can weld all unionists together into a solid mass under a single leadership – I would struggle to see how that would actually work in practice. Can you cooperate at a certain level? I don’t doubt that that’s possible, especially with seats here. Trying to amalgamate everybody? I remain to be convinced that that should be the case.”

Accusing the DUP of having “led unionism into a valley”, and of “lashing out”, he added: “They’ll never absorb all of our votes. They can try as hard as they like, but they’d end up with fewer than they have now.”

Patrick Maguire writes about politics and is the 2016 winner of the Anthony Howard Award.