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The end of austerity

The next prime minister will partly reverse fiscal austerity. This is only partially justifiable
July 11, 2019

Fiscal austerity is over. Both of the candidates to be next prime minister are competing to promise tax cuts and spending rises. Boris Johnson has promised income tax cuts for higher earners, cuts in national insurance, increased school spending and a public sector pay rise, while Jeremy Hunt is promising a corporation tax cut, higher military spending and aid to farmers and fishermen.

Of course, these are mere promises. But they are nevertheless significant. The fact that both men think there are no votes to be had from promising more austerity shows that Conservative party attitudes to fiscal policy have shifted. This is partly justifiable, but not for the reason most commonly given.

The idea that the government has £27bn of “fiscal headroom” is silly. This number is simply the extent to which public sector net borrowing – which was 1.1 per cent of GDP last year – undershot chancellor Phillip Hammond’s earlier target for borrowing to be 2 per cent of GDP. This target, however, was arbitrary and it’s quite likely that a no-deal Brexit would weaken GDP and hence tax receipts and so increase borrowing even before the next prime minister has made a penny of tax cuts or spending increases.

Instead, the case for such loosening is conventional Keynesianism. If or when the economy weakens after a no-deal Brexit, macroeconomic policy should counteract it. With interest rates near zero, this job is better done by fiscal than monetary policy.

And from one perspective, there’s plenty of room for a giveaway simply because financial markets are paying the government to borrow: longer-term index-linked gilt yields are now minus 2 per cent. Simple maths suggests that the government could stabilise the ratio of government debt to GDP with a primary budget deficit of around 2.8 per cent of GDP. Given that this is now in surplus, this means the government could borrow an extra £70bn a year without raising the debt-GDP ratio.

So, what’s the problem? One is that the candidates are promising the wrong sort of stimulus. The conventional response to a temporary cyclical downturn is temporary fiscal loosening, such as pulling forward infrastructure spending. But both men are offering permanent loosenings instead.

For another, a no-deal Brexit won’t just depress demand. It’ll tend to push up prices as well. This isn’t merely because sterling will fall – and as we discovered in 2016 this does more to squeeze real incomes than it does to boost exports. It’s also because non-tariff barriers, and perhaps the need to rejig supply chains. will raise companies’ costs. And in the longer term, slower growth in external trade will raise prices by depressing productivity growth and competition. Adding a fiscal expansion to these pressures will push up inflation, and not just temporarily. This would require either higher interest rates or for the next chancellor to raise the inflation target. While there is a case for doing that, neither leadership candidate is making it.  

And then there is the Big Fact. Anything that depresses national income (relative to what it would otherwise be) means we’ll be less able to afford spending on public services without raising taxes. Increased government borrowing might avoid this dilemma for a while, but whether it can do so forever is unlikely.