Hammond: The Treasury's prisoner
Bold Budget is necessary, but fanciful
by Brian Reading in London
Wed 22 Nov 2017
Only a bold Budget can curb the Conservative UK government's growing unpopularity; don't expect Philip Hammond, the chancellor of the exchequer, to deliver one. He is the prisoner of Treasury fiscal orthodoxy, with the independent Office for Budget Responsibility as warden, and has little room for manoeuvre. The harsh austerity promoted by the previous government was flawed in principle and bungled in detail. Hammond ought to admit and address the economic and social damage those policies have done.
George Osborne, the former chancellor under Prime Minister David Cameron, promised in his first Budget in July 2010 to eliminate the 10% of GDP budget deficit within five years. The OBR said his budget tightening gave him better than 50% chance of keeping his promise. No further tightening would be needed. But in every year since, the target date for balancing the budget has been pushed further into the future. Every year the OBR's revised forecast says the previous target would be missed. Every year the OBR says further tightening is needed to give a better than 50% chance of hitting the new target. Last March Hammond promised to reduce the deficit to 2% of GDP in 2020-21 and balance the budget as early as possible in the next decade. If he manages to do so, it will have taken 15 years of worsening austerity to achieve what Osborne promised to achieve in five.
Tax increases and public spending cuts directly reduce income, spending and GDP growth. These are first-round reductions in the circular flow of income. The economic multiplier measures the final percentage reduction in incomes that results from budget tightening. Knock-on effects are steadily diminished, as cuts are offset by reduced private savings, reduced imports and lower tax receipts. Other things being equal, multipliers must exceed unity as the first-round effect is unlikely to be fully offset by these leakages. For the chancellor, the interaction of the economic and fiscal multiplier means eliminating a 10% of GDP budget deficit arithmetically requires, all things being equal, 15% of GDP tightening, which reduces national income by 18%.
But other things are not equal. The Bank of England controls monetary policy but not the markets. In 2010, markets would have punished fiscal profligacy. A flight out of sterling would have necessitated monetary tightening and punitive interest rates. The Treasury believed this would have caused worse damage to growth than austerity. Allowing for market consequences and monetary freedom, the OBR put the economic multiplier at one for public investment cuts, 0.3 for tax cuts and 0.6 for other spending cuts. It has not changed these assumptions in the seven years since, although 80% of its budget forecast changes are put down to over-optimistic GDP assumptions.
Due to the prospects for export-led growth in the face of weak domestic demand, multipliers are larger when all major economies pursue austerity and when output is below potential. Market consequences are less malign against the background of a global savings glut and when quantitative easing is commonplace and policy rates near zero. Exchange rates reward growth rather than fiscal rectitude. The Treasury is haunted by past crises. It cried for help over Britain's exit from the European Union and was rebuked for doing so, although its fears of a medium-term slowdown may be justified.
Needlessly harsh austerity has done economic as well as social damage. Demand consequences deter investment. Cheap and easy money inhibit economic innovation. Weak government spending contributes to lower productivity, damaging longer-term growth prospects.
A bold Budget concentrating on cheap borrowing for public housing and infrastructure investment would boost growth, bringing budgetary benefits to make the National Health Services and other pressing expenditure needs more affordable. Hammond, regrettably, is more likely to remain timid.
Brian Reading was an Economic Adviser to Prime Minister Edward Heath and is a Member of the OMFIF Advisory Board.
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