On 25th November last year, George Osborne, the former Chancellor of the Exchequer, delivered his Autumn Statement and Spending Review. At the time it looked like it would be the defining budgetary event of this parliament. He planned four more years of cuts so that by 2019-20, the government’s revenues would exceed its spending—it would have balanced the budget. The Brexit vote means that these fiscal plans will be torn up. The economy is now expected to grow much less quickly, and even if Osborne’s spending plans were left in place, we can still expect to be running a sizeable budget deficit in 2020. The new defining fiscal event of the parliament looks likely to be the first Autumn Statement delivered by Philip Hammond, the new Chancellor. In his final days in office, Osborne scrapped his target of achieving a budget surplus by 2020 and this, combined with the uncertainty over our economic prospects, means that Hammond has some big judgments to make—they will be the biggest since those taken by Alistair Darling, the former Labour Chancellor, at the height of the 2008 financial crisis.
Hammond will find himself confronted by already high government borrowing and debt. He will be making decisions in a fog of uncertainty about the state of the economy and what the future holds. And whatever decisions he makes for the short run, he will also need to keep an eye on long-run sustainability. At the time of the 2008 crisis, Britain had national debt approaching 40 per cent of national income. It is now more than twice that amount following several years of large-scale government borrowing that in 2009-10 rose to around £150bn, or 10 per cent of national income.
Borrowing has since fallen, but it was still £75bn last year—4 per cent of national income. So the country goes into the post-referendum period with debt at its highest level since the late 1960s. But we also go in after six years of austerity. Spending on public services has been squeezed more than at any time since the Second World War. Even the NHS, which has been relatively protected, has experienced the tightest period of spending restraint since its earliest years. And while some taxes have been cut, since 2010 there has been an overall net tax rise.
At face value, all this would seem hugely constraining. Neither more borrowing nor more spending cuts look attractive. It is hard to imagine there is much scope for spending cuts beyond those already announced. Just keeping to current plans will involve cuts of more than 30 per cent from 2010 levels for many important areas of public spending. And don’t forget substantial cuts in the generosity of social security benefits—at least for those of working age—are still in the pipeline.
Whether we are constrained in what we can borrow over the next few years is less clear. Government borrowing is very cheap because there is plenty of demand for its debt. This is more a sign of the weakness of the economy and investors’ desire to find a safe haven for their cash than a sign that the government’s finances are considered especially strong. But the British government is not currently constrained by markets in the amount it can borrow.
It is also worth recalling that, while UK government debt is high by recent historic standards, it is not high relative to levels earlier in the 20th century (or earlier), nor is it out of line with the other members of the G7 group of large economies. None of this is to suggest that borrowing is a free lunch. More borrowing now means more costs for later generations. It also means spending or tax adjustments further down the line. But if it proves necessary, borrowing more is an affordable option.
In 2010, the Chancellor and Treasury did not realise how little they knew about what was happening to the economy or that the forecasts made by the Office for Budget Responsibility (OBR) would turn out to be too optimistic—we were in a world of unknown unknowns. Today, the known unknowns (the things we know that we do not know) split into two: the short term and the long term.
In the short term, we are in a period of heightened uncertainty. We will know a little more about how the economy is reacting to the Brexit vote by late autumn. But there is still a lot we will not know. The OBR will need to make a judgement about the consequences for, among other things, investment, productivity, consumer spending and the housing market. But they will also need to take some sort of view about how long this period of uncertainty and adjustment is likely to last. That will be an almost impossible task given the set of political decisions that will determine, for example, when to trigger Article 50, the measure that will start the two-year countdown to Britain’s exit from the European Union. We know that there is a lot we don’t know even in the short run.
Longer-term uncertainty is equally acute. Economic and fiscal forecasts will need to be made without knowing anything about the kind of settlement Britain is likely to reach with the rest of the EU, particularly on our membership of the single market. The longer-term economic consequences of different trade relationships are likely to be fundamentally different. Britain’s economy will be significantly smaller by 2030 if we end up trading with the EU on standard World Trade Organisation terms—the default arrangement offered to non-EU nations—than would be the case if we retain full or near full membership of the single market. The scale of the difference could be comparable to the long-term effects of the 2008 financial crisis.
All of this will pose problems not just for the Chancellor but for Robert Chote, chairman of the OBR, and his colleagues. There are very different tracks that the economy might follow and the OBR will need to think much more carefully than usual about how it reflects this in its forecasts. It is required by law to make a central forecast based on current government policy, but in this environment it is hard to see how they can carry out that duty. Whatever the range of the OBR’s forecasts the Chancellor will then need to make big decisions in the knowledge that he is doing so in an atmosphere of uncertainty. I n this world of tough constraints and uncertainty, Hammond’s first decision will be how to respond in the short term to the likely economic slowdown. What degree of fiscal loosening, if any, should be used to support the economy? Second, if he acts, he will need to take specific decisions on tax and spending. Third, he has to decide whether to announce a new fiscal framework and set of fiscal targets, given that his predecessor’s rules appear to have been consigned to the dustbin of history.
The next set of official economic forecasts will be worse than those delivered in March, so borrowing will be higher than expected. It was as a direct result of this that Osborne, in the short window between 23rd June and his sacking on 13th July, announced the end of his ambition to reach fiscal balance by 2019-20. That target could only be hit with big spending cuts or tax rises, possibly of the order of £20-40bn a year in addition to those already announced. That is not going to happen.
That announcement does not necessarily mean an end to austerity. It is entirely consistent with keeping to current tax and spending plans—in other words with continued spending cuts. The point is that planned cuts will no longer be enough to reach a balanced budget because a smaller economy will produce less tax revenue. But it could mean a temporary end to austerity at least. The Chancellor may loosen the purse strings to support the economy through what will be a seriously rocky period.
This is where Hammond will have an astonishingly difficult set of judgments to make. Does he take the view that the economic shock created by Brexit is so severe that it will need a big fiscal loosening to support the economy and prevent a deep or prolonged recession, just as Darling loosened policy in the face of the financial crisis in autumn 2008? If so, how big should that loosening be?
One question he will need to consider carefully is whether he feels that he knows enough about the impact of the Brexit vote to commit to a specific plan of fiscal loosening, or whether he should delay until the Budget in March 2017. On the one hand, he won’t want to make one set of judgments in November only to have to change them in March in the face of new data. On the other hand, a “wait and see” approach may look complacent. And if a fiscal stimulus is needed, it is important that it is not injected too late.
Suppose he does loosen fiscal policy—what form should that policy take? If consumer spending is down, a temporary cut to the main rate of VAT, as introduced by Darling in December 2008, might look attractive. It has the merit of delivering quick results, it was quite effective last time and is explicitly temporary. On the other hand, a big concern is likely to be that uncertainty is causing a sharp drop-off in investment by business, which affects growth in both the short and long term. In that case, additional temporary incentives for investment, whether that be increased capital allowances or even direct subsidies, might look like a good bet and would be more effective than Osborne’s proposed additional permanent cut in the rate of corporation tax.
Spending on infrastructure—roads, rail, housing—is another obvious possibility, but it is difficult to make that happen quickly. Experience suggests that there are usually few “shovel ready” projects that can be got off the ground within a few months. But given an expectation of low growth (at best) for a considerable period, this might be the sort of medium-term boost needed.
This expectation of a long-term hit to the economy is one big difference between now and the period between 2008 and 2010. Back then, it was thought that there had been a one-off shock but that quite a bit of the loss in potential output would be made up after the initial shock had worn off. That expectation turned out to be wrong, which is why both austerity and high levels of borrowing have persisted for longer than expected. This time around, the expectation is of an immediate economic loss but with, in addition, a widely held expectation that growth could be badly hit for the foreseeable future. What this means is that a significant fiscal loosening in the short run would likely have to be followed, at some point, by more years of austerity. Reinvigorated growth can’t be relied on to return us to a balanced budget.
"If we end up out of the single market and lose a substantial part of the financial services industry, the rest of us will have to pay the huge taxes they currently pay, or suffer worse public services"So having decided on his short-term strategy, the Chancellor will have to give us some sense of his medium-term objective: that is, his version of the fiscal rules pursued by Gordon Brown, Darling and Osborne over the last two decades. Some form of fiscal anchor can help to achieve the necessary long-term credibility and certainty. That could take the form of an intention to return to a balanced budget by a certain date, presumably well after 2019-20. Given the pervasive uncertainty over the future, that might be unlikely. It could mean a commitment not to let debt rise above a particular fraction of national income. But a target that looked constraining might not be credible in the face of any further downgrade in the economic forecasts. It could mean returning to Osborne’s first fiscal rule, which was to set a spending policy intended to result in a balanced budget five years hence based on contemporary economic projections. This target applies to day-to-day spending and allows borrowing for investment, which may well make sense. Being a rolling target it is flexible in the face of economic change. What it lacks is a real anchor—the end point can be continually pushed forward.
Whatever the short-term response and long-term ambition, there is no getting away from the fact that our economic prospects have just got worse. This could be painful in the short term and it is possible that the Chancellor will try to offset this by reining in some of the planned spending cuts and even introducing targeted tax cuts or spending increases. That may be heralded as the end of austerity. But that should not blind us to the fact that there will be a price to pay down the road. If we end up out of the single market and lose a substantial part of the financial services industry, the rest of us will have to pay the huge quantity of taxes that they currently pay, or suffer worse public services. If we restrict immigration of, overwhelmingly young, educated, and hard-working, citizens from the EU, then again the rest of us will either have to pay taxes they would otherwise have paid, or suffer worse public services. An end to austerity in the short run will likely merely herald more tax rises or spending cuts in the long run.
Prospect will be hosting a second Brexit debate on Wednesday, 21st September at 6.30pm. Panelists will be: Paul Johnson, Director of the Institute for Fiscal Studies; Rupert Harrison, former Chief of Staff at the Treasury to George Osborne, now at BlackRock; Vicky Pryce, Chief Economic Advisor and Board member at the Centre for Economics and Business Research and leading Brexiter John Redwood, Conservative MP for Wokingham. The event will be chaired by Duncan Weldon (former Newsnight economics correspondent). Click hereto book your tickets to attend.
