George Osborne set out the Coalition Government’s fiscal framework in the Emergency Budget in June 2010.
It is for the elimination of the structural budget deficit over five years principally achieved by discretionary reductions in public expenditure. The ratio of public expenditure to national income will be reduced by over eight percentage points and will be reduced to just under 40 per cent of GDP. The Chancellor described his 2011 Budget as a budget for growth and characterised the Emergency Budget as a rescue budget. The Emergency Budget stabilised the UK’s public finances in a convincing manner, but it did more than that. By reducing the ratio of public expenditure it represents the real growth strategy of the government, by contributing to a significant reduction in the role of the public sector and the crowding out that a public sector creates when it takes a disproportionate share of GDP.
The individual business measures in the budget may be helpful at the margin for some businesses and certainly create a rhetorical atmosphere that is welcoming for business, but in terms of the overall performance of the economy the measures make little difference. The real growth agenda is the reduction in future public spending announced in June 2010.
The UK economy is suffering from two challenges. The first is an impaired credit system and overhang of debt on private sector balances, which results in a much slower pace of recovery than would normally be experienced after the 6.4 per cent fall in output. This is aggravated by the tax and expenditure measures necessary to stabilise the public finances. Disappointing demand, however, does not necessarily mean that the economy is operating with spare capacity on the scale that many historically based economic models such as the traditional Treasury model may imply.
Supply-Side Constraints and Estimates of the Trend Rate of Growth
The combination of a public expenditure ratio of 47 per cent of GDP, a rising tax burden and a complex framework of means tested social security benefits and tax credits created over the last thirteen years has a malign effect of the economy’s supply performance. The labour market is more flexible than it was twenty-five years ago... Private sector wages in the recent slump have responded more flexibly than they did in the recessions of the 1980s and 1990s, with the result that the rise in unemployment has been smaller for a larger fall in output. The difficulty is that the productivity and efficiency of those in work has been blunted by regulation throughout the economy. While work incentives have been blunted for most families with children as a result of high net rates of benefit and tax withdrawal for incomes earning up to not just average earnings but around one and a half times average earnings.
There are two big questions: how much spare capacity is there? and what is a realistic assessment of the future trend rate of growth that will be sustainable? In the Budget in March 2010 Alistair Darling estimated that the trend rate of growth at 2.75 per cent. The Office of Budget Responsibility that now provides the economic forecast estimates trend growth is just over 2 per cent. There are good reasons to ask whether that is on the optimistic side. The Institute for Fiscal Studies in its Green Budget estimates that it is 1.7 per cent. An estimate of under 2 per cent, or lower of around 1.8 to 1.9 per cent may well be more realistic.
In an economy where public sector spending is approaching half of national income overall reported GDP changes are less significant than estimates of the evolution of private sector home demand that is household consumption, stock building and investment minus state transfer payments. This is the economy’s effective tax base. It contracted sharply during the slump falling between the first quarter of 2008 and the fourth quarter of 2009 by some 16 per cent. In 2010 it recovered, rising 4.6 per cent in real terms through the year. That fact that GDP growth was 1.3 per cent in 2010 illustrates the weakness of the UK supply base, because among other things a healthy expansion of private home demand was significantly diverted into net trade losses.
A more pessimistic estimate of trend GDP has implications for future tax receipts. In the years immediately ahead of the credit crunch the Treasury was too optimistic future tax receipts. The combination of weaker medium term growth and a forecast methodology that appears to have a bias to assuming that tax receipts return to a previous historic patterns to may mean that the forecasts for tax revenue may be on the optimistic side.
UK Inflation and the Role of the Exchange Rate
Optimism about the trend rate of growth and the amount of spare of capacity has implications for future monetary policy and the operation of the inflation target. Inflation has been above the 2 per cent CPI target each year since 2005. Over the last year inflation has been higher than the authorities expected. There is a significant divergence between the CPI and the RPI. There has been a deterioration within nominal GDP between real output growth and measured inflation. The GDP deflator has accounted for over half of the nominal change in GDP.
The MPC explains this by the fall in the exchange rate and the effect of imported higher commodity prices. The MPC assumes that large amounts of spare capacity will mean than these imported price pressures will act as a temporary relative price effect that will drop out of the measured indices as the wider background of an economy with large amounts of spare capacity contains future price pressure. The UK is a highly open economy well over a third of expenditure is on imported goods and services. A fall in the exchange rate of over a fifth has significant implications for price stability. While it would be an exaggeration to a assume a mechanical pass through with a lower exchange rate leading to a permanently higher rate of inflation, in the past sterling has played a significant role in both aggravating UK inflation and containing.
Moreover the response of the economy to a lower exchange rate has been disappointing. Despite a big improvement in world trade, and a much lower exchange rate, net trade reduced UK GDP over the last year by one percentage point. The OECD has commented that firms have seen the lower exchange rate as an opportunity to increase profit margins in the short term rather than to use it as an opportunity to increase their share of international markets. This response to the fall in the exchange rate illustrates wider and entrenched problems with the supply performance of the UK economy.
Reviewing the Inflation Target and Functioning of the MPC
The Chancellor reaffirmed the inflation target in the Budget Statement. Given its failure to contain inflation over the last five years and the highly accommodating bias of monetary policy that resulted in the asset price bubble before the credit crunch, there needs to be a debate about UK monetary policy and its institutional framework. The inflation target should be reviewed; the role of asset prices should be looked at. The manner in which the MPC carried out its mandate needs to be investigated and there should be a consideration of the central bank’s institutional arrangements. This should include the background, experience and intellectual policy interests of individuals appointed to apply the policy. The review should start from the perspective that constructing appropriate monetary institutions and policy arrangements is not easy, but the present UK inflation target and its application has proved to be defective.
This note summarises a presentation given by Warwick Lightfoot to the London Society of Chartered Accountants following the budget on 24 March 2011.
Warwick is the author of ''Sorry We Have No Money - Britain's Economic Problem'' http://www.searchingfinance.com/products/current-titles/sorry-we-have-no-money-britain-s-economic-problem.html