Osborne's plan isn't working - and Labour shouldn't follow it. Photo: Oli Scarff/Getty Images
Show Hide image

There is no economic reason for Osborne’s surplus plan. It’s time Labour stopped playing catch-up

Osborne is using the budget as an excuse for reducing the size of the state. Labour must not follow his lead.

When George Osborne imposed tough fiscal austerity in his first two years as Chancellor, he at least had an excuse. He could point to Greece and say: we must do whatever it takes to avoid that fate. Many economists at the time argued that eurozone countries were rather different from the UK, and we now understand much better why having your own central bank is the critical difference. But back in 2010 there were many who were worried by what was happening in the eurozone and supported the spirit if not the detail of Osborne’s plans.

Five years later, and the Chancellor wants to repeat the experience of those first two years by making it unlawful for the government to run budget deficits in normal times. On this occasion he has no excuses: there is no chance the UK will become like Greece. Seventy-nine economists have already written a letter denouncing the surplus plan, and both the Financial Times and the Economist have joined the criticism.

Why are economists against the idea? The Chancellor wants to bring government debt down rapidly. Yet economic theory is pretty clear that if you want to reduce government debt, it is generally best to plan to do this slowly. The costs of raising taxes or cutting spending today can easily exceed the future benefits that come from having to pay less interest because debt is lower.

However, Osborne rarely appeals to economic theory when it comes to fiscal policy, preferring household analogies involving credit cards. Yet even this does not work for him. We should pay off credit cards quickly because interest rates on credit-card debt are very high. In contrast, interest rates on UK government debt are historically low. Any business will tell you that the best time to invest is when borrowing is cheap. Now is the time to borrow to improve the UK’s infrastructure, but in order to achieve its surplus target the government plans to spend less on public investment than at any time over the past 12 years. So, how does the Chancellor justify going for surpluses? One argument is an old favourite of those advocating austerity: reducing the burden on future generations. Yet intergenerational equity hardly justifies reducing debt rapidly. Those who have suffered the most from the Great Recession are the young and it is they who will bear the cost of going for surpluses.

The second argument the Chancellor uses is that we need to be prepared for an uncertain future. It is important to decode what this means. He is not talking about a possible recession in the next few years, because the economics goes completely the other way. As the governor of the Bank of England, Mark Carney, has said, going for surplus will be a big drag on growth. He may be able to offset this by keeping interest rates low, but if other things go wrong the Bank will run out of ammunition. Going for surplus increases the chances of a downturn in the next few years, which is another reason why Osborne’s plans have angered many economists.

The risk that the Chancellor probably has in mind is not a mild economic downturn but another major crisis, like a new global financial crash. He wants the government to be able to run up large deficits in such a crisis and to have the resources to be able to bail out financial institutions once again. (The Conservatives may say the 2010 deficit was down to Labour profligacy but Osborne knows that is not true.) However, presumably the Chancellor also thinks that the banking measures he has implemented should prevent such a crisis happening in the next decade or two, so we are talking about something 30 or 40 years hence. In that case we do not need budget surpluses: modest deficits will be sufficient to cut the current debt-to-GDP ratio by half in 30 years’ time.

There is a quite different explanation for why Osborne is so keen to get to a budget surplus quickly. It is a great excuse for reducing the size of the state, particularly when you have pledged not to raise most taxes. Politically, this is best done quickly, to be well clear of the next election. This was what happened from 2010 to 2015: sharp austerity, followed by much more modest cutbacks and tax breaks. Even though the economy suffered as a result, he still won the election, so why not do it again?

How will Labour respond to Osborne’s surplus strategy? Some MPs want to capitulate completely: say they overspent before the recession and follow Osborne’s lead today. That is a frightening prospect, because it would leave the SNP as the only major party talking any sense about UK fiscal policy. (Ironically, this is the same party that tries to pretend, against all the evidence, that the immediate fiscal position of an independent Scotland would not be dire.)

The problem for Labour is that it keeps on making the same mistake on fiscal policy, which is to triangulate between sensible macroeconomics and what works well in focus groups. Just before and after the 2010 defeat, it should have made the positive case for ensuring recovery before worrying about debt. Instead, the message of “too far, too fast” just sounded like “austerity-lite”. And crucially, it failed to counter the narrative of past Labour profligacy, preferring to “move on”.

It is time for Labour to change the strategy to something completely different – to start telling the truth. To say that managing the government’s finances is different from running a household budget and that the deficit fetishism of the past five years has damaged the economy. Only that way can it avoid being tagged in five years’ time as the party that is always fiscally irresponsible.

Simon Wren-Lewis is Professor of Economic Policy at the Blavatnik School of Government, University of Oxford


 Simon Wren-Lewis is is Professor of Economic Policy in the Blavatnik School of Government at Oxford University, and a fellow of Merton College. He blogs at mainlymacro.

This article first appeared in the 19 June 2015 issue of the New Statesman, Mini Mao

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?