Opinion: Mind the gap – a sceptical view of the need for cuts

The UK’s economic position has deteriorated, government revenues are lower and welfare expenditure higher than anticipated, worsening the deficit so that austerity must continue further into this decade. Because of this deterioration a combination of increased taxes or cuts must be identified in the Autumn Spending Statement in December.

That is the orthodox view. It is based on the generally accepted proposition that the structural deficit should be eliminated. This has set off widespread debate as to whether the increased scale of the structural deficit should be eliminated by increased taxes (such as a Mansion Tax) or expenditure reductions and where these should be identified, with the Conservatives placing welfare cuts at the top of their agenda.

But a recent research note put out by Roger Bootle’s Capital Economics is rocking these old certainties, and challenging the orthodox view. An article Why the UK output gap could be a chasm | FT Alphaville (register to view) sets out Bootle’s position.

The structural deficit is that part of the deficit that would exist even if the economy were operating at full potential. If we were at full potential now then the whole of any deficit would be a structural deficit.

Clearly we are not operating at full potential so to calculate the size of the structural deficit we need to know by how much below full potential we are operating, i.e. the difference between actual GDP and potential GDP – known as the Output Gap. The closer we are to full potential the greater is the proportion of the deficit which is structural. And the further we are from full potential the smaller is the proportion of the deficit that is structural.

The Office for Budget Responsibility (OBR) calculates that the economy is presently operating at around 2.6% below full capacity and from this deduces a figure for the structural deficit. It is the deterioration in the OBR’s figure that is putting pressure on the Coalition to find further cuts or tax increases.

So, what is Bootle saying?

We don’t think that it is out of the question that the economy was close to its potential in 2007 and that very little output has been permanently lost in the recession. On that basis, the output gap would be about 13% of GDP.

Even a highly cautious view of the situation still has Bootle’s estimate for the output gap coming in at 6%. If we were to take his 6% figure, Bootle concludes that, “this implies unnecessary fiscal consolidation under current plans of about 2.5% of GDP, or £35bn in current prices”.

As Izabella Kaminska concludes in the FT, “And that means… a) fiscal and monetary policies may be far too tight and b) there could be plenty of scope for the economy to grow strongly without inflation rearing its ugly head”.

So, why are our leaders allowing the debate over the Autumn Statement to be framed around the Welfare v Mansion Tax issue, when they could be calling into question the need for £35 billion pounds of cuts and when we could be arguing the case for a significant non-inflationary monetary and fiscal stimulus?

* Bill le Breton is a former Chair and President of ALDC and a member of the 1997 and 2001 General Election teams

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  • Geoff Crocker 21st Oct '12 - 10:36am

    Bill, as you know I totally agree with you. We need a fiscal and monetary stimulus, not recessionary cuts. The only solution to the inevitable structural deficit caused by productivity growing faster than real wages, is a universal credit funded outside PSBR. Gavyn Davies has shown how this can be funded. My calculation of the output gap for 2007 is £55bn, but we can compromise at £45bn!

  • Richard Dean 21st Oct '12 - 10:40am

    But surely the problem is that the longer you put off reducing a defiicit, the more “structural” the deficit becomes? And if the economy performs below potential for a long time, the effect is to reduce the potential GDP. Greece is what happens to a country that doesn’t tackle this kind of problem.

    Imagine you go to your bank manager and say “I haven’t got a job, but ***IF*** the world economy improved I’d have no trouble getting one, and when I get one I won’t need to borrow any more. So, please lend me some more money.”.

    The bank manager says “That’s a big IF. Look at the facts. You haven’t got a job now, and you have no control over whether the economy will improve or not, and actually I can’t see how it will. Plus your skills are going out of date, your tools are rusting, you’re finding it difficult to get up in the morning, you’re beginning to drink to much, and your morale is collapsing, How can I be confident that you’ll be able to pay the money back?”.

    Maybe we shouldnlt play russian roulette unless there’s no other choice?

  • So you are saying, Richard, that if someone is in the kind of problems that you describe, that there is nothing either the private sector – in the shape of this bank manager – or the public sector (remember your tirade against you being deprived of “freedoms” to assist others in theirs?) I find your Liberal Democracy more than perplexing.

  • Richard Dean 21st Oct '12 - 12:32pm

    The basic problem is the output gap, isn’t it?. Do we know how much of it is due to loss of export markets? That would be the part we can’t do much about, perhaps, but the rest we should be able to fix.

    Stop stalking me. I remain free from your prison of consistency, A different meaning can reveal itself

  • Richard Dean 21st Oct '12 - 4:27pm

    Perhaps I should clarify.

    Bill seems to be arguing that the government should say to the financial martkets “IF the world economy gets better, we would be able to pay you back, so give us more money”. He’s arguing this on the basis that Bootle, whose company offers advice to investors, says that the difference between our actual and potential GDP is larger than previously thought. The difference represents our ability to repay debt, but only if we can fix the problems that create the gap.

    But borrowing more does not seem top offer a way for us to do that. It does not seem to help us resolve own internal problems, and it won’t fix the world economy’s problems. It would seem to get us more stuck in the mire of increasing debt, and so might actually increase the problems we have to face in the future. That’s why I suggest it’s potentially worse than the planned cuts.

    Another way to say this might be as a question: How will more debt now help us recover? Won’t it simply make recovery harder to achieve?

  • Bill,
    here, let me throw some more random numbers into the mix and see how many people who already support my conclusion will repeat their agreement with me. That’s right, let the figures cast their mystical spell!

    That’s not a political argument, that’s a series of indecipherable technocratic opinions, namely: you don’t like austerity, you don’t want austerity, you don’t think austerity helps LibDem electoral chances, you don’t think austerity is necessary – in that order.

    Agree or disagree? it’s the old tory game of divide and conquer/ Labour game of wedge issues.

    But it’s irrelevant because it’s impractical and fails to translate.

    More than that it’s politically naive because it cedes the initiative on the one hand to our partners in government to claim all and any credit for the good things that are happening (like the growth in employment), and consequently on the other hand to the bolshy opposition to say we’re ineffectual (like on the lack of GDP growth) – it’s a statement of strategic suicide. Do you wonder why we’re getting squeezed between the two?

    In my book ‘stimulus’ is a dirty word. It inspires images of artificially sweetened coffee-fueled hyperactivity to no productive end, which eventually wears off leaving the recipient back where they began but now on a downer (personally I prefer plain tea).

    No, our economy does not more artificial ‘stimulus’, it needs to be rebalanced so that it is on a more robust footing, capable of serving the needs of more people and able to look into the future with confidence. We should be concentrating less on output and more on content. A more productive economy requires more productive jobs.

    We must frame the debate about spending cuts and tax rises in the context of rebalancing the economy, just as we did during the 2010 election with the ‘tax switch’ campaign.

    So our monetary and fiscal policy choices must abhor the phrase ‘stimulus’, which is implicitly artificial, external and reactive – all the things that LibDem politics is against. To apply this word is for LibDems to concede defeat.

    A ‘mansion’ tax is acceptable within this context, and though I’m flexible about the rate it should be levied it would be more reasonable to add new higher bands to council tax, as politically we can then argue this takes account of the massive house price inflation (and the negative effect this has had on social mobility and equality) over the past couple of decades (which other parties systematically ignored) whereas a mansion tax will be criticised as a punitive measure, hammering the new universal orthodoxy of aspiration.

    So if you see what I’ve done there (I disagreed to agree rather than agreed to disagree) the way we can reformulate the political choice is by turning back on the traditional Conservative/Labour duopoly we’ve finally broken to retort that their inflationary policies entrenched inequality because it destroys aspiration.

    Our economic choice is therefore a matter of ‘inflation vs aspiration’.

  • Bill le Breton 21st Oct '12 - 7:08pm

    Oranjepan, I am afraid that I see little reasoning in your comment. There is a lot of faith and a lot of gut instinct. Reading it made me feel strangely Vulcan 😉 But I think you speak for many who instinctively support the present Coalition economic policy.

    I had thought that the aim of that policy was to remove the structural deficit. I think you go beyond this. People need to be clear in their own minds about this – who is arguing for removal of the structural deficit and who wants to go further?

    Ok, there obviously is a structural deficit, but if it could be proved that there is no structural deficit, your position seems to be that you would still advocate the present set of spending and tax proposals as set out in the last autumn statement and the last budget – with amendments in the next autumn statement for changes to the projected overall deficit.

    Mine is firmly that efforts should be made to remove the structural deficit and therefore, when Roger Bootle and his team say, ‘this is our figure for the output gap’ [not a random or mystical figure] and it is very different from the 2.6% adhered to by the recently discredited Office for Budgetary Responsibility, I ask, what is our treasury team (recently supplemented by David laws and Tim Leunig) doing to produce ‘our’ figure for the output gap. And, as an open and democratic party, what are they saying their figure is and where are their calculations?

    Next, you mention inflation, but if it could be proved that there is no domestically derived inflation would you still argue for deflationary policies to offset the rise in prices purely attributed to imported fuels and other commodities?

    From what you are saying, I think you would. My opinion is that it was exactly this tightening of policy around 2008, in reaction to oil and other commodity prices rises that turned a recession into the Great Recession. But that is what happens when using the Consumer Price Index as a target instead of a figure for the nominal GDP (level target).

    People need to be clear why and on what grounds our tax and spending decisions for the autumn statement are being made. Would we blindly support any other policy position without such an explanation from our Government Team?

  • Bill le Breton 21st Oct '12 - 7:17pm

    Richard, Bootle is arguing that there has not been as much capacity ‘permanently’ lost as feared. Employment figures suggest that there has been a good deal of labour hoarding and of reducing people’s hours rather than losing them to the business. The increased numbers of self-employed will either make a success of their ventures or be available to come back into paid employment.

  • Richard Dean 21st Oct '12 - 7:59pm

    I imagine that the consumption gap (potential less actual consumption) equals the output gap less the deficit.

    So if the output gap is larger than previously thought, the consumption gap is too, implying there is a bigger unsatisfisfied market in the UK than was previously thought. If correct, this is good news. It surely makes the UK more attract to investors since a larger market is one with less risk of failure and more chance of profit. It might even persuade companies to increase their outputs and so reduce the labour hoarding you mention. Hoarding has its own issues too – one being that a “stimulus” will not necesarilyt lead to an increase in employment.

    But if the cuts are cancelled, the effect would seem to be to increase the deficit compared to what would otherwise have occurred, thereby reducing the consumption gap, and so making the UK less attractive to investors. In effect, deficit would be competing with investment.

    As an amateur in this field, I am aware that this might be a peculiar argument! But perhaps it is less peculiar than professionals in the field use every day?

  • Bill,
    I think I must apologise for teasing you a little bit too much!

    You state your desire for clarity, but you drown this in a bunch of figures, leaving it totally unclear.

    Either you can say we face a choice and describe the choices, or you can argue for a particular choice. To then try to do both confuses the issue and contradicts your earlier message.

    I agree with your criticism that the official calculation of an output gap is (or at least should be) discredited, but I don’t see you offer any alternative. Frankly speaking, calculating an output gap is in my opinion a bogus concept because we all assume that the growth potential of the economy within an undefined timescale is infinite. I could, for example, point to wasted time and resources put into commonplace commuting, amounting to possibly as much as 50% of current product – which Bootle doesn’t even consider!

    How to reclaim such waste presents both a massive challenge and opportunity for the state of personal, corporate and national finances in equal measure. But is this too big a question to ask inside the hothouse of a Westminster-centric debate?

    Next, I don’t argue for deflationary policies, rather I suggest that in seeking to restrain inflation by imposing central targets and central controls previous governments have perversely locked the country into a cycle of excessive inflation via cyclical spending choices, with the result that pre-existing expectations for growth are maintained artificially, and leading to a destructive race to the bottom with all the associated consequences for social policy (ie perpetual failure on inequality and social mobility etc). This leaves the wider impression that democratic government is fighting a losing battle against history, and presents the divisive choice to continue this futile fight by continuing with the 20th century consensus (the left) or float with the tides wherever it takes us (the right).

    A more natural (ie liberal) approach would be to change the economic paradigm and manage down inflation and deficit simultaneously, by accepting lower trend growth while actively developing new markets to support future generations. However in a polarised political climate this amounts to an unreasonably moderate stance which is so far-reaching that it’s beyond the will and competence of a nationally-focussed parliament.

    A closer reading of Keynes shows that he forsaw the choice of economic intregration or political disintegration as the way to deal with evolving public expectations, but I don’t think the full implications of his conception have yet been digested within the professional political sphere.

    In short, I suggest we should stronlgy renew our calls for a ‘tax switch’ as a more effective and less invasive, interventionist and authoritarian means to rebalance the economy – as such it is in perfect alignment with the principles behind your post, even though on the specific point I’d prefer to expand the scope of Council Tax rather than introduce a new ‘Mansion Tax’.

    On a personal level, I’m amused at your attempt to categorise me as a ‘deficit hawk’. On the contrary, I’m attacking your description of Bootle ‘rocking old certainties’ as an overly-timid attempt to return to universally accepted but widely misunderstood and misapplied theories.

    Anyway, I’m happy to have a constructive discussion to eke (tease?) out more practical insights between us, but it’s late now and I’ve got to sleep. The caffeine has worn off until it’s topped up in the morning.

  • Paul Reynolds 22nd Oct '12 - 4:35am

    I loved reading this debate. It reflects many other such debates in LDV and of course elsewhere. … the stimulus/no cuts to state spending versus reductions in spending, limited tax rises and QE to prop up UK issued bond markets. At Cionference a proposal was made based on the former that low UK borrowing costs were due to low growth and thus low inflation expectations rather than expected debt reductions, implying that a stimulus and an end to spending reductions would not cause a rise in borrowing costs. This dispute in the pary in ulikely ever to be resolved since it is ideological more than factual. It may be a fissure which cannot be reconciled and thus holding the party tother is a special challenge.

  • Geoff Crocker 22nd Oct '12 - 6:42am

    It’s much simpler than this. The important ‘output gap’ is the one between output GDP and aggregate disposable consumer income. This is readily measurable from ONS statistics. In 2007 it was filled by £55bn of unsustainable consumer credit to increase consumer income to match output GDP. It is now being closed by recession to reduce output GDP to match consumer income. It should be filled by a citizen’s income funded outside PSBR.

  • Richard Dean 22nd Oct '12 - 8:54am

    What a neat number is £55bn ! Like pi, it seems to turn up in many places. Is it real? Where will it come from, if not the PSBR?

  • Andrew Tennant 22nd Oct '12 - 8:57am

    It seems absurd to me to claim that the economic conditions of 2007, based on a vast credit and housing bubble, and demonstrably seen to crumble, could represent a stable peak for the UK economy.

    Simply repeating the myth that the country can borrow against the inflated value of such assets and the future again will just repeat the cycle; instead I’d prefer we built a sustainable future based on reality.

  • Bill le Breton 22nd Oct '12 - 9:04am

    Andrew, what is the output gap now?

  • Andrew Tennant 22nd Oct '12 - 9:56am

    Frankly Bill I’m doubtful anyone can make an accurate claim as to how the economy should be were it not for real life getting in the way. Policy makers should judge the logic of each argument so they get the rules right rather than spend their time pretending they can decide if the economy goes up or down.

  • Bill le Breton 22nd Oct '12 - 10:36am

    Thanks Andrew, just for clarity, Bootle, like you advocate, did factor in a positive reading for the output gap in 2007 of between 2 – 3% above full potential. The full quote is, “If we assume (generously in our view) that the economy was operating 2% or 3% above potential in 2007, and that the financial crisis dealt a permanent blow to the economy of 5% of GDP, the output gap should still be about 6% of GDP.”

    The IMF has recently suggested the economy may have been 4 to 5% above full potential in 2007, though we should recall that not many people were saying in that year that things were overheating. No wage inflation. No firms reporting shortages.

    In a wise and very even handed piece , Professor Simon Wren-Lewis here http://mainlymacro.blogspot.co.uk/2012/10/misusing-cyclically-adjusted-budget.html concludes, ‘Third, does this mean looking at cyclically adjusted budget deficits is a bad idea, if the adjustment itself is so uncertain? The answer is clearly no. It makes sense to run surpluses in a boom and deficits in a recession. We do the best we can to estimate when we are in a boom and when we are in a recession. Much of the time it is pretty obvious … Sometimes, particularly in extraordinary times like these, we may get things wrong, but that does not imply that we should give up trying.’

    Which is why I do not agree with Paul above that we cannot ever exclude ideology from economic policy. It is always worth trying. There are some very fine economists now challenging policy makers rationally that ,if it really is the structural deficit that they wish to eliminate, (by 2017) they are cutting more than they need and more quickly.

    Of course – some Liberal Democrats may be arguing that they wish to see more of the deficit eliminated than the structural deficit. I only want these people to come clean and say so.

  • Matthew Green 22nd Oct '12 - 11:19am

    Thank you for your clarification in the last comment, Bill. The evidence that the economy in 2007 was well beyond its potential is overwhelming – trade deficit, consumer debt, property bubble, etc. It is helpful to see that Mr Bootle has taken that point on board to some extent.

    I think that all this does is highlight that the output gap is one of those nice theoretical concepts in economics (like equilibrium unemployment) that is in fact impossible to translate into actual numbers of practical use. We may only come to a realistic estimate long after the event. I have read that the whole 1970s stagfalation crisis was because policymakers assumed that high unemployment meant that spare capacity was much higher than it in fact was. I feel that low consumer inflation may be causing a similar mistake this time (i.e. it is being taken as evidence of spare capacity when its actual causes are other). But that’s just a feeling – we shouldn’t use estimates of spare capacity, structural deficits, etc as the main foundation for arguments on monetary or fiscal policy.

    Which sounds as if I fundamentally disagree with Prof Simon-Wren – though I haven’t read his blog piece. All the certainties of how you do macroeconomics have been upended – but I see too many macro-economists sticking to the comfort zones of familar aggregagates as a subsitute for asking what is really going on. In fact monetary policy is broken as a policy tool, inflation is a much less useful economic indicator than it used to be and financial markets have become quite dysfunctional as they make practically no attempt to price long-term value. Caution and reform should be the watch-words.

  • Bill le Breton 22nd Oct '12 - 12:19pm

    Matthew, those I have cited here agree with you that ‘something’ was going on in (say 2007) that meant that the ‘data did not fit the prevailing reality’. That it could be that the workings of the economy have changed fundamentally sometime in the middle Noughties. They draw //s with Greenspan in the 1990s here http://ftalphaville.ft.com/2012/08/31/1135531/time-to-resurrect-the-missing-variable/

    It is difficult to get all these things into 500 words first up.

    In fact the + 4 – 5% 2007 output gap now proposed by the IMF is a big change from their position at the time. It could be as simple as our bearings having been upset by the extraordinary influence of the Far East on disinflation at that time.

    And I am deeply influenced by experience in the late ’70s when the IMF eventually changed its ‘figures’ for the UK long after its had forced a level of cuts on the economy that led to a deeper recession than would have been necessary had they got those figures right at the time. Communities and families with three generations of unemployed still pay the price for those errors.

    There is historic evidence to suggest that there are no ‘middling’ recessions. They are either of short duration (in the main) or every so often a ‘normal’ recession is transformed by our own mistaken policies in much deeper affairs.

    I know you have a different view on the role of monetary policy in this to me, but I do think that the initial ‘mistake’ was over tightening of monetary policy in 2008/9 and this was then compounded by over tightening of the fiscal policy because ‘gut instincts’ suggest that the ‘debt problem must be tackled’, before recovery, when there is an argument for doing so more effectively when recovery is firmly set in.

    So, how do we ensure that ‘gut instinct’ does not rule us in these matters and that reason does? The OBR’s 2.6% figure for the Output Gap is fortuitously??? slap bang in the middle of the 16 figures provided by the 16 consultancies listed in their workings.

    What would happen if we Liberal Democrats challenged the OBR figure, took that of Capital Economics (-6%) or NIESR (-4%) and said that we held to the figures set out in the 2011 autumn statement? The OBR does have egg on its face over the question of multipliers and its apparently blind following of the IMF’s now altered views on those.

    At the very least, Danny Alexander and David Laws should be telling the party what their figures are for the Output Gap and the Structural Deficit that they are using to guide their decision taking on negotiations for the Autumn Statement.

  • Bill,
    ‘It makes sense to run surpluses in a boom and deficits in a recession.’
    Yes, that is tradional Keynesian orthodoxy.

    Problem is previous governments disagreed – they ran deficits during booms (thinking they’d eliminate busts), thereby creating bubbles, and bigger deficits in the recession after their bubbles burst.

    Question is then, how do we apply anti-cyclical measures when the cycles themselves are made measure-dependent in that way?

    Answer is, we can’t. How then do we adjust to compensate for the changed context? It’s not a matter of ideology, it’s a matter of applied ideology, of methodology.

    So, yes, having those figures may be advisable, but they’re not something I’ll be putting in any Focus leaflet anytime soon.

    Matthew Green,
    ‘the economy in 2007 was well beyond its potential’
    I think you need to define your terms. Certainly the areas you identify had gone beyond the point of sustainability, but that indicates over-specialisation in the wider economy rather than an underlying problem with the ability to manage government finances.

    While I tend to agree with you that caution and reform are right at present, I also agree with Bill that a large amount of responsibility must be placed previous governments for by their extreme and volatile policy choices – the classic example of this being use of interest rates in the early 90s, though the IMF fiasco in the 70s is a prime contender.

    Anyway, my earlier coffee metaphor for an over-stimulated economy still seems appropriate. Clear heads are needed.

  • Richard Dean 22nd Oct '12 - 5:52pm

    The nice, paternalistic Mister Keynes was wrong about governments running surpluses during booms. Democratic reality cannot work that way..

    1. You don’t know it’s a boom until it’s followed by a bust, and even if you suspect it might be a boom, you don’t know what the middle ground is. It’s like shares going up or down. You never know if a particular up is going to be the new norm, or whether it will be followed by another up or by a down. If people did know, they’d be able to predict ups and downs so well they’d all make fortunes – which not all do.

    2. Democratic electorates won’t accept it. If the government runs a suprlus, electorates will demand lower taxes, and governments who refuse will be promtly sacked

    3. If the government was to run a surplus, it would have to do something with the money. Invest it in the shares maybe? But when the bust comes – and it won’t be easily predictable – those shares won’t be worth what we the taxpayers paid for them. So government running a surplus translates into free handouts to the stock market.

    One consequence seems to be that democratic governments are naturally always in crisis management mode. Another seems to be that Keynesian economics needs to be corrected to account for this reality.

  • Peter Chegwyn 22nd Oct '12 - 6:42pm

    I understand Lib Dem Peers are voting for a cut in the single persons’ Council Tax allowance as a way of balancing the books. That’s going to make us really popular with millions of single people, many of them on fixed or low incomes!

  • Andrew Tennant 22nd Oct '12 - 7:32pm

    Just a thought Richard but, if ever we’re fortunate enough to run a surplus in my lifetime, couldn’t we invest by paying a small part of our debt off, reducing our interest payments and therefore increasing the surplus for the next year?

  • Richard, at the risk of being accused of stalking you again! Our local (Tory run for ever and a day) District Council paid off any debt, and amassed a ludicrously high reserve a few years ago, but was never voted out of office despite us, and others, urging it to spend money on local need of various kinds!

  • Richard Dean 22nd Oct '12 - 8:31pm

    @Tim13, apologies for my earlier rudeness. Insistence on consistency tends to make my brain uncomfortable! 🙂

    Interesting counter-examples, but I remain cyncial that these can be the norm. There’s always something a government could spend money on – more social services, more “free” handouts – and there’ll surely always be contractors wanting any money that’s available?

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