Osborne's cuts will cost Britain in the long run

Through his narrow focus on making the books add up now, the Chancellor is piling up social costs for the future.

George Osborne today set out the grim departmental spending settlement for 2015-16: the year after the next general election and so, in some ways, no more than a starting point for whoever wins. Yet it is a critical baseline: whatever its political colour, if the government of the day wishes to deviate from these plans they will either need to set out how they will reallocate cuts between departments, or how they will replace these cuts by either increasing taxes or increasing borrowing. It is also likely, then, to mark a turning point in the framing of the political debate about austerity.

Unless there has been no or very little pick up in the economy by 2015, (in which case the economy is in much more serious trouble than many think) it looks increasingly likely that Labour will go into the general election with a 1997-style type pledge to match Conservative spending plans, at least on current spending. Even if that isn’t the position, all of the parties are signed up to medium-term fiscal consolidation. As the debate moves away from the here and now, and towards what happens after the next election, "too far, too fast" will become increasingly irrelevant.

This is why Miliband and Balls have shifted the debate away from the pace of deficit reduction towards starting to set out how Labour might seek to make savings. The debate is not so much about the size of the state but about how fiscal consolidation is to be achieved. There are some major flaws in the way Osborne is cutting and the centre-left should be highlighting these while still emphasising the need for medium-term cuts.

A smart corporate looking to take almost a fifth of its cost base out over an eight-year period would probably start with three principles. First, it would look right across its activities and investments to take a comparative view of what adds most value to its business, and would start by taking out the lowest-value expenditure. Second, it would take a long-term view spanning decades not months: ensuring cuts made today would not create higher costs over a ten or twenty year period. Last, it would have its best and smartest minds focused on the significant task at hand: it certainly wouldn’t be letting its top performers go, or distract its board and mid-level management with big restructures or expansion into new markets.

Osborne’s approach couldn’t be further from this sort of strategy. First, the government is not looking at what it does in the round, taking a comparative view of the value of its activities. Thus it is ring-fencing universal pensioner benefits, such as the Winter Fuel Allowance and free bus passes, some of which are paid to older people with an income far in excess of average earnings in retirement, while cutting working-age benefits and services for young people. Four out of five pounds of every welfare cut are hitting families in work, for example through cuts to childcare tax credits. Despite historically high levels of long-term youth unemployment, the Future Jobs Fund and the Education Maintenance Allowance have also been cut. The cumulative result of Osborne’s decisions, from his first emergency Budget up until today, is a big redistribution from the young to the old, further consolidating the intergenerational transfer that’s happened via the housing price bubble and shifts in pension provision away from defined benefit towards defined contriubution.

Second, Osborne is taking a short-term view, pursuing cuts that may make the books add up that year but which risk creating big long-term costs for the state. The short-sightedness of his decision to cut the Future Jobs Fund, proven to work in reducing youth unemployment, is a perfect example: the long-term costs of youth unemployment through the 'scarring' impact it has on a young person’s lifetime employment opportunities are well-established. But there are many others. Cutbacks to the early years services offered in children’s centres risk manifesting themselves in higher costs later on, for example through poorer school results and employment outcomes for the young children who no longer benefit from them. The government has forecast its increased tuition fees will save money based on some highly optimistic predictions about the rate at which graduates will pay back loans: the Higher Education Policy Institute have said the new system could actually end up costing more than the old system, despite a £9,000 a year price tag on most degrees. Some decisions will end up costing more in the even shorter term. The bedroom tax is forcing local authorities to move those who cannot afford it to more expensive bed and breakfast accommodation when there are no smaller homes available. Social care cuts simply shift the load over to the NHS as hospitals are forced to keep older people on wards longer than necessary because of a lack of community care, an even more expensive solution.

Osborne would claim that in the case of social care and children’s centres, it is local authorities choosing to make these cuts in light of their reduced settlement, not him. But if Whitehall were taking the long view it would be incentivising local government to think longer-term, for example by enacting a settlement that allows councils that do achieve long-term savings to keep a proportion to reinvest.

Last, the government certainly does not seem to be creating space for its brightest and best minds to focus on the challenge in hand without distraction. Cutting headcounts is an inevitable part of any austerity programme. But this has not been used as an opportunity to performance-manage out the poor performers. Instead, in many Whitehall departments, the best staff have taken voluntary redundancy packages and left. And the government’s misguided public service reform programme is absorbing huge amounts of energy at a time when morale is low. The NHS faces its tightest spending settlement since the Second World War: demographic pressures and social care cuts mean the ring-fence will feel very much like a cut. Yet health commissioners are focused not on the challenge at hand but on a massive structural reorganisation with no clear rationale as to why this will improve the quality of healthcare. In education, primary schools in several local authorities are being forced to become academies, getting grants of tens of thousands of pounds from central government to figure out how to recreate back-office and school improvement economies of scale. Ofsted has said this risks distracting school leaders from their core mission of improving standards at a time when cuts to children’s services are loading more onto schools.

The centre-left cannot make these sorts of critiques without saying more about how it would be cutting differently. Yet by setting out what he would do were he still Chancellor in 2015, Osborne is effectively forcing Labour onto this territory. Miliband and Balls made a good start a couple of weeks ago in making it clear universal pensioner benefits are no longer sacrosanct in light of what that means for support for young people and working families, and insetting out how a Labour government would seek to bring down the medium-term cost of social security by investing upfront in house building and encouraging businesses to pay the living wage. Eventually though, and before the next general election, Labour will need to say exactly how their plans would differ from Osborne’s; with the assumption that unless they set out more tax rises or accept higher levels of borrowing to pay for current spending, they will need to accept his cuts unless they are reapportioned elsewhere. This is what Ed Miliband signalled is to come in a recent speech: it will represent a marked shift in the tone of the political debate.

Sonia Sodha is a former policy adviser to Ed Miliband and writes in a personal capacity

George Osborne and Danny Alexander leave the Treasury for the House of Commons before the Spending Review. Photograph: Getty Images.

Sonia Sodha is head of policy and strategy at the Social Research Unit and a former senior policy adviser to Ed Miliband. She tweets @soniasodha.

Getty
Show Hide image

We're racing towards another private debt crisis - so why did no one see it coming?

The Office for Budget Responsibility failed to foresee the rise in household debt. 

This is a call for a public inquiry on the current situation regarding private debt.

For almost a decade now, since 2007, we have been living a lie. And that lie is preparing to wreak havoc on our economy. If we do not create some kind of impartial forum to discuss what is actually happening, the results might well prove disastrous. 

The lie I am referring to is the idea that the financial crisis of 2008, and subsequent “Great Recession,” were caused by profligate government spending and subsequent public debt. The exact opposite is in fact the case. The crash happened because of dangerously high levels of private debt (a mortgage crisis specifically). And - this is the part we are not supposed to talk about—there is an inverse relation between public and private debt levels.

If the public sector reduces its debt, overall private sector debt goes up. That's what happened in the years leading up to 2008. Now austerity is making it happening again. And if we don't do something about it, the results will, inevitably, be another catastrophe.

The winners and losers of debt

These graphs show the relationship between public and private debt. They are both forecasts from the Office for Budget Responsibility, produced in 2015 and 2017. 

This is what the OBR was projecting what would happen around now back in 2015:

This year the OBR completely changed its forecast. This is how it now projects things are likely to turn out:

First, notice how both diagrams are symmetrical. What happens on top (that part of the economy that is in surplus) precisely mirrors what happens in the bottom (that part of the economy that is in deficit). This is called an “accounting identity.”

As in any ledger sheet, credits and debits have to match. The easiest way to understand this is to imagine there are just two actors, government, and the private sector. If the government borrows £100, and spends it, then the government has a debt of £100. But by spending, it has injected £100 more pounds into the private economy. In other words, -£100 for the government, +£100 for everyone else in the diagram. 

Similarly, if the government taxes someone for £100 , then the government is £100 richer but there’s £100 subtracted from the private economy (+£100 for government, -£100 for everybody else on the diagram).

So what implications does this kind of bookkeeping have for the overall economy? It means that if the government goes into surplus, then everyone else has to go into debt.

We tend to think of money as if it is a bunch of poker chips already lying around, but that’s not how it really works. Money has to be created. And money is created when banks make loans. Either the government borrows money and injects it into the economy, or private citizens borrow money from banks. Those banks don’t take the money from people’s savings or anywhere else, they just make it up. Anyone can write an IOU. But only banks are allowed to issue IOUs that the government will accept in payment for taxes. (In other words, there actually is a magic money tree. But only banks are allowed to use it.)

There are other factors. The UK has a huge trade deficit (blue), and that means the government (yellow) also has to run a deficit (print money, or more accurately, get banks to do it) to inject into the economy to pay for all those Chinese trainers, American iPads, and German cars. The total amount of money can also fluctuate. But the real point here is, the less the government is in debt, the more everyone else must be. Austerity measures will necessarily lead to rising levels of private debt. And this is exactly what has happened.

Now, if this seems to have very little to do with the way politicians talk about such matters, there's a simple reason: most politicians don’t actually know any of this. A recent survey showed 90 per cent of MPs don't even understand where money comes from (they think it's issued by the Royal Mint). In reality, debt is money. If no one owed anyone anything at all there would be no money and the economy would grind to a halt.

But of course debt has to be owed to someone. These charts show who owes what to whom.

The crisis in private debt

Bearing all this in mind, let's look at those diagrams again - keeping our eye particularly on the dark blue that represents household debt. In the first, 2015 version, the OBR duly noted that there was a substantial build-up of household debt in the years leading up to the crash of 2008. This is significant because it was the first time in British history that total household debts were higher than total household savings, and therefore the household sector itself was in deficit territory. (Corporations, at the same time, were raking in enormous profits.) But it also predicted this wouldn't happen again.

True, the OBR observed, austerity and the reduction of government deficits meant private debt levels would have to go up. However, the OBR economists insisted this wouldn't be a problem because the burden would fall not on households but on corporations. Business-friendly Tory policies would, they insisted, inspire a boom in corporate expansion, which would mean frenzied corporate borrowing (that huge red bulge below the line in the first diagram, which was supposed to eventually replace government deficits entirely). Ordinary households would have little or nothing to worry about.

This was total fantasy. No such frenzied boom took place.

In the second diagram, two years later, the OBR is forced to acknowledge this. Corporations are just raking in the profits and sitting on them. The household sector, on the other hand, is a rolling catastrophe. Austerity has meant falling wages, less government spending on social services (or anything else), and higher de facto taxes. This puts the squeeze on household budgets and people are forced to borrow. As a result, not only are households in overall deficit for the second time in British history, the situation is actually worse than it was in the years leading up to 2008.

And remember: it was a mortgage crisis that set off the 2008 crash, which almost destroyed the world economy and plunged millions into penury. Not a crisis in public debt. A crisis in private debt.

An inquiry

In 2015, around the time the original OBR predictions came out, I wrote an essay in the Guardian predicting that austerity and budget-balancing would create a disastrous crisis in private debt. Now it's so clearly, unmistakably, happening that even the OBR cannot deny it.

I believe the time has come for there be a public investigation - a formal public inquiry, in fact - into how this could be allowed to happen. After the 2008 crash, at least the economists in Treasury and the Bank of England could plausibly claim they hadn't completely understood the relation between private debt and financial instability. Now they simply have no excuse.

What on earth is an institution called the “Office for Budget Responsibility” credulously imagining corporate borrowing binges in order to suggest the government will balance the budget to no ill effects? How responsible is that? Even the second chart is extremely odd. Up to 2017, the top and bottom of the diagram are exact mirrors of one another, as they ought to be. However, in the projected future after 2017, the section below the line is much smaller than the section above, apparently seriously understating the amount both of future government, and future private, debt. In other words, the numbers don't add up.

The OBR told the New Statesman ​that it was not aware of any errors in its 2015 forecast for corporate sector net lending, and that the forecast was based on the available data. It said the forecast for business investment has been revised down because of the uncertainty created by Brexit. 

Still, if the “Office of Budget Responsibility” was true to its name, it should be sounding off the alarm bells right about now. So far all we've got is one mention of private debt and a mild warning about the rise of personal debt from the Bank of England, which did not however connect the problem to austerity, and one fairly strong statement from a maverick columnist in the Daily Mail. Otherwise, silence. 

The only plausible explanation is that institutions like the Treasury, OBR, and to a degree as well the Bank of England can't, by definition, warn against the dangers of austerity, however alarming the situation, because they have been set up the way they have in order to justify austerity. It's important to emphasise that most professional economists have never supported Conservative policies in this regard. The policy was adopted because it was convenient to politicians; institutions were set up in order to support it; economists were hired in order to come up with arguments for austerity, rather than to judge whether it would be a good idea. At present, this situation has led us to the brink of disaster.

The last time there was a financial crash, the Queen famously asked: why was no one able to foresee this? We now have the tools. Perhaps the most important task for a public inquiry will be to finally ask: what is the real purpose of the institutions that are supposed to foresee such matters, to what degree have they been politicised, and what would it take to turn them back into institutions that can at least inform us if we're staring into the lights of an oncoming train?