Blair misses the point on the pre-crisis deficit

Tony BlairWriting in this month’s centenary issue of the New Statesman, former prime minister Tony Blair writes:

Labour should be very robust in knocking down the notion that it “created” the crisis. In 2007/2008 the cyclically adjusted current Budget balance was under 1 per cent of GDP. Public debt was significantly below 1997. Over the whole 13 years, the debt-to-GDP ratio was better than the Conservative record from 1979-97. Of course there is a case for saying a tightening around 2005 would have been more prudent. But the effect of this pales into insignificance compared to the financial tsunami that occurred globally, starting with the sub-prime mortgage debacle in the US.

It’s a common assertion, albeit rather better expressed by Blair than it usually is. But it misses the point, and probably does so deliberately.

The point is that the economic conditions in the years before the financial crisis were unsustainable – we were in a boom. Money, and therefore a sense of improving living standards, were being created by lending irresponsible amounts to people who, with a proper analysis of the risk, would not have been lent to by any sensible financial institution.

And because of the boom in the economy there was a boom in public revenues. Any sensible analysis of the economic climate – and particularly one influenced by Keynes – would have recognised this and made it a policy commitment to run a budget surplus: first to reduce debt and create a cushion when output and revenues inevitably fell, and secondly to suppress demand in an attempt to deflate the bubble.

But government policy was exactly the opposite. It was to treat the income from the boom as a permanent source of revenue and stimulate demand by running a deficit. It was Gordon Brown who chose to ignore warnings that we were living through a credit-fuelled boom.

So to claim that Labour should not be held responsible for the current state of the public finances because the deficit was relatively small is disingenuous.

Blair is right that it would have been “prudent” to “tighten” in 2005, but wrong when he says this would have been insignificant. Had we been running a budget surplus equivalent to 2 or 3% of GDP in 2007, rather than a similar-sized deficit (see the red box on the above chart), the deficit now would half what it is, and with a lower debt burden. That would have meant fewer cuts and tax rises and a stronger economic recovery.

The financial crisis and subsequent recession would have hit public finances whatever government policy pre-2007. But Labour’s policies before that time were precisely the wrong ones to prepare for such an event, and the austerity they now oppose is the price we all have to pay.

* Nick Thornsby is a day editor at Lib Dem Voice.

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52 Comments

  • The IMF now say we were running a 5.2% budget deficit in 2007 once external factors are removed. If we’d instead been running a ~4% surplus we’d have had no deficit at all. Looking at how the surplus was growing in 1999 this would have been easily attainable if Labour had focused on reforms rather than profligate spending.

  • Why do the Tories get a free pass for running a deficit for 16 of the 18 years they were in power?

  • Nick,

    I think your analysis is spot on. It was increasingly evident by 2005 that the UK economy had become over-reliant on an unstable credit fuelled consumer and housing boom.

    It is also quite clear from subsequent comments by Mervyn King that the reason the BofE did not tighten is that asset price inflation was not at the core of their inflation mandate and the Central bank were constrained from deploying monetary policy to deflate the economy as a consequence. Siimilarly, the government did not tighten fiscal policy for purely political reasons and indeed changed the time period measurement of the business cycle to meet the fiscal rules they had established.

    It is by no means clear, however, that the present coalition government would have acted differently at the time in allowing political imperatives to trump unpallatable economic reasoning. I would like to think that lessons have been learnt, but if history is any guide, the next generation are doomed to repeat the same mistakes unless the current administration can somehow cement evidence based economic principles into the future management of the public finances and macro-prudential regulation.

  • @Joe Otten
    “There was no need to be prudent, remember. Labour had abolished boom and bust. Or “Tory boom and bust” as it was known. And they didn’t need to worry because they had a golden rule that would ensure the books would be balanced over the economic cycle. Does anyone know the final outturn on that?”

    It’s a good job nobody in this country has access to the internet so they can find out that the Lib Dems believed Brown and adopted the same policy.

  • We are poking the stick at the Blair Government for a few % points. I would hold fire for a few years before throwing those stones. We’re not looking too rosy now.

  • He deals with that point by talking about “cyclically adjusted budget deficit” – i.e. adjusted for the changes of boom and bust. But given that’s what he is talking about the figure of 1% seems simply unbelievable. I’d be interested to see the data he uses to justify that claim.

  • @Joe Otten
    Page 10 of the 2005 Lib Dem manifesto states quite clearly that the guiding principle is for a Lib Dem administration to keep the national debt below 40% of GDP (part of the golden rule to which you refer) which is identical to Brown’s policy.

    http://newsimg.bbc.co.uk/1/shared/bsp/hi/pdfs/LD_uk_manifesto.pdf

    “Vince Cable’s warnings”

    They were nothing more than warnings – they had no effect on Lib Dem policy on the matter.

  • David Allen 11th Apr '13 - 5:16pm

    “The point is that the economic conditions in the years before the financial crisis were unsustainable – we were in a boom. ”

    Yeah, yeah, yeah. We all know that now. Nobody, barring Nouriel Roubini and one or two other non-household names, really had a clue about that then. Not even Vince, who thought that private debt was a bit of an issue, but wasn’t much concerned about public debt.

    So what you’re doing is blaming Labour for being myopic, at a time when the Tories were equally myopic, the Lib Dems were almost equally myopic, and the stock markets were being even more myopic. It is cynical, it is dishonest, and if there was any justice in this world, it would rebound on those making these essentially bogus accusations. I hate to say it, but Blair has hit the nail on the head this time.

  • Stuart Mitchell 11th Apr '13 - 5:51pm

    “Money, and therefore a sense of improving living standards, were being created by lending irresponsible amounts to people who, with a proper analysis of the risk, would not have been lent to by any sensible financial institution.”

    And yet, the level of house repossessions never really got that high. It didn’t get anywhere near the level we saw in the early ’90s when house prices were a fraction what they are now.

    Fact: if the Lib Dems had been elected in 2001 or 2005, they would have spent MORE than Labour. Yet still Lib Dems try to claim that “Any sensible analysis of the economic climate… would have… made it a policy commitment to run a budget surplus”. At least Blair and Brown have admitted they made mistakes – has any senior Lib Dem admitted that they made even bigger mistakes?

  • I’d like to see the evidence of a leading Lib Dem stating that the national debt prior to the crash needed reducing in GDP terms by running a surplus. The thing is you can’t produce that evidence as it doesn’t exist, so what purpose does it serve to sneer at Brown?

  • I think it is fair to say that none of the mainstream political parties were calling time on government spending or fiscal policy in 2005. But this is true of all asset bubbles. The fact that we know all bubbles burst is forgotten after a few years of steady economic growth – this time it is different and irrational exuberance comes up with plausible explanations for why there will be a soft landing or that ‘boom and bust’ has been abolished.

    The level of forclosures in the UK has been lower than the early 90’s but then house prices have received very generous support from quantative easing and near zero interest rates, together with widespread forbearance by banks that cannot afford to accelerate repossesions without serious damage to their own weakended balance sheets.

    We can’t stop the economy from going through periodic corrections, but surely we have enough experience of housing booms and busts, stock market and credit bubbles to know that trouble lurks therein and not to try to reflate them – or do we?

  • Nick T Nick Thornsby 11th Apr '13 - 6:42pm

    Re Vince, here is what he said in 2003:

    “The Chancellor’s great claim—which has been vindicated so far, and for which he deserves credit—is that the old economy of boom and bust has gone. However, it has reappeared in a new form. There is a massive boom in credit and debt expansion, and in the housing market.
    “A very dangerously unstable position has developed, based on excessive and irresponsible lending by the banking system.
    “Something is seriously wrong when a reputable bank, like the Royal Bank of Scotland, can send out a gold card with a £10,000 credit limit to a dog called Monty.”

    I would read that as warning of a boom financed by the unsustainable provision of credit. More here:
    http://fullfact.org/factchecks/assessing_the_vince_cable_backlash-1459

  • Paul In Twickenham 11th Apr '13 - 6:42pm

    I think that the earliest warnings about the extent of the impending credit crunch (primarily I’m talking about the US sub-prime disaster) date to somewhere around the end of 2006. So to ask “why didn’t you see it coming in your 2005 manifesto?” is disingenuous. Once the first signs of trouble appeared, Vince Cable was asking the right questions.

    There’s a very entertaining video of Peter Schiff clips from CNBC where Schiff – cheerleader for prophets-of-doom everywhere – describes what he sees (correctly) as the impending recession to incredulous correspondents in 2006-2008. http://www.youtube.com/watch?v=2I0QN-FYkpw

    You might particularly note the initial section where Art Laffer (of Laffer curve fame) which is a perfect example of hubris: in 2006 we hear Laffer saying “The US economy has never been in better shape and monetary policy is spectacular”, a remark that would have found favour in Whitehall at that time and which today sounds ominously like Irving Fisher’s notorious “Permanently High Plateau” for stocks in the summer of ’29.

  • David Allen 11th Apr '13 - 6:57pm

    Yes, Vince got halfway there, and he deserves credit for that. But to re-ask Steve’s question, did he or did the Lib Dem manifesto, prior to the bust, actually argue that we should be running a bigger budget surplus?

    If we can’t produce evidence of actual foresight, we shouldn’t sneer in hindsight.

  • Stuart Mitchell 11th Apr '13 - 7:09pm

    Yet Vince still stood on a manifesto of greater spending in 2005.

    Even in 2010, the Lib Dems only promised to tackle the deficit “at least as fast” as Labour.

    Let’s remember also that the Tories only stopped matching Labours spending plans in late 2008, and even then by a tiny amount.

    During the period 2000-2008 we had the most remarkable period of consensus on levels of public spending in our lifetimes – with only the Lib Dems breaking ranks slightly, wanting to spend a bit more.

  • Anthony Hawkes 11th Apr '13 - 7:09pm

    “Any sensible analysis of the economic climate – and particularly one influenced by Keynes – would have recognised this and made it a policy commitment to run a budget surplus: first to reduce debt and create a cushion when output and revenues inevitably fell, and secondly to suppress demand in an attempt to deflate the bubble.”

    If your analysis is correct, which I believe it to be, then is does ask the question that why, if we should run a surplus in times of boom, are we not now doing the converse, of running a deficit to encourage growth in times of bust?

    Plan A always went against Keynsian theory and despite some poor attempts at stimulus, we are feeling the effects of poor economic judgement.

  • Nick T Nick Thornsby 11th Apr '13 - 7:26pm

    @ Anthony Hawkes

    But we are doing exactly that. We’re running the highest ever peacetime deficit. Yes we’re reducing it, slowly, but the state will be stimulating demand until 2018 on current forecasts.

  • Nick T Nick Thornsby 11th Apr '13 - 7:30pm

    To those suggesting that perfect foresight doesn’t mean we can’t attribute responsibility, I say: nonsense.

    A historical analysis will lay blame in lots of places, and what I am suggesting is that the Labour government has to bear a large proportion of that responsibility. Speculating on what might or might not have happened if other parties were in charge rather misses the point: Labour were in charge. Gordon Brown was in the treasury. They were making the decisions.

  • David Allen 11th Apr '13 - 7:40pm

    @ Stuart Mitchell,

    I’m not clear what your evidence is that the LibDems were actually the least “prudent” party in 2005-2008. (I’m not saying it isn’t there, I just don’t personally see it proven.) I do think that there wasn’t a lot of difference between all three parties, so Labour aren’t especially to blame.

    I do think, in hindsight, that an earlier generation of Lib Dems deserve more credit than they usually get for their fiscal policies in and around the late nineties, the era of the famous “penny in the pound” on income tax to pay for better health and education. It was a neat phrase, which in a gentle sort of way took on board the need to increase taxes and thus to get up there repairing that roof while the sun was shining. It is not often that a political party has the courage to call for a tax increase. We did. While Labour dithered, stealth taxed, and belatedly ramped up spending – going from too slow to too fast – the Lib Dems under Ashdown and Kennedy showed them what was needed.

    One of the strongest arguments which anti-Keynesians make is that everybody wants to go Keynesian when it means running a deficit in hard times, nobody wants to go Keynesian when it means running a surplus in good times. Well, back in the nineties we weren’t doing too badly against that yardstick. Of course, Clegg’s complete reversal of “penny in the pound” politics is a U turn on our principles and a brilliant way to lose voters, but that’s another story!

  • Stuart Mitchell 11th Apr '13 - 8:17pm

    “Labour were in charge. Gordon Brown was in the treasury. They were making the decisions.”

    That’s true of course, but it’s perfectly legitimate to point out that the decisions Labour were making were at least less bad than the decisions their critics were urging them to make at the time.

    It’s very difficult to respect people (and I’m not saying this is true of you personally) who spent the ’00s campaigning for higher spending but now, aglow with hindsight, criticise Brown for spending too much – without the slightest acknowledgement that they’d have done the same.

    I can actually remember, probably about ten years ago, reading a Daily Mail editorial in which they grudgingly admitted that it was impossible to knock Brown’s record as Chancellor. Looking back, it was a strange time.

  • I agree with Joe Burke. booms creates a false sense of security. It happened on Labour’s watch and of course Brown and Blaire. should take the blame for failing to see the dangers, I remember cringing when I saw the no more Mr Boom, No more Mr Bust posters. However, this time the bust was so large any surplus would have been eaten into very quickly and I’m far from certain that any lessons have been learned. The problem with quantitative easing is that it only really makes the vulnerable parts of the economy look stable by devaluing the whole of the economy, plus the support scheme for home buyers set up by Osbourne shows a marked lack wisdom.. Even the Spectator views it as a Ponzi scheme. Maybe the point is that we are not letting things readjust but are simply pumping air into the remnants of a bubble in the hope that it will suddenly re inflate,

  • Osborne has ended boom and bust – now we just have bust.

  • “Steve 11th Apr ’13 – 5:05pm
    @Joe Otten
    Page 10 of the 2005 Lib Dem manifesto states quite clearly that the guiding principle is for a Lib Dem administration to keep the national debt below 40% of GDP (part of the golden rule to which you refer) which is identical to Brown’s policy.”

    The failings of the Lib Dem 2005 manifesto do nothing to justify Labour’s position; that argument is like when a Chinese lady tried to justify invading Tibet by bringing up the Iraq war. The fact is were are accountable for our decisions; as such, Labour were in charge, they had access to all the information, they should have known better than anyone what was coming, but they choose to ignore that, thus they take the blame.

    However, I do agree, that we too should be honest about any failings, as well as successes in our past policies.

  • @Liberal Al
    “The failings of the Lib Dem 2005 manifesto do nothing to justify Labour’s position”

    I wasn’t justifying Labour’s position. I simply highlighted that the Lib Dems don’t have a leg to stand on in attacking Labour on this issue in such a tribalistic manner (as in the comments above). It is of course right to discuss why the Labour government failed in this regard, but an honest discussion would also need to address why the opposition parties did not oppose Labour’s fiscal policy.

  • Richard Harris 12th Apr '13 - 8:20am

    I thought the Lib Dems were going to put a stop to this name calling ya-boo kind of politics and get on with the job of running the country in a mature way. Why run an article about “how much to blame Labour was” at all? You are in power. Sort it out and I’m sure you will be showered with appreciative votes at the next GE. How do you expect our politics to improve if you just carry on like the other parties?

  • Anthony Hawkes 12th Apr '13 - 8:29am

    “But we are doing exactly that. We’re running the highest ever peacetime deficit. Yes we’re reducing it, slowly, but the state will be stimulating demand until 2018 on current forecasts.”

    A budget deficit should be expected, but just because automatic stabilisers increase spending and reduced economic activity reduces tax revenue does not mean that we are stimulating demand. This is an austerity policy, not stimulus. Keynes proposed that stimulating demand in ‘bust’ times while running a surplus in ‘boom’ times was the way to act. I agree.

  • @Steve: Fair enough, I misunderstood.

    @Richard: IfTony Blair publically states something, then we have right to refute and debate such claims. If Mr Blair does not wish for anyone to ever disagree with him, then stating his opinions publically is probably not the best way to achieve that goal. In fact, if you had read the comments, you would see that most people here, Lib Dems mostly, have been equally critical of their own parties past policies, so yes, this is a mature debate.

  • An excellent article which I think hits the nail on the head.

    Sadly in the real world, governments are praised or hated by electors for what they actually do to them in the short term. People hate this coalition government because they’re hurting now and public spending is having to be reined in. They loved Labour because everything was rosy and they were being showered with gifts from the state. No matter that Labour were spending and spending on the basis of an unsustainable credit-fuelled boom which was going to burst at any time. But sadly I think only few people actually see this – they don’t see the obvious cause / effect of irresponsible government spending leading to pain later. The last Labour government knew this (actually I think all governments know this) – they knew that they would be kept in power by being seen to spend money on people and that cutting back on spending was undesired because it would cost them votes – Labour, because they would be cutting spending on people who were their natural voters, Tories, because they would be painted as “those heatless Tories”. Labour chose to act irresponsibly because it was politically expedient at the time. Or perhaps they were in denial – thnking that credit could forever expand and the piper would never have to be paid.

    The classic left wing line now is that our current crisis is all the fault of those pesky bankers. While the bankers are certainly to blame in part they are far too convenient a scapegoat for all our current woes. To blame them entirely misses the main point. The banking crisis was just a symptom of the underlying problem – individuals, companies and whole countries spending more than they could afford.

  • Even though I know little about economics; I could see that Brown thought he knew it all- but kept making bad decisions.
    I can’t remember when Vince started to say that there was too much debt, but it has been obvious to me for many years.
    If someone had taken notice and steered the ship just a fraction of one degree in a safer direction,-well before-hand- The Titanic would have missed the iceberg!
    It would appear that the present government were surprised to find such a mess when they came to power, so any previous manifesto cannot indicate what a party would if in government.

  • Bill le Breton 12th Apr '13 - 10:44am

    As usual these discussions seem to ignore monetary policy.

    In 1997 the Bank of England was given its so-called independence and a mandate or target to achieve CPI of close to 2%, though it came to be accepted that the target or was the Bank’s *forecast* for inflation two years ahead.

    The main tool it used to achieve this was its policy rate. Here are the changes to that rate of interest for the period under discussion. They illustrate that through this period the Bank was confident that it was meeting its mandate. Changes were infrequent and never more than an increase or a cut of one quarter of a per cent: a nudge on the tiller now and then.

    Oct 2008 4.5000
    Apr 2008 5.0000
    Feb 2008 5.2500
    Dec 2007 5.5000
    Jul 2007 5.7500
    May 2007 5.5000
    Jan 2007 5.2500
    Nov 2006 5.0000
    Aug 2006 4.7500
    Aug 2005 4.5000
    Aug 2004 4.7500
    Jun 2004 4.5000
    May 2004 4.2500
    Feb 2004 4.0000

    The proposition by Nick is: “Had we been running a budget surplus equivalent to 2 or 3% of GDP in 2007, rather than a similar-sized deficit, the deficit now would half what it is, and with a lower debt burden.”

    The first thing to understand is that monetary policy always trumps changes in fiscal policy. That is what the ‘mandate’ dictates. Suppose the autumn statement in 2005 had announced lower deficit forecasts for 2006/07 and 2007/08 (with the aim of moving the budget into surplus by 2007/08), the Bank’s next meeting of the MPC would have reviewed a new set of inflation forecasts taking into account t the change to fiscal policy in the 2006 and 2007 budgets. It would therefore have matched the new deflationary fiscal policy by lowering interest rates.

    So what Nick is advocating produces looser monetary policy at a time when history suggests it was already too indulgent. The cravers after surpluses may have obtained a lower public deficit for a year or two perhaps, but by creating an even larger private deficit – storing up even more violent deleveraging, destruction of asset values, unemployment and even larger subsequent public deficits.

    The reverse side of this coin is that the Bank of England did not at the time believe fiscal policy was too stimulative. It had everything under control! (It was this same leadership of the Bank that was to navigate its way through the plunge in NGDP of 2008 and the anaemic 2% growth in NGDP since the Coalition came into being in 2010.

    OK. So the mandate set by the Chancellor was wrong and the leadership at the Bank was negligent.

    A look at this graph of the change in nominal GDP shows clearly when the Bank should have tightened (and actually not by very much) and of course when it should have loosened: http://uneconomical.files.wordpress.com/2013/02/uk-pn2-ngdp-trend-2012q4.png?w=595

    The delay in loosening in 2008 (look above: Bank Rate still 4.% in October 2008) with the economy coming to a screeching halt) is the reason why the 2008 recession became a Great Recession. [Some figures: For a long time before 2008, NGDP had risen consistently by 5% a year. In 2008 NGDP increase only 2%, increase in real GVA -0.8%. In 2009 NGDP decrease -2.7% and a decrease in GVA of 4.1%]

    The incompetence that failed to keep loosening monetary policy in 2010 (and 20011 when the MPC ALMOST increased interest rates) is why the Great Recession has lasted for longer than any recession or depression in over 100 years.

    Why do these guys above fixate on fiscal policy and cuts? Because they want a smaller state. It suits that ideology, even if their policy prescription would have made matters far worse.

  • David Allen 12th Apr '13 - 1:21pm

    Nick Thornsby said:

    “To those suggesting that perfect foresight doesn’t mean we can’t attribute responsibility, I say: nonsense.”

    Ah yes, that mythical opponent of yours, the guy who argues that you can’t possibly attack Labour unless your own policy prescription at the time was 100% perfect. Yes, you have slain that opponent, albeit with the help of a clever sentence containing a triple negative whose real meaning can only be divined by intuition. I wasn’t that guy, though. Nobody on this post was that guy.

    And another thing. When we are talking about good foresight, we are making the point that, insofar as Vince did recognise the debt problem earlier than Gordon did, he (or the Lib Dems in general) might be somewhat entitled to say “Told you so!” Now, who was it who first mentioned Vince in this thread, and allowed that he could take some credit for foresight? Actually, it was me! In the original article by Nick Thornsby, there is no mention whatsoever of Vince, or of Lib Dem policy at the time of the boom. There is nothing in Thornsby’s article which couldn’t have been written by a Tory propagandist.

    And that’s where we stand these days. We have become Little Sir Echo to the Tories. We slag off Labour, just the way they slag off Labour. We can’t even be bothered to point out, when it is the case, that we did better than the Tories did. Indeed, we are probably more assiduous in regularly slagging off Labour than the Tories are. That’s because we need to get away from that old Lib Dem tradition of “equidistance” and make it clear whose side we are now on. Wonderful.

  • Bill,

    you will note from the GDP graph in the article above that Gordon Browen as Chancellor, having transferred interest rate setting powers to an independent Bank of England, did run a budget surplus from 1998-2001. Brown continued Ken Clarke’s spending plans for the first two years of the labour government and elminated the deficit in 1998. This allowed Brown to record four years of budget surplus’ 1998 – £703 million, 1999 – £12 billion, 2000 – £16.7 billion, 2001 – £8.4 billion. The base rate was held fairly stable during this period gradually reducing from circa 6.5% to 5%. Monetary loosening in the form of aggessive rate cutting began in the aftermath of the 2001 attack on the New York World Trade Centre dropping to a low of 3.75% by November 2003. Coupled with the loose fiscal policy adopted from 2001 an asset bubble began to form in housing. Housing prices levelleled off for a time in 2004 but began to rise rapidly again afterabout 6 months, as historically low levels of interest rates were maintained and government deficit spending continued to stimulate an overheating economy.

    The actual trend of NGDP growth at around 5.3% annually, has been remarkably level from 1990 through to 2008 indicating that there has been little if any change in monetary policy before or after independence of the Bank of England (regardless of fiscal stance) and certainly no indication that an independent Bank of England works to offset fiscal policy whether it is tight as in the 1997-2001 period or loose as in the post 2001 period.

    The BofE focus was on forecast CPI. It did not have a mandate to arbitarily counter asset price inflation with policy measures that would dampen economic growth. What was needed in 2005 was macro-prudential regulatory measures, targeted at bank capitalisatiion, liquidity and debt maturity mismatches. It is unlikely that any monetary policy tightening barring a draconian doubling of interest rates would have significantly slowed the property boom at the time. Even if hiking interest rates could pop the housing bubble, crashing the economy is not in the gift of the BofE govenor, so it was for the Chancellor to act..

  • Bill le Breton 12th Apr '13 - 5:48pm

    Joe, I can’t think I disagree with any of that, nor understand why you should think I would.

    I think actually the Bank was quietly targeting 5% NGDP growth during the period you point to – the Great Moderation. If it were so or if it were still actually targeting the forecast for CPI, either way it MUST have then changed its monetary policy to preserve this position in response to any change in fiscal policy.

    The idea that sometime in 2005 or 2006 or around then a chancellor could have reduced the deficit without the Bank then lowering interest rates is impossible. Nick’s prescription would have led to lower rates and more fuel in the rocket. But as usual he doesn’t answer that because he has no idea how monetary policy works.

    Also there seems to be a strong correlation between periods of surplus and subsequent periods of high deficits. Look at the political paradox of Clinton’s surplus being followed by neo-con Bush’s deficits.

    The way to keep an economy on a reasonably stable path of say 2-3% growth is to have 2% inflation, a small working deficit. and a central bank practicing level targeting of the combined 4 to 5% nominal growth. That is what was happening in the Great Moderation.

    Try to have a period of surplus and it leads to periods of deficit. Try to have a rate of inflation lower than 1.5 -2% and you lack the room to respond to ‘shocks’ and are all too soon at the lower bound.

    Thus if hawks who want very low inflation and surpluses get their way they get recessions, stubborn deficits and mounting debt to GDP ratios.

    Look how effective loosening monetary policy was in the reaction in 2001 that you highlight. Look how the global economy shrugged off Black Monday.

  • @Steve
    “Page 10 of the 2005 Lib Dem manifesto states quite clearly that the guiding principle is for a Lib Dem administration to keep the national debt below 40% of GDP (part of the golden rule to which you refer) which is identical to Brown’s policy.”

    Except Brown didn’t keep to his policy, whereas we’re arguing now that the principle holds and is worth sticking to.

    @Bill Le Breton
    which is why BoE ‘independence’ was flawed from the offset – not the idea of independence, but that an appointed cartel of the favoured elite would ever make truly independent decisions on interest rates.

    Whereas a mechanism designed to allow and encourage limited rate competition would.

  • I agree with David Allen, Blair hits the nail on the head: Labour did not create the financial crisis. However, they could of done more to ensure the government finances were in better shape, remember part of the problem was that the Treasury assumed that it would continue getting significant tax revenues from the financial services sector. In my opinion about the best thing New Labour did (with respect to the financial crisis) was to appoint and retain Alistair Darling as chancellor for 2007~2010.

  • Bill,

    the CPI inflation rates in this period indicate that monetary policy was kept looser than meeting the inflation mandate required from 2000 through 2004 even though the fiscal stance was loosened from 2001 forward in the form of budget deficits. This is the period when the housing bubble formed in earnest and gained the momentum that propelled it forward even when the bank was meeting its inflation target from 2005 onwards. NGDP was maintained at a steady level throughout.

    Year Rate
    2007 2.30%
    2006 2.30%
    2005 2.10%
    2004 1.30%
    2003 1.40%
    2002 1.30%
    2001 1.20%
    2000 0.80%

    I can see no reason why the fiscal deficit could not have been reduced from 2005 forwards whether by spending restraint or tax increases without impacting the Banks forecast CPI inflation targets. Fiscal tightening cools excess demand when it is outstripping supply constraints, but (excepting indirect taxes) will not impact consumer price inflation. Even if indirect taxes were deployed, It is highly unlikely that the BofE would deliberatly add more fuel to the housing boom then underway by lowering rates instead of ‘looking through’ such fiscal adjustments to longer term inflation expectations, as they have consistently done in recent years.

  • @Oranjepan
    “Except Brown didn’t keep to his policy, whereas we’re arguing now that the principle holds and is worth sticking to.”

    As a general rule, when engaging in logical and rational debate, do not change the subject to suit your prejudice. This article is about the run-up to the crash and recession (you don’t even need to read the article – the ‘pre-crisis’ bit in the headline would have given you a clue if you had bothered to read that far). In that specific context, Brown absolutely did keep to his policy and the Lib Dems supported his policy.

  • This BBC article from 2003 gives a flavour of what was happening at the time Analysis: The budget shortfall

    Some economists accused Mr Brown of “moving the goalposts,” and changing the year the economic cycle began to 1997/98, instead of 1999. Geoffrey Dicks, an economist with RBS Financial Markets, said that without that change, Mr Brown would meet his budget rule with only £4bn to spare.

    And there is also controversy over when the economic cycle will end. The government predicts that it will be in 2005/6, which would give Mr Brown time to get declining surpluses to get back into balance.

    But if that turns out to be incorrect, or tax revenues continue to fall, then the golden rule could be breached.

    There are also questions over his decision to exclude all spending for investment from the calculations over the budget deficit. Some economists worry that Mr Brown has fudged his definition to further flatter the figures.

    “The Chancellor is in denial,” said Peter Spencer, chief economist for the ITEM Club/Ernst and Young forecasting model.

    Even using Brown’s own preferred measure, the current budget deficit, which excludes spending on investment and using the earlier date of 1997/98, he was never able to get the budget back to balance over the business cycle before the downturn came in 2008.

  • Alex Sabine 15th Apr '13 - 4:05am

    Realise I’m late to this thread, but Nick’s post nails it. By way of amplification:

    1. The first problem with Blair’s partial defence is that it ignores the clear link between (1) the credit boom and associated asset price bubble and (2) the level of tax receipts. The tax revenue was unsustainable because the candyfloss economy that generated it was unsustainable.

    Gordon Brown’s Treasury was relying to an unprecedented degree on buoyant revenue from the overheating financial and housing sectors, which were skewing the composition of the tax base and filling the coffers.

    Just as the bursting of the bubble revealed that the underlying state of the economy was nothing like as rosy as the official GDP numbers suggested, so it shone a merciless light on the true state of the public finances.

    2. For a moment let’s leave to one side the extent to which this was evident and diagnosed at the time (I will come back to that). The point is that, in his New Statesman article, Blair is trying to ‘set the record straight’ based on what we know now, not on foresight.

    With the benefit of hindsight, he seems to accept that the credit boom was unsustainable (though, failure being an orphan, naturally he emphasises the global culprits and the US sub-prime mortgage debacle). Yet in order to acquit Labour of the charge of profligacy, he cites the out-turn for his chosen fiscal indicator – the cyclically adjusted current budget deficit – as though the supposedly modest deficit had nothing to do with the credit boom. Logic, and empirical evidence, is not on his side.

    3. The reason I say Blair is attempting only a partial defence is that – unlike Ed Balls and Ed Miliband – he concedes that, ‘Of course there is a case for saying a tightening around 2005 would have been more prudent.’

    Indeed there is. It was made rather more forcefully by Blair himself in his memoirs.

    In one passage he makes due reference to the global nature of the financial crisis, then adds:‘However we should also accept that from 2005-06 onwards Labour was insufficiently vigorous in limiting or eliminating the potential structural deficit. The failure to embrace the Fundamental Savings Review of 2005-06 was, in retrospect, a much bigger error than I ever thought at the time.’ In several other passages he rues the missed opportunities (for which he blames Brown’s resistance) to consolidate the fiscal position well before the crisis hit.

    The version in his memoirs is the more candid and plausible assessment, though it greatly understates the case and doesn’t acknowledge that the problem set in several years earlier.

    4. Thanks to the leaked memos which the media dubbed ‘the Ed Balls files’, we now know that by the start of Labour’s third term Treasury officials had belatedly woken up to the problem. They warned Brown to freeze spending as well as setting out detailed plans of potential savings. Brown ignored the advice and pressed ahead with plans for significant real-terms increases in the next spending round.
    (Link:  http://www.telegraph.co.uk/news/politics/labour/8569367/Labour-spending-Gordon-Brown-and-Ed-Balls-ignored-warnings-and-wasted-billions.html)

  • Alex Sabine 15th Apr '13 - 4:08am

    5. In his New Statesman article, inevitably Blair picks the most favourable metric he can find. He’s right that the cyclically adjusted current budget deficit was fairly modest, although on the OBR figures it was 1.6% of GDP rather than ‘under 1%’ as Blair claims.

    This paints a very flattering picture, however. For a clearer snapshot we need to look at a range of other measures. For example (courtesy of Treasury and OBR figures):

    The overall deficit (Public Sector Net Borrowing) in 2007-08 was 2.6% of GDP. In every fiscal year from 2002 onwards it was at least 2.4% of GDP, and in 2004-05 – near the top of the cycle, and with a general election on the immediate horizon of course – it was 3.4%.

    So, in each of six consecutive years when the economy was growing robustly, Brown was borrowing many billions of pounds.

    Even if they thought the economic growth was built on solid foundations rather than feet of clay, Keynesians and fiscal conservatives alike should have been aghast – not lauding the ‘iron Chancellor’ and getting taken in by his smoke-and-mirrors rhetoric of Prudence.

    If you paid attention to what he was doing rather than what he was saying – and this Chancellor needed watching like a hawk – it was apparent that, after an initial courtship, Brown had cast dear Prudence aside as long ago as 2000 when he turned on the spending taps at full blast.

    But too much of the political class and commentariat took him at his own valuation. One can only speculate as to why that was. I suspect one reason was that a lot of people bought into the idea – carefully cultivated by Brown’s henchmen – that here was a morally serious statesman with a peerless command of the figures, in contrast to the slippery lightweight Blair. In reality Brown was the biggest spin merchant of the lot, a master of distraction and subterfuge.

    6. The laxness of Labour’s fiscal policy during most of its second and third terms is confirmed when we look at the figures adjusted for the economic cycle. Even based on the optimistic assumptions about trend GDP that the Treasury held at that time, there was a persistent structural deficit in the overall government budget.

    From approximate balance in 2001-02, the budget swung into a cyclically adjusted deficit of 2.3% of GDP in 2002-03, reaching 3.3% by the pre-election phase of 2004-05. It was some 2.4% of GDP on the eve of the crisis in 2007-08.

    Of course, the trouble with cyclically adjusted measures is that they require judgements on the level of potential (or trend) GDP in order to extrapolate the ‘output gap’ and thus the underlying (cyclically corrected) state of the public finances. Estimates of the economy’s productive potential vary significantly, and it is difficult to pin down what it was even many years later.

    Back in the days when a politicised Treasury was responsible for marking its own homework, Brown of course used this to his advantage by reclassifying the start and end dates of the cycle so as to meet his ‘golden rule’ by a whisker.

    If we take more recent figures based on the OBR’s current understanding of the cyclical position of the economy, then the structural deficit arose in 2001-02 and peaked at 4% of GDP in 2004-05. Cyclically adjusted PSNB stood at 3.7% of GDP just before the crisis in 2007-08.

    As Thomas Long notes, the IMF reckons the structural deficit was higher still. On any reasonable assumptions it was sizeable, at between 2.4% and more than 5% of GDP. Given that the British economy had been growing steadily since 1993, this was a parlous position to be in and left us ill-prepared for any coming turbulence, let alone an epic financial crisis.

    7.  Since there is no escaping this unpalatable fact about the structural deficit, Blair glides over it by pointing out that the deficit on the government’s current (ie day-to-day operating) budget was only minor in 2007-08.

    Some context might be helpful here, though. Throughout the postwar Keynesian high noon, no British government ran a deficit on its current account in any year until 1973-74. It was expected that the government should finance its day-to-day activities from revenue, and borrow for some (though not all) investment projects, particularly during cyclical downturns.

    The reason that overall borrowing was nevertheless substantial in some periods was that the capital budget was much larger because the government owned so many nationalised industries. The current budget was expected to be in surplus even when the economy was in a downturn. Indeed, when Roy Jenkins left a strong fiscal position in 1970, the current budget showed a surplus of 7% of GDP!

    Obviously the modern context is different, but the point is that we should not allow Brown’s discredited version of ‘prudence’ to hold sway. It is perfectly sensible for government to borrow for investment purposes in some situations, but that doesn’t mean every item of spending that is classified as capital rather than current should routinely be financed by borrowing. Or, to put the same point another way, in normal times the government should budget for a surplus on its day-to-day activities to ensure that the overall deficit and debt levels remain sustainable in the face of a recession, and that it has maximum room for manoeuvre should it need it.

    Just as he abused the concept of cyclical adjustment by changing the timing of the cycle, Brown saw the opportunity the current/capital split (which in principle is fine) gave him to reclassify what was really current spending as investment so as to meet the golden rule. And in his speeches and Labour’s narrative, hiring teachers or paying GPs’ salaries or increasing tax credits was always virtuous-sounding investment, never simply spending; the term investment was abused until it had little economic meaning.

    8. The Maastricht Treaty measure of the deficit – the general government budget balance – is less favourable to Brown than our domestic measure. It shows a deficit of 2.6% of GDP in 2002-03 rising to a Treaty-breaching 3.3% the following year and 3.6% in 2004-05. In 2007-08 the deficit was still 2.9% of GDP, and a cyclically adjusted 4.3%.

  • Alex Sabine 15th Apr '13 - 4:12am

    9. Apologists for Brown’s conduct of fiscal policy claim the national debt was reduced between 1997 and 2008. This claim needs both qualification and context.

    – First, it is true that Brown’s genuinely prudent phase – the first three years of his Chancellorship, for two of which he was following Ken Clarke’s spending plans – plus the skilfully handled auction of the 3G mobile phone licence enabled him to repay some national debt in the early years. Public sector net debt stood at £347 billion in 1996-97 and was down to £311 billion by 2000-01 (those were the days!).

    However, the switch into high-spending mode swiftly undid the good work. By 2004-05 debt had risen to £422 billion and by 2007-08 it was up to £527 billion. So, over the course of seven years of uninterrupted output growth, he racked up an additional £216 billion of debt; that is to say he was running deficits of £30 billion per year on average. For the majority of that period a Keynesian Chancellor would have been running surpluses, thus continuing to reduce the national debt in absolute terms.

    Taking 1997 as the starting point rather than the point at which the spending floodgates opened (2000), public debt rose by £180 billion over Labour’s first decade in power.

    – Now, it’s fair to say that few Chancellors actually reduce the national debt in absolute terms during their period of office as a whole, so Brown certainly isn’t unique in that regard. However the global backdrop was exceptionally benign for most of his tenure, and – as he never missed an opportunity to boast – he did preside over a period of uninterrupted GDP growth.

    With a following wind like that, to increase the stock of accumulated debt by  52% in cash terms and 20% in real terms can hardly be called prudent.

    Arguably it is more meaningful to look at national debt in relation to the country’s ability to service it, the simplest proxy for which is the debt:GDP ratio. Since real GDP was rising briskly, on this basis Brown did reduce net debt somewhat, from 42.1% of GDP in 1996-97 to 36.4% in 2007-08, a reduction of 5.7 percentage points.

    We can distinguish two clear phases, however. in Labour’s first term, prudent fiscal policy (for the first three years) and the 3G auction yielded a sharp drop in the debt:GDP ratio, from 42.1% in 1996-97 to 29.8% by 2001-02. (This was just shy of the postwar low point for net debt, 25.4% in 1990-91.) Thereafter the heavy annual borrowing outstripped GDP growth and took the debt ratio back upwards in each and every year, by a total of 6.6 percentage points.

    Incidentally, in the UK our main public debt measure is net debt, whereas the OECD, the EU and many countries use gross debt (or ‘general government gross financial liabilities’). On this measure debt was 52% in 1997, fell to 40.4% by 2001 and then rose to 47.2% by 2007. (It’s now heading for 100% of GDP in the next few years…)

    While there was a modest fall in the debt ratio between 1997 and 2007 (followed, as we know, by a spectacular rise), the UK’s performance was not impressive by international standards.

    We reduced our gross debt by 5 percentage points; by comparison, debt fell by 23 percentage points in Australia over the same period, 30 percentage points in Canada and  16pp in New Zealand. The US had a similar 5pp drop. In Europe, France’s already-high public debt increased, and Germany’s did too initially but there was a sharp improvement at the end of the period. Greece and Portugal were predictable offenders. But there were really dramatic falls in the debt ratio in Sweden (34pp), the Netherlands (31pp), Belgium (40pp, albeit from a high base), Denmark (41pp), Finland (23pp), and – aided by unsustainable property booms even bigger than ours – Spain (33pp) and Ireland (33pp). Few countries in the OECD were increasing their debt ratios between 2002 and 2007 (whereas the UK was) and many used the ‘good times’ to consolidate sharply.

    10. Likewise on the deficit, most other developed countries improved their fiscal balances over the 2000s whereas ours worsened. Australia, New Zealand, Canada and the Scandinavian countries were running year-on-year surpluses. When the crisis hit in 2007, Australia had a surplus of 1.4% of GDP, Canada the same, New Zealand had a surplus of 4.5% of GDP, Luxembourg 3.7%, Sweden 3.6%, Germany 0.3%, Spain 1.9%, Denmark 4.8%, Estonia 2.5%, Finland 5.2%, the Netherlands 0.2%. These are surpluses, remember. In that context the UK deficit of 2.8% (fractionally worse than France and worse than Italy) doesn’t exactly mark us out as having been a model of fiscal prudence…

    As Nick says, had we run a surplus of, say, 3% of GDP in 2007 (modest by the standards of our northern European counterparts and New Zealand) it would have dramatically reduced the scale of the fiscal repair work that now needs to be done.

    With the exception of Ireland and Spain, which had much bigger property crashes than us and are imposing much fiercer austerity while being locked into an overvalued currency (for them), most of the countries that went into the crisis with their finances in good shape came out the other side with manageable deficits and in some cases (Sweden, Germany, Australia) are already back to near-balance. Moreover, those that wanted to were able to launch large stimulus packages to help nurse their economies through recession without running into market pressures or putting their debt onto an unsustainable path. Thanks to Brown’s imprudence from 2000-01 onwards, we were much more boxed-in and now have a much higher mountain to climb.

  • I’d just like to say thank you to Alex for all his comments over the past few days. I am not an economist and the clear way in which he has explained the economic structure of the Thatcher and Brown years has been very informative. My feelings about Thatcher are too deeply bitten into my psyche to change significantly and I tend to think that the style she employed was a reasonably accurate reflection of the intention behind the substance, but Alex’s analysis has certainly given me cause to reflect on the consequences of what she was trying to do.

  • A very thorough analysis, Alex and the points you make abour capital spending are crucial to undestanding how Brown.s budgets came to be spun as prudence:

    “.. the point is that we should not allow Brown’s discredited version of ‘prudence’ to hold sway. It is perfectly sensible for government to borrow for investment purposes in some situations, but that doesn’t mean every item of spending that is classified as capital rather than current should routinely be financed by borrowing. Or, to put the same point another way, in normal times the government should budget for a surplus on its day-to-day activities to ensure that the overall deficit and debt levels remain sustainable in the face of a recession, and that it has maximum room for manoeuvre should it need it.

    Just as he abused the concept of cyclical adjustment by changing the timing of the cycle, Brown saw the opportunity the current/capital split (which in principle is fine) gave him to reclassify what was really current spending as investment so as to meet the golden rule. And in his speeches and Labour’s narrative, hiring teachers or paying GPs’ salaries or increasing tax credits was always virtuous-sounding investment, never simply spending; the term investment was abused until it had little economic meaning.”

  • Alex Sabine 15th Apr '13 - 5:47pm

    Tony and Joe, thanks for the kind words.

    A few commenters seem to think that disinterring all these facts and statistics is about political mud-slinging at Labour, but that is not the purpose at all. Economic history is an essential guide to understanding the present, and thinking about better ways of doing things in the future – indeed in many ways it is more useful than economic theory, whose propositions are often untestable in the real world.

    So, as Tony Blair would say, ‘let me be clear’ what I’m saying about Labour’s role in this:

    On any objective assessment Brown’s stewardship of the public finances from 2001 onwards was imprudent. When you look at the full range of aggregates – Public Sector Net Borrowing, the national debt, the cyclically adjusted deficit, the current balance, the Maastricht Treaty measures, the primary balance, international comparisons – that conclusion is inescapable.

    When you consider the benign economic backdrop both globally and domestically, this imprudence starts to look indefensible. It is not even as if Brown was borrowing to cover the transitional costs of economic restructuring and renewal, as could be argued for the immediate postwar years and the 1980s. Instead, the economic model he nurtured and boasted of itself massively amplified the fiscal problems when the bubble burst.

    Imprudent and indefensible though it was, Brown’s fiscal stewardship was not the main cause of the financial crisis. Its pro-cyclical nature may have played a minor role in fuelling the consumer bubble, but the failures of monetary policy, banking supervision and the mis-pricing of risk were much more important.

    Many of these, too, bear the fingerprints of Brown and Balls: to take just two examples, the lousy institutional structure they devised for macro-prudential regulation, and the decision to switch the inflation measure to one which excluded housing just as the property boom was getting underway (RPI to CPI). By reducing the attractiveness of saving, the raid on occupational pensions in Brown’s first budget also reinforced the already strong appeal to Britons of property as an investment class sans pareil, which was reflected in the buy-to-let boom that followed.

    There is plenty of blame to be shared around, however, and many of the same mistakes were made in other major countries, notably the US (though they were not universal: Australia and Canada had a much better record on banking supervision and solvency). There were the growing global imbalances between debtor and creditor nations which resulted in a glut of cheap money looking for high returns. And there were also intellectual (rather than just institutional or policy) failings that underestimated the dangers of the structure of incentives in the financial sector, moral hazard etc; plus the usual ‘this time is different’ hubris that is probably ingrained in human nature and has always accompanied financial bubbles.

    The real objection to Brown’s fiscal handiwork is not that it caused the crisis, but that it left us ill-prepared for any setback at all, let alone the global ‘financial tsunami’ that Blair prays in aid in the New Statesman. He really did fail to ‘fix the roof while the sun was shining’ in David Cameron’s phrase, though whether Tory or Lib Dem fiscal policy would have been more than a marginal improvement is open to question.

  • Alex Sabine 15th Apr '13 - 5:49pm

    My personal perspective is fiscally conservative, in the sense that I think the government should aim to balance its budget with a modest surplus over the business cycle but allow ‘automatic stabilisers’ to work to offset cyclical downturns and recessions. I’m not a great believer in the ‘fine-tuning’ of demand through fiscal policy, which Keynesians often advocate, since I think monetary policy is a more effective tool for macroeconomic stabilisation (on this I can agree with Bill le Breton). The problems of fiscal fine-tuning – particularly the long time lags and the political difficulty of reversing tax and spending measures when required – were apparent in the stop-go cycles that stunted our progress in the 1950s and 1960s, when the economy’s growth performance lagged well behind countries like Germany that didn’t rely on such techniques.

    – However, I think it is important to keep Keynesian remedies ‘in reserve’ for sharp prolonged slumps and situations where the transmission mechanisms of monetary policy (ie banks) are not functioning properly or monetary policy might be ineffective (‘pushing on a piece of string’ in Keynes’s words).

    This, you might say, is precisely our current situation, so why do I support (with reservations) the coalition’s austerity strategy? Well one reason is well explained by Nick, which is that budgeting for the highest ever peacetime deficits for year after year is hardly fiscal masochism. Yes, an attempt is being made to squeeze the budget, but it’s important to keep it in perspective: the timescale for bringing the budget back to structural balance was always gradual and has been relaxed further in response to circumstances.

    But the more fundamental reason is that a willingness to use fiscal stimuli during slumps, and the judgement call on how large a deficit is justifiable and appropriate, must take account of the starting point. If when recession hits you have a large surplus and low and falling public debt (like, say, New Zealand), you have a great deal more scope to stimulate without either investors taking fright or your actions putting debt onto a path that will retard future growth. Thanks to Brown’s improvidence we were not in that position; we were able to muster a small discretionary stimulus in 2008-09 but did not have the option of either bolder fiscal action, or continuing to stimulate indefinitely.

    – Whether you take a fiscally conservative or a Keynesian perspective, Brown’s post-2000 policy was imprudent and improvident.

    But orthodox Keynesians should be especially keen on running surpluses in years of plenty, since they see a key role for fiscal policy as a macroeconomic stabilisation tool (ie to cool an overheating economy). They also also need to create the fiscal ‘head room’ for the stimulus measures they favour in a downturn.

    This implies that in the good times the debt:GDP ratio should be kept low enough that it will still be at a reasonable level even after several years of large deficits. Roger Bootle, an economist who takes a broadly Keynesian view of fiscal policy, has suggested that in the UK case this should be about 20% of GDP – half the UK level when the crisis hit (on the net debt measure it was 36% and on the gross measure it was 47%). It certainly precludes the significant accumulation of £216 billion of public debt that occurred between 2001 and 2007.

    As Bootle argues in his recent book ‘The Trouble with Matkets’, the UK’s long tradition of fiscal laxity during the good times ‘amounts to a gross dereliction of duty. It is the equivalent of a government leaving a country undefended against its enemies; in this case undefended against itself. It is all very well racking up huge debts as the result of a war for survival, as Britain did three times in the last 200 years… But the amassing of huge debt as a result of peacetime fiscal incontinence, especially to finance burgeoning welfare spending, is unforgivable.’

    Some people on the left still seem to entertain the notion that Brown was a Keynesian. The reality is, he only discovered his inner Keynesian when the sh*t hit the fan, his improvidence was laid bare, and he needed political cover.

    More faithful disciples were the Australians, who used their resource boom to run surpluses for year after year and actually eliminated their net public debt altogether in 2006, giving themselves maximum room for manoeuvre to respond to the global crisis. They deployed a large stimulus programme and got out of the woods with barely a scratch and a budget that is now almost back to balance. (Like the Canadians, they also did a notably good job of supervising their banking system, but that’s another matter.)

  • Alex,

    “I’m not a great believer in the ‘fine-tuning’ of demand through fiscal policy, which Keynesians often advocate, since I think monetary policy is a more effective tool for macroeconomic stabilisation.”

    I think Keynes himself would have wholeheartedly agreed. As you note, fiscal Stimulus is a tool for for sharp prolonged slumps and situations where the transmission mechanisms of monetary policy (ie banks) are not functioning properly or monetary policy might be ineffective (‘pushing on a piece of string’ in Keynes’s words).

    On our current situation, Bootle notes:

    “The policies designed to help us emerge from the Great Contraction have been dominated by various forms of government “stimulus”. Stimulus policies take two forms – monetary stimulus, based on near-zero interest rates and “quantitative easing” (printing money), and fiscal stimulus, based on deliberate expansion of the government’s deficit. While not denying the importance of the first, Bootle robustly engages with those monetarists who believe that printing money is a sufficient condition of recovery. As he points out, this presupposes a stable relationship between the supply of money and the demand for loans. This may be true in normal times, but these are not normal times. If the banks are afraid that if they lend money or buy assets they will lose it all, why should they be eager to do either? Better to sit on their enlarged cash balances and wait and see. And the same is true of investors, who may refrain from borrowing, even at very low rates of interest. This is not just theory, but history. In the 1990s, the Japanese central bank flooded its member institutions with money in an attempt to revive the stagnant Japanese economy. The supply of credit, and the demand for it, however, lagged way behind. The same is happening in western economies today. So, escape from prolonged recession will have to be achieved mainly through fiscal policy, whatever the dangers for the long-term sustainability of government finance.”

    This is a view I share. Additionaly, as neither monetary or fiscal stimulus will address longer-term structural issues, I would favour fiscal stimulus in the form of spending on economic infrastructure and social housing that produce lasting benefits.

    Equally important is following through on Bootle’s suggestions for breaking up banks into a three-tier structure:-
    narrow banks, limited to offering basic services to depositors and in the assets they can hold; wider commercial banks, with more freedom to operate, but still not allowed to engage in investment banking; and investment banks, which can engage in risky banking but should also be allowed to fail. The basic principle is that banks whose deposits are guaranteed by the taxpayer should not be allowed to gamble with their depositors’ money. Bonuses at regulated banks should be paid in stock not cash, and clawed back if profits fall.

    On monetary policy, Bootle points out that for the Bank of England to set interest rates solely to hit an inflation target within two years leaves it powerless to prevent asset bubbles, whose effect on the price level develops over a longer period. He proposes two reforms to deal with this problem. The first is “macro-prudential” banking regulation: bank margins and capital ratios should be adjusted counter-cyclically; that is, they would be required to rise during a boom and fall in a slump. The second is that the Bank should aim to achieve price stability over five years, not over two. These reforms should result in greater variability in the inflation rate, but greater stability in asset prices.

    His other ideas like reviving Keynes proposal for an international reserve currenct – the Bamcor – may need to wait for a yet bigger international crisis to bring the Americans to the table.

  • Alex Sabine 15th Apr '13 - 8:32pm

    Joe: I agree with a lot of Roger Bootle’s analysis,  but not the proposition that we can ignore dangers for the long-term sustainability of government finance.

    It seems to me the delicate question is whether greater risks might have to be taken with short-to-medium term financing, in the form of an upward shift in public infrastructure investment, accompanied by a commitment to deeper cuts in government consumption and transfer payments in the medium term.

    The latter means more radical action to reduce the long-term drivers of public expenditure, notably on housing market reform, pensions (possibly a sharper increase in the state pension age, the axing of the universal pensioner benefits and better incentives to private provision) and, yes, welfare too. Also, ringfences will needed to come off and the burden of cuts distributed more evenly across government departments, with some real-terms reduction in NHS spending as Labour have been doing in Wales. Pretty sure Bootle agrees with most of that…

    That said, I don’t think it should be a case of pressing the panic button just yet. There have been false dawns before, but there are signs that – if you exclude financial services and North Sea oil and gas – the economy is recovering reasonably well.

    David Smith believes this helps to explain the puzzling strength of employment alongside weak overall output. As he says: ‘The decline of two of the struggling sectors, the North Sea and financial services, is explicitly linked to the unbalanced economy and that huge current account deficit… The broader message is that most of the economy has been able to grow at a reasonable rate in a very challenging period. Some of the growing parts are the high-skilled sectors we will need in the future. In fact we will need more of them.
    http://www.economicsuk.com/blog/001851.html

    The rebalancing is happening in other words, albeit slowly. The problem for the Treasury is that it does not generate the same level of tax receipts as the model hitched to the financial sector (with its City salaries and bonuses) and a rampant property market. There are areas like construction that have suffered badly from the capital cuts, and here the government could help by recalibrating its fiscal priorities (it has taken baby steps in this direction, but could do more).

    But there are grounds to believe that the economy is ‘healing’. The real problem is still the banks, their balance sheets and the contradictory pressures they are under from government.

  • Alex,

    I share your respect for Roger Bootle’s work, but we will have to agree to differ on his proposition that we can, for the time being, ignore dangers for the long-term sustainability of government finance – a proposition that I support at this juncture in the economic cycle.

    On the balance of risks between borrowing for infrastructure and housing investment and increased risk premia on bonds, I think Vince Cable called it right in his recent interview in the Guardian Vince Cable exposes coalition divisions over austerity . Some key quotes :

    The business secretary has called for a capital injection into housebuilding in the region of 1 % of GDP. He said: “If you are talking about under 1 % of GDP that is hardly going to shake the markets to the foundations”, adding this amounts to reinstating the capital spending cut since the peak of 2008-9.

    Cable said there were “crucial sectors of the economy, like construction, which need a demand boost after being laid low by the bursting of the bubble” and highlighted commercial and residential property prices outside London as needing support.

    He added: “To most people it seems merely common sense that in a crisis where the private sector lacks the confidence to invest, the government should do so: building modern infrastructure or giving councils the freedom to build affordable homes.” Historically, low interest rates mean that government (and local government) can borrow to invest cheaply.”

    “Some people say we mustn’t frighten the horses. They say that any change in direction, however sensible, is too risky and will cause panic. There is of course a balance of risks and that mattered most when we came into office. But we should ask whether that balance of risks has changed”

    As to Vince’s question as to whether the balance of risks has changed, I am persuaded by the views of economists such as Martin Wolf and Samuel Brittan of the Financial Times, Simon Wren-Lewis of the University of Oxford and Jonathan Portes of the National Institute of Economic and Social Research, Bradford DeLong of Berkeley and Larry Summers, the former US treasury secretary – that the time is ripe to ramp up construction spending. If this is accompanied, as you suggest, by a commitment to deeper cuts in government consumption and transfer payments in the medium term, I would see that as no bad thing and part and parcel of the longer term structural reforms that are needed.

  • Stuart Mitchell 16th Apr '13 - 8:06am

    @Alex
    “whether Tory or Lib Dem fiscal policy would have been more than a marginal improvement is open to question”

    The Lib Dems wanted to increase spending during the entire period you say Brown was spending too much. How would their fiscal policy have been any improvement at all, rather than worse?

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