The Spending Problem

It's almost certain that tomorrow's budget projections will incorporate yet another downgrade to growth expectations. Which means that the current plans for public spending have become even less affordable.

Since George's' first budget in June 2010, the Office for Budget Responsibility (OBR) has downgraded its growth forecasts almost every time it's opened its mouth. For 2015-16 - the last year of the current Parliament - it originally forecast GDP would be £1902bn. By last December, it had cut that to £1763bn, a reduction of over 7%. Some of that is accounted for by lower projected inflation (amazingly), but most reflects a real terms GDP reduction of 6%.

So by 2015-16 our national income will be 6% less than George expected back in June 2010. Yet far from trimming his spending budget, he's still planning to spend almost as much.

Back in June 2010, spending in 2015-16 was projected to be £757bn (Total Managed Expenditure - TME). So if he'd cut his cloth in line with the poorer outlook for national income, he should now be planning of spending closer to £700bn. Instead of which, spending is actually projected at £745bn.

Here's a chart of successive spending projections (TME). The top line is Labour's final effort (projection out to 2014-15), the others are successive coalition plans:

As we can see, the June 2010 budget cut Labour's planned 2014-15 spending by 5% in cash terms. And as we can also see, the latest coalition plans have cut it a little further (by about one percent). That's all to the good, but the problem is that with the outlook for GDP so much worse than George initially thought, it needs to go further.

When the coalition took over, public spending was running at 47% of GDP. That was far higher than government revenues at 37%, and wholly unsustainable: as ministers kept telling us, it meant government was borrowing one pound in every four it spent. The plan was to get public spending down under 40% of GDP by 2015-16, and to increase revenues to 39%. Which they reckoned would leave borrowing at a comfortable level.

Unfortunately, things haven't panned out like that. With weaker growth, revenue is falling short and borrowing is significantly overshooting.

Of course, there are plenty of people who say we could solve the problem without further spending cuts. For example, we could tax the rich: except as we've blogged many times, there aren't enough of them. Moreover,  we should note that no government in at least the last 50 years has ever managed to raise much more than about 38% of GDP in tax revenues - that seems to be the limit of acceptability and/or practicality (see BOM book).

Or maybe we could borrow more. Except with inflation a looming problem, and Sterling subject to attacks of the vapours, those fickle bond and currency investors could well take it the wrong way. Especially when we understand that the only reason the coalition's spending totals have stayed within their initial projection is that debt interest has so far been lower than forecast (saving an expected £9bn next year alone). We really cannot afford to upset the gnomes of Zurich, or anywhere else.

But surely, you say, once the economy recovers back to full strength, revenue will rise and these problems will take care of themselves.

Yes, if only.

The problem is that we can't be at all sure what full strength means any more. Back in 2008 the economy suffered a heart attack, and although the jump leads got it back upright again, it's still hobbling around and avoiding strenuous exercise. It may no longer be capable of scaling the peaks it sprinted up during its Ben Johnson years of unlimited debt steroids.

The OBR tries to work out if and how quickly we can expect a full recovery, by assessing potential output both now and in the future. But it's the first the recognise the problems:

"The amount of spare capacity in the economy (the ‘output gap’) and the growth rate of potential output are key judgements in our forecast. Together, they determine the scope for actual growth as activity returns to a level consistent with maintaining stable inflation in the long term. The size of the output gap also determines how much of the fiscal deficit at any given time is cyclical and how much is structural. In other words, how much will disappear automatically, as the recovery boosts revenues and reduces spending, and how much will be left when economic activity has returned to its full potential. The narrower the output gap, the larger the proportion of the deficit that is structural, and the less margin the Government will have against its fiscal mandate, which is set in structural terms... 

But neither the level of potential, nor the pace of recovery, are possible to estimate with confidence, not least because the former is not a variable that we can observe directly in the economic data."

Here's its summary table on potential output growth:

Many people (probably including the OBR) wonder if they are being too optimistic on these key judgements. For example, it assumes that the potential growth of labour productivity in the future will be 1.9% pa, whereas the average growth over the last 15 years is only 1.4% - and since 2008 it's actually fallen.

The horrible reality is that the economy now looks a lot weaker than when the coalition came to power. And with a weakened poorer economy we cannot afford to maintain their initial spending plans. GDP is going to be much lower than he assumed then, but he hasn't cut his spending plans. George needs to recognise that tomorrow and tell us how he's going to address the problem.

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www.gudanggrosiran.com Categories: growth, public spending

A Forensic Focus On Growth

"When we say we're going to build a new economic dynamism, we mean it.

In the weeks and months ahead, ministers will be developing detailed plans to turn this strategy into action. Everything – from bank lending to skills, green tech to high tech, competition to innovation, international trade to local growth – will be put under the microscope.

That forensic, relentless focus on growth is what you will get from this government."

Thus spake Mr Cam at the CBI conference.

Good. A forensic relentless focus on growth sounds like the very thing we need.

And even better, he explicitly recognises that:

''The new jobs, the new products, the new ideas that will lift us up will be born in the factories and offices you own – not in the corridors of Whitehall.''

Yes, very VERY good.

Just one small point. If he's serious about his forensics, he will want to do whatever it takes to stimulate growth. And that means one thing above all else - tax cuts.

In particular, he has to abolish that economically bonkers 50p tax rate. As we've blogged before, every serious independent analysis says that it will raise virtually no revenue, and may even produce a loss as higher rate taxpayers change their behaviour to escape it (eg see this blog).

Ah yes, the escape hatch. The ultimate escape is to leave the country, and when high earners do that, they very likely take their businesses and their jobs and their economic dynamism with them.

We know there are lots of high earners thinking about this right now. Tyler was chatting recently to some City types, who virtually to a man were eyeing the hatch. And this morning the CBI published a poll showing that "84pc of FTSE 250 bosses surveyed said "personal taxation levels" had made the UK less attractive for investment".

Does Mr Cam understand the risk? The same Mr Cam who lived in Notting Hill and knows loads of top bosses? Surely he must do.

In which case, there really is no excuse. If we are to secure the prosperity and jobs we desperately need, "forensic focus on growth" must trump "all in this together".

****

And talking of growth, this morning's Independent front page really does underline how desperate the left are to undermine the economic recovery.

The headline was "Britain stares into the abyss again as household confidence plummets". But when you read the actual story, there was hardly even a pothole to be found, let alone an abyss. Instead, all we got was speculation that the latest official growth stats (due tomorrow) may show a slow-down from Q2's spectacular 1.2% (4.9% pa) back down to a more sustainable 0.4% (1.6% pa).  That, and some survey evidence that the property market is still pretty groggy.

Although the flimsiness of the story didn't stop the BBC giving it extensive coverage this morning.

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www.gudanggrosiran.com Categories: growth

We Don't Make Anything Anymore

On the starting grid

You know how our problem is that we don't make anything anymore? How most of our manufacturing base has already been exported to China, and that the government should damned well do something before the rest joins it?

Well, Tyler's local area is bucking the trend. Just down the road, McLaren Automotive is opening a brand new factory to build its brand new road-going sports car, the snappily named MP4-12C. If the car is a success, it's reckoned it will create thousands of new jobs.

Which is brilliant. Especially since it gives us some key pointers to the future of British manufacturing.

First of all, the McLaren sports car is no family runabout. It will be priced north of £150 grand, and BOM's motoring correspondent says it will be pitched at the same high-rolling market segment as the Ferrari 458 Italia and Lamborghini Gallardo. Production is planned to be just 1000-2000 pa (street value £150-£300m).

This is manufacturing focused on high-tech luxury goods, aimed at emulating the kind of global success achieved by the resurgent Rolls Royce, and capitalising on Britain's F1 heritage of speed and engineering excellence (oh yes). Critically, it is a high value-added product that will not be competing primarily on price and volume.

Second, it's happening in the already prosperous, and already crowded, Greater South East. The GSE's advantages of geography and skilled motivated workforce seem to have been critical, as presumably they were in BMW's decision to locate their new RR factory in genteel Goodwood, rather than our old friend Hull. As we've blogged many times, to get any new business up to Hull, you have to offer something even more compelling - much lower taxes.

Third, most of the new jobs - by a ratio of 2-to-1 - will come not in the factory itself, but from the spill-overs into the local economy (shops, healthcare, schools, etc etc). Just like the City, our world-beating manufacturers are the bed-rock that holds everything else up. Which is why we should praise and value them, not devise new ways of dragging them down.

Fourth, the real value added at McLaren will not be bashing metal. Indeed much of the actual bashing (or carbon fibre shaping as it is today) will be done elsewhere, often abroad. No the real value-added lies in the design, the management of the production process - especially quality control - and the marketing. Not, it must be said, areas in which British Austin Allegro manufacturing has always excelled.

And that's why we shouldn't necessarily be concerned by the long decline in UK manufacturing production as measured. To the extent we are exporting the commodity, low value-added, end of manufacturing we're not losing that much.

As you probably know, although China has become a major exporter, many of its products are manufactured under contract for western companies, using many imported components, and the percentage of value-added retained by China is quite small (it has been famously estimated that of the $150 cost of a Chinese assembled Apple iPod, only $4 actually goes to the Chinese).

And finally, that long looong decline in British manufacturing... the one we hear so much about... er... just a minute... where's it gone?

When you look up the actual stats, you get rather a shock. Because setting aside the current downturn, by 2007 UK manufacturing had reached the highest level of output in its entire history - even back when we were the workshop of the world. Here's the chart (the ONS stats only go back to 1948):

WTF?

Well, some industries, like textiles, have indeed seen a very pronounced decline. But others have delivered big growth. For example, Britain's world-beating pharmaceutical industry has driven an elevenfold production increase in the chemical and artificial fibres sector since 1948.

The fact is that when people talk about the problem with manufacturing, they're not really talking about output at all - they're talking about employment. Since 1950, despite the increase in output, employment in manufacturing has fallen from over 8m down to less than 3m - a big fall, especially when you remember that many of those job losses have been concentrated in particular regions.

But in truth, for Britain, high employment manufacturing is a thing of the past. Massive productivity growth - A GOOD THING THAT'S MADE US ALL RICHER - combined with globalisation, has blown these jobs away.

And instead of crying over the past, we need to find ways of rewarding the likes of McLaren for setting up in Hull instead of Woking (or better yet, get Merc to set up in Hull instead of Hungary). State direction won't do it. State subsidies are expensive and distortionary. The only real course is lower taxes and less regulation - just as we've blogged many times.

Yes, it would be much better to cut tax and regulation right across the country. But the pressing priority has to be some action in places like Hull.

What McLaren shows is that Britain can still attract manufacturing investment. We can still make things. And we can still create real jobs outside the financial sector.

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www.gudanggrosiran.com Categories: growth, Unemployment

Seriously Though...

My Lord Myners in happier times

Now he tells us:

"There is nothing progressive about a government that consistently spends more than it can raise in taxation and certainly nothing progressive that endows generations to come with the liabilities incurred with respect to the current generation...

I found it very frustrating to sit in meetings with some of my fellow ministers talking about creating jobs in the green economy, creating jobs in biotechnology. The Government can't create jobs. The Government can create the environment which is conducive to the creation of jobs but it cannot create jobs and we mislead ourselves if we believe it can."

That's absolutely brilliant My Lord.

Just a shame you didn't think to mention it before.

Of course, ex-Treasury Labour Goat Myners at least got a peerage for his collaboration with Stalin - all the rest of us got was a serious headache and two decades of penury.

But seriously though, just how are we going to dig ourselves out of Labour's latest horribly deep hole - deeper and more horrible than any previous hole even they've managed to fashion?

Ratings agency Fitch advises us to tighten our belts a few notches:

"The scale of the United Kingdom's fiscal challenge is formidable and warrants a strong medium term consolidation strategy...

"Both the size of the deficit currently projected for 2011 and the failure to reduce the deficit to 3 percent of GDP within five years are striking... A more ambitious deficit-reduction path — with borrowing 1 percent lower than in budget 2010 through the medium term — would result in an earlier peak in the debt/GDP ratio and a clearly declining debt path within the medium-term horizon, helping to go some way to restoring fiscal space, or a cushion against further shocks."

Yes, but what does that actually mean? We've been trying to work it out, and to help us we've taken a quick look at George's latest public spending paper.

Let's start with his summary chart on Labour's management of the public finances - total expenditure vs total tax receipts, both as a percentage of GDP:

As we can see, whereas receipts trundled along fairly steadily at an average 38% of GDP, expenditure was on the increase virtually from the start. We moved into deficit in 2001-02, and remained there ever since - despite the economic boom up to 2007.

So starting from the gap we now have, to cut borrowing from this year's 11% of GDP down to 3% by 2014-15 entails some combination of the following (and do stop me if you've heard all this before):

1. Spending cuts - other things equal, we'd need to reduce spending by about 17%, or £120bn pa - roughly the entire UK NHS budget, say.
2. Tax increases - other things equal, we'd need to increase tax revenue by around 22% - hiking the standard rate of income tax from 20p to 50p might do it (at least, according to the HMT tax ready reckoner)
3. Increase GDP - the magic bullet - it not only increases the denominator in our calculation of borrowing as a percentage of GDP, but more importantly it generates extra tax revenue for a given set of tax rates, and reduces welfare spending as more people move into work.

Have a quick ponder on those alternatives.

Spending cuts are definitely on the agenda, and yesterday George published his framework document explaining the process by which he will attempt to deliver them. Including his hopes to engage the public in thinking the unthinkable.

But engagement or not, just how much cutting will the public tolerate over a single Parliament? And more to the point, just how many by-election defeats will Cam/Clegg tolerate? The TPA/IOD have proposed cuts totalling £50bn pa (see this blog), but even those - many of which have been rejected by Cam/Clegg - fall way short of Fitch's implied £120bn target. However much we might want to see cuts of that magnitude, realistically it just ain't going to happen.

Tax hikes are already coming thick and fast, including the new 50p top rate, higher employees' NICs, and the prospective VAT increase. But a hike delivering £120bn pa isn't on anyone's hitlist.

Besides, the one thing we must all understand by now is that tax hikes would zap any chance of help from our third alternative - the one real hope of escape - GDP growth.

As we've blogged before, the old HM Treasury rule of thumb says that a 1% increase in GDP (relative to trend) cuts the fiscal deficit by around 0.7% of GDP, through its impact on tax receipts and welfare spending.

Which in our current predicament is really rather encouraging. Because it means that we could achieve Fitch's target without spending cuts and without tax increases if we could just somehow grow our GDP by around 11% from current levels.

11%.

Surely that can't be too much to ask, can it?

Why, our last Chancellor but one wouldn't have wiped his spotty behind on a mere 11%. Over 5 years that's just 2% pa - a tad below our actual long-term trend growth rate, let alone his own historic achievements.

And that is why George really must do whatever it takes to promote growth. Not the kind of growth that depends on government support and subsidy - the green economy and biotech nonsense Lord Myners is now so irritated about. No, we must have the kind of self-sustaining growth that takes place in the real world of the market economy. And that means cutting business and payroll taxes soonest, and all other growth destroying taxes immediately thereafter.

Of course, a market-based growth strategy is no substitute for spending cuts. They need to happen anyway, and George will need to accept and spell out a decade of severe restraint. Sharing the proceeds is dead for the forseeable future, and instead, public spending growth will be held well below the growth of the economy.

But a strategy based on promoting growth offers us hope. And as we enter our decade of cuts, cuts, cuts, and more cuts, hope is something that will be in pretty short supply.

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www.gudanggrosiran.com Categories: cuts, growth

OECD Tells George To Brace Up

That's where 13 years of Labour leaves you

The OECD published its six-monthly World Economic Outlook today. And you know what? It's not all bad news.

They say that world growth is picking up faster than they expected last time, and it's been driven by China and the other emerging economies, rather than by yet more fiscal blow-outs here in the West.

So world trade is picking up again, and basket economies like the UK have a real chance of earning their way back to solvency.

Right, that's the good news over with.

The bad news is that when it comes to government borrowing we are still the worst economy in the whole of the OECD, bar Ireland (see chart above). The OECD forecasts that HM Government will borrow 11.5% of GDP this calendar year, and a further 10.3% next. Which compares with the laughably optimistic figure of 8.5% forecast by Darling for 2011-12.

The OECD's assessment?

"A weak fiscal position and the risk of significant increases in bond yields make further fiscal consolidation essential. The fragile state of the economy should be weighed against the need to maintain credibility when deciding the initial pace of consolidation, but a concrete and far–reaching consolidation plan needs to be announced upfront. While monetary policy should remain expansionary over the forecast period to support activity against the background of low levels of resource utilisation, the process of normalisation of interest rates needs to start soon in response to the expected gradual rise in underlying inflation."

Translation: public sector borrowing needs to be gripped soonest; George needs to announce a quantified plan for getting the public finances back in the black and keeping them there (aka a new set of explicit fiscal rules); the Bank of England needs to increase interest rates now before inflation balloons completely out of control.

Oh, and George will also need one of these:

PS The more we hear and see of young Mr Laws, the more impressed we are. We thought he was pretty good under fire in the Commons today, and in matters fiscal, he seems a whole lot drier than many a Tory front bencher. Hopefully he'll provide some much needed resolve when the shooting starts for real. We like him.

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www.gudanggrosiran.com Categories: cuts, growth