The Institute of Fiscal Studies (IFS) has just published its annual ‘Green Budget‘. This is, in effect, a pre-Budget report (or a substitute for a government ‘Green Paper’) and is published ahead of the government’s actual Budget.
The Green Budget examines the state of the UK economy, likely economic developments and the implications for macroeconomic policy. This latest Green Budget is written in the context of Brexit and the growing likelihood of a hard Brexit (i.e. a no-deal Brexit). It argues that the outlook for the public finances has deteriorated substantially and that the economy is facing recession if the UK leaves the EU without a deal.
It predicts that:
Government borrowing is set to be over £50 billion next year (2.3% of national income), more than double what the OBR forecast in March. This results mainly from a combination of spending increases, a (welcome) change in the accounting treatment of student loans, a correction to corporation tax revenues and a weakening economy. Borrowing of this level would breach the 2% of national income ceiling imposed by the government’s own fiscal mandate, with which the Chancellor has said he is complying.
A no-deal Brexit would worsen this scenario. The IFS predicts that annual government borrowing would approach £100 billion or 4% of GDP. National debt (public-sector debt) would rise to around 90% of GDP, the highest for over 50 years. This would leave very little scope for the use of fiscal policy to combat the likely recession.
The Chancellor, Sajid Javid, pledged to increase public spending by £13.4bn for 2020/21 in September’s Spending Review. This was to meet the Prime Minister’s pledges on increased spending on police and schools. This should go some way to offset the dampening effect on aggregate demand of a no-deal Brexit. The government has also stated that it wishes to cut various taxes, such as increasing the threshold at which people start paying the 40% rate of income tax from £50 000 to £80 000. But even with a ‘substantial’ fiscal boost, the IFS expects little or no growth for the two years following Brexit.
But can fiscal policy be used over the longer term to offset the downward shock of Brexit, and especially a no-deal Brexit? The problem is that, if the government wishes to prevent government borrowing from soaring, it would then have to start reining in public spending again. Another period of austerity would be likely.
There are many uncertainties in the IFS predictions. The nature of Brexit is the obvious one: deal, no deal, a referendum and a remain outcome – these are all possibilities. But other major uncertainties include business and consumer sentiment. They also include the state of the global economy, which may see a decline in growth if trade wars increase or if monetary easing is ineffective (see the blog: Is looser monetary policy enough to stave off global recession?).
- Why would a hard Brexit reduce UK economic growth?
- To what extent can expansionary fiscal policy stave off the effects of a hard Brexit?
- Does it matter if national debt (public-sector debt) rises to 90% or even 100% of GDP? Explain.
- Find out the levels of national debt as a percentage of GDP of the G7 countries. How has Japan managed to sustain such a high national debt as a percentage of GDP?
- How can an expansionary monetary policy make it easier to finance the public-sector debt?
- How has investment in the UK been affected by the Brexit vote in 2016? Explain.
What have been, and will be, the monetary and fiscal responses to the Brexit vote in the referendum of 23 June 2016? This question has been addressed in speeches by Mark Carney, Governor of the Bank of England, and by George Osborne, Chancellor the Exchequer. Both recognise that the vote will cause a negative shock to the economy, which will require some stimulus to aggregate demand to avoid a recession, or at least minimise its depth.
Mark Carney stated that:
The Bank of England stands ready to provide more than £250bn of additional funds through its normal facilities. The Bank of England is also able to provide substantial liquidity in foreign currency, if required.
In the coming weeks, the Bank will assess economic conditions and will consider any additional policy responses.
This could mean that at its the next meeting, scheduled for 13/14 July, the Monetary Policy Committee will consider reducing Bank Rate from its current level of 0.5% and introducing further quantitative easing.
In a speech on 30 June, he went further:
I can assure you that in the coming months the Bank can be expected to take whatever action is needed to support growth subject to inflation being projected to return to the target over an appropriate horizon, and inflation expectations remaining well anchored.
Then in a speech on 5 July, introducing the latest Financial Stability Report, he said that the Bank of England’s Financial Policy Committee is lowering the required capital ratio of banks, thereby freeing up capital for lending to customers. The part being lowered is the ‘countercyclical capital buffer’ – the element that can be varied according to the state of the economy. Mark Carney said:
The FPC is today reducing the countercyclical capital buffer on banks’ UK exposures from 0.5% to 0% with immediate effect. This is a major change. It means that three quarters of UK banks, accounting for 90% of the stock of UK lending, will immediately have greater flexibility to supply credit to UK households and firms.
Specifically, the FPC’s action immediately reduces regulatory capital buffers by £5.7 billion and therefore raises banks’ capacity to lend to UK businesses and households by up to £150 billion. For comparison, last year with a fully functioning banking system and one of the fastest growing economies in the G7, total net lending in the UK was £60 billion.
Thus although there may be changes to interest rates and narrow money in response to economic reactions to the Brexit vote, the monetary policy framework remains unchanged. This is to achieve a target rate of CPI inflation of 2% at the 24-month time horizon.
But what of fiscal policy?
In its Charter for Budget Responsibility, updated in the Summer 2015 Budget, the government states its Fiscal Mandate:
3.2 In normal times, once a headline surplus has been achieved, the Treasury’s mandate for fiscal policy is:
• a target for a surplus on public-sector net borrowing in each subsequent year.
3.3 For the period outside normal times from 2015-16, the Treasury’s mandate for fiscal policy is:
• a target for a surplus on public-sector net borrowing by the end of 2019-20.
3.4 For this period until 2019-20, the Treasury’s mandate for fiscal policy is supplemented by:
• a target for public-sector net debt as a percentage of GDP to be falling in each year.
The target of a PSNB surplus by 2019-20 has been the cornerstone of recent fiscal policy. In order to stick to it, the Chancellor warned before the referendum that a slowdown in the economy as a result of a Brexit vote would force him to introduce an emergency Budget, which would involve cuts in government expenditure and increases in taxes.
However, since the vote he is now saying that the slowdown would force him to extend the time for reaching a surplus beyond 2019-20 to avoid dampening the economy further. But does this mean he is abandoning his fiscal target and resorting to discretionary expansionary fiscal policy?
George Osborne’s answer to this question is no. He argues that extending the deadline for a surplus is consistent with paragraph 3.5 of the Charter, which reads:
3.5 These targets apply unless and until the Office for Budget Responsibility (OBR) assess, as part of their economic and fiscal forecast, that there is a significant negative shock to the UK. A significant negative shock is defined as real GDP growth of less than 1% on a rolling 4 quarter-on-4 quarter basis. If the OBR assess that a significant negative shock:
||occurred in the most recent 4 quarter period;
||is occurring at the time the assessment is being made; or
||will occur during the forecast period
||if the normal times surplus rule in 3.2 is in force, the target for a surplus each year is suspended (regardless of future data revisions). The Treasury must set out a plan to return to surplus. This plan must include appropriate fiscal targets, which will be assessed by the OBR. The plan, including fiscal targets, must be presented by the Chancellor of the Exchequer to Parliament at or before the first financial report after the shock. The new fiscal targets must be approved by a vote in the House of Commons.
||if the shock occurs outside normal times, the Treasury will review the appropriateness of its fiscal targets for the period until the public finances return to surplus. Any changes to the targets must be approved by a vote in the House of Commons.
||once the budget is in surplus, the target set out in 3.2 above applies.
In other words, if the OBR forecasts that the Brexit vote will result in GDP growing by less than 1%, the Chancellor can delay reaching the surplus and thus not have to introduce tougher austerity measures. This, in effect, is what he is now saying and maintaining that, because of paragraph 3.5, it does not break the Fiscal Mandate. The nature of the next Budget, probably in the autumn, will depend on OBR forecasts.
A few days later, George Osborne announced that he plans to cut corporation tax from the current 20% to less than 15% – below the rate of 17% previously scheduled for 2019-20. His aim is not just to stimulate the economy, but to attract inward investment, as the rate would below that of any major economy and close the rate of 12.5% in Ireland. His hope would also be to halt the outflow of investment as companies seek to relocate in the EU.
Videos and podcasts
Statement from the Governor of the Bank of England following the EU referendum result Bank of England (24/6/16)
Uncertainty, the economy and policy – speech by Mark Carney Bank of England (30/6/16)
Introduction to Financial Stability Report, July 2016 Bank of England (5/7/16)
Osborne: Life will not be ‘economically rosy’ outside EU BBC News (28/6/16)
Osborne takes ‘realistic’ view over surplus target BBC News (1/7/16)
Why has George Osborne abandoned a key economic target? BBC News (1/7/16)
Mark Carney says Bank of England ready to inject £250bn into economy to keep UK afloat after EU referendum Independent, Zlata Rodionova (24/6/16)
Carney Signals Rate Cuts as Brexit Chaos Engulfs Political Class Bloomberg, Scott Hamilton (30/6/16)
Bank of England hints at UK interest rate cuts over coming months to ease Brexit woes International Business Times, Gaurav Sharma (30/6/16)
Carney prepares for ‘economic post-traumatic stress’ Financial Times, Emily Cadman (30/6/16)
Bank of England warns Brexit risks beginning to crystallise BBC News (5/7/16)
Bank of England tells banks to cut buffer to boost lending Financial Times, Caroline Binham and Chris Giles (5/7/16)
George Osborne puts corporation tax cut at heart of Brexit recovery plan Financial Times (3/7/16)
George Osborne corporation tax cut is the wrong way to start EU negotiations, former WTO boss says Independent, Hazel Sheffield (5/7/16)
George Osborne abandons 2020 UK surplus target Financial Times, Emily Cadman and Gemma Tetlow (1/7/16)
George Osborne scraps 2020 budget surplus plan The Guardian, Jill Treanor and Katie Allen (1/7/16)
Osborne abandons 2020 budget surplus target BBC News (1/7/16)
Brexit and the easing of austerity BBC News, Kamal Ahmed (1/7/16)
Osborne Follows Carney in Signaling Stimulus After Brexit Bloomberg, Simon Kennedy (1/7/16)
- Explain the measures taken by the Bank of England directly after the Brexit vote.
- What will determine whether the Bank of England engages in further quantitative easing beyond the current £385bn of asset purchases?
- How does monetary policy easing (or the expectation of it) affect the exchange rate? Explain.
- How effective is monetary policy for expanding aggregate demand? Is it more or less effective than using monetary policy to reduce aggregate demand?
- Explain what is meant by (a) capital adequacy ratios (tier 1 and tier 2); (b) countercyclical buffers. (See, for example, Economics 9th edition, page 533–7 and Figure 16.2))
- To what extent does increasing the supply of credit result in that credit being taken up by businesses and consumers?
- Distinguish between rules-based and discretionary fiscal policy. How would you describe paragraph 3.5 in the Charter for Budget Responsibility?
- Would you describe George Osborne’s proposed fiscal measures as expansionary or merely as less contractionary?
- Why is the WTO unhappy with George Osborne’s proposals about corporation tax?
- What is the Nash equilibrium of countries seeking to undercut each other’s corporation tax rates?
On election to office in May 2015, the UK’s Conservative government set new fiscal targets. These were set out in an updated Charter for Budget Responsibility. As Box 12.3 in Essentials of Economics (7th edition) states:
The new fiscal mandate set a target for achieving a surplus on public-sector net borrowing by the end of 2019/20. More controversially, government should then target a surplus in each subsequent year unless real GDP growth falls below 1 per cent … Meanwhile, the revised supplementary target for public-sector debt was for the net debt-to-GDP ratio to fall each year from 2015/16 to 2019/20.
What is more, the Charter requires the government to set a cap on welfare spending over a five-year period. Such spending includes spending on pensions, tax credits, child benefit and unemployment benefit. In July 2015 the Chancellor set this cap at £115bn for 2016/17, a reduction of £12bn.
Whether or not such a tight fiscal target is desirable, the government has been missing the target. In November last year, the Chancellor had to backtrack on his plans to make substantial reductions in tax credits and as a result the welfare cap has been breached, as the following table from page 5 of the December 2015 House of Commons briefing paper shows.
Also, with the slowing of economic growth, the Chancellor has stated that he will miss the requirement for a fall in the net debt-to-GDP ratio unless further cuts in government spending are made, equivalent to 50p in every £100.
But, if the economy is slowing, is it right to cut government expenditure? In other words, should there be some discretion in fiscal policy to respond to economic circumstances? There are two issues here. The first is whether the resulting cut in aggregate demand will be detrimental to growth. The second is who will bear the cost of such cuts. Critics of the government claim that it will largely the poor who will lose if the cuts are made mainly from benefits.
The articles below examine the public finances, the difficulties George Osborne has been facing in sticking to his fiscal mandate and the options open to him.
Budget 2016: Osborne’s economic fitness regime BBC News, Andy Verity (14/3/16)
Budget 2016: George Osborne fuels speculation of nasty shocks The Guardian, Larry Elliott and Anushka Asthana (14/3/16)
Charter for Budget Responsibility: Summer Budget 2015 update HM Treasury (July 2015)
OBR publications, including ‘Economic and fiscal outlook’ and ‘Fiscal sustainability report’ Office for Budget Responsibility
- Outline the main points of the Charter for Budget Responsibility (CBR).
- What are the arguments for sticking to fiscal rules, such as those in the CBR?
- What are the arguments for using discretion to adjust fiscal policy as economic circumstances change?
- Compare the Conservative government’s fiscal mandate with the newly announced approach to fiscal policy of the Labour opposition?
- How does the Labour Party’s new approach differ from the Golden Rule followed by Gordon Brown as Chancellor in the Labour government from 1997 to 2007?
- What factors will determine whether or not the government will return to meeting the rules set out in the Charter for Budget Responsibility?
In his annual Mansion House speech to business leaders on 10 June 2015, George Osborne announced a new fiscal framework. This would require governments in ‘normal times’ to run a budget surplus. Details of the new framework would be spelt out in the extraordinary Budget, due on 8 July.
If by ‘normal times’ is meant years when the economy is growing, then this new fiscal rule would mean that in most years governments would be require to run a surplus. This would reduce general government debt.
And it would eventually reduce the debt from the forecast ratio of 89% of GDP for 2015 to the target of no more than 60% set for member states under the EU’s Stability and Growth Pact. Currently, many countries are in breach of this target, although the Pact permits countries to have a ratio above 60% provided it is falling towards 60% at an acceptable rate. The chart shows in pink those countries that were in breach in 2014. They include the UK.
Sweden and Canada have similar rules to that proposed by George Osborne, and he sees them as having been more able to use expansionary fiscal policy in emergency times, such as in the aftermath of the financial crisis of 2007/8, without running excessive deficits.
Critics have argued, however, that running a surplus whenever there is economic growth would dampen recovery if growth is sluggish. This makes the rule very different from merely requiring that, over the course of the business cycle, there is a budget balance. Under that rule, years of deficit are counterbalanced by years of surplus, making fiscal policy neutral over the cycle. With a requirement for a surplus in most years, however, fiscal policy would have a net dampening effect over the cycle. The chancellor hopes that this would be countered by increased demand in the private sector and from exports.
The rule is even more different from the Coalition government’s previous ‘fiscal mandate‘, which was for a ‘a forward-looking target to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period’. The current budget excludes investment expenditure on items such as transport infrastructure, hospitals and schools. The fiscal mandate was very similar to the former Labour government’s ‘Golden rule’, which was to achieve a current budget balance over the course of the cycle.
By excluding public-sector investment from the target, as was previously done, it can allow borrowing to continue for such investment, even when there is a substantial deficit. This, in turn, can help to increase aggregate supply by improving infrastructure and has less of a dampening effect on aggregate demand. A worry about the new rule is that it could lead to further erosion of public-sector investment, which can be seen as vital to long-term growth and development of the economy. Indeed, Sweden decided in March this year to abandon its surplus rule to allow government borrowing to fund investment.
The podcasts and articles below consider the implications of the new rule for both aggregate demand and aggregate supply and whether adherence to the rule will help to increase or decrease economic growth over the longer term.
Video and audio podcasts
George Osborne confirms budget surplus law Channel 4 News, Gary Gibbon (10/6/15)
Osborne To Push Through Budget Surplus Rules Sky News (10/6/15)
OECD On Osborne’s Fiscal Plans Sky News, Catherine Mann (10/6/15)
‘Outright fiscal madness’ Osborne’s Mansion House Speech RT UK on YouTube, Harry Fear (11/6/15)
A “straightjacket” [sic] on future government spending? BBC Today Programme, Robert Peston; Nigel Lawson (11/6/15)
Thursday’s business with Simon Jack BBC Today Programme, Gerard Lyons (12/6/15)
Osborne seeks to bind successors to budget surplus goal Reuters, David Milliken (10/6/15)
George Osborne to push ahead with budget surplus law The Telegraph, Peter Dominiczak (10/6/15)
Osborne Wants U.K. to Build Treasure Chest During Good Times Bloomberg, Svenja O’Donnell (10/6/15)
Questions over Osborne’s Victorian-era budget plans BBC News (10/6/15)
Years more spending cuts to come, says OBR BBC News (11/6/15)
Is Chancellor right to want surplus in normal times? BBC News, Robert Peston (10/6/15)
George Osborne Unveils New Budget Surplus Law, But Critics Warn It Means Needless Cuts Huffington Post, Paul Waugh (10/6/15)
George Osborne’s fiscal handcuffs are political, but he does have a point Independent, Hamish McRae (11/6/15)
Osborne’s budget surplus law follows UK tradition of moving goalposts Financial Times, Chris Giles (10/6/15)
George Osborne’s budget surplus rule is nonsense and it could haunt Britain for decades Business Insider, Malaysia, Mike Bird (10/6/15)
To cut a way out of recession we need growth, not austerity economics Herald Scotland, Iain Macwhirter (11/6/15)
George Osborne moves to peg public finances to Victorian values The Guardian, Larry Elliott and Frances Perraudin (10/6/15)
The Guardian view on George Osborne’s fiscal surplus law: the Micawber delusion The Guardian, Editorial (10/6/15)
Academics attack George Osborne budget surplus proposal The Guardian, Phillip Inman (12/6/15)
Osborne plan has no basis in economics Guardian letters, multiple signatories (12/6/15)
Is there an optimal debt-to-GDP ratio? Vox EU, Anis Chowdhury and Iyanatul Islam
No basis in economics Mainly Macro, Simon Wren-Lewis (16/6/15)
- Explain what is meant by a ‘cyclically adjusted current budget balance’.
- How does the speed with which the government reduces the public-sector debt affect aggregate demand and aggregate supply?
- What are the arguments for and against running a budget surplus: (a) when there is currently a large budget deficit; (b) when there is already a budget surplus? How do the arguments depend on the stage of the business cycle?
- Do you agree with the statement that ‘the biggest issue with the UK economy right now is not the government deficit’. If so, what bigger issues are there?
- How could public-sector debt as a proportion of GDP decline without the government running a budget surplus?
- How might the term ‘normal times’ be defined? How does the definition used by the Chancellor affect the rate at which the public-sector debt is reduced?
- How sustainable is the current level of public-sector debt? How does its sustainability relate to the interest rate on long-term government bonds?
- If there is a budget surplus, such that G – T is negative, what can we say about the balance betwen (I + X) and (S + M)? What good and adverse consequences could follow?
- Why do George Osborne’s plans for budget surpluses ‘risk a liquidity crisis that could also trigger banking problems, a fall in GDP, a crash, or all three’?
Original post (24/4/12)
The result of the first round of the French presidential elections on 22 April make it likely that François Hollande will be the new president.
M. Hollande can be described as an austerity sceptic. In other words, he questions the wisdom of trying to meet the target agreed by eurozone countries of reducing public-sector deficits to no more than 3% of GDP.
If elected, M. Hollande promises to adopt a more Keynesian stance of stimulating demand in order to prevent a slide into recession. This would mean a reversal of cuts and a growth, at least temporarily, of the public-sector deficit.
Currently France’s deficit is much higher than the 3% target. In 2010 it was 7.1%; in 2011 it had fallen somewhat to 5.2%. But it is set to rise in 2012, thanks to the slowing economy in France and most of the rest of Europe.
And it is not just in France that ‘austerity sceptics’ are on the ascendant. In the Netherlands the centre right government of Mark Rutte fell. He was unable to get his coalition partners to agree to sufficient cuts to achieve the 3% target. And yet, the Netherland’s deficit is considerably lower than most eurozone countries’. In 2012 it is projected to be just 4.6% of GDP.
So if doubts about the 3% target could lead to a change in policy in the Netherlands and France, what hope is there that the targets could be adhered to by countries with much larger deficits and where the pain of the cuts is already causing political turmoil?
The growth in austerity scepticism has spooked the markets. The day following M. Hollande’s first round victory and the fall of Mark Rutte’s government, stock markets around Europe plummeted and bond prices rose. The higher bond prices will make it even harder for governments to refinance maturing government debt. Take the case of France. As Robert Peston remarks in his article below:
According to IMF figures, 59% of France’s government debt is held overseas – which means that well over half of all lending to the French state is not motivated by sentimentality or patriotism in any way.
To put that figure into context, just 24.8% of UK general government debt is provided by foreigners.
Perhaps more relevantly, the French government has to borrow a colossal sum equivalent to 18.2% of GDP this year and 19.5% next year to finance debt that is maturing and the current deficit.
So what are the implications of the rise in austerity scepticism? Will it make deficits harder to finance? Will a collapse of confidence push the eurozone into a deep recession. Might the eurozone break apart? Or will a dose of Keynesian policies turn the tide and allow growth to resume, making it easier to service government debts? The following articles explore the issues?
François Hollande was indeed elected president on 6 May. The question now is to what extent he will be able to enact measures to simulate the economy. In his campaign he had talked about renegotiating the European treaty on budget discipline. Angela Merkel, responding to M. Hollande’s victory, said that the European fiscal treaty had been agreed and could not be renegotiated. Nevertheless, she said she was happy to consider new growth strategies that did not involve increased budget deficits.
François Hollande’s potential spending spree in France has caused concern in austerity Europe The Telegraph, Bruno Waterfield (23/4/12)
European turmoil, American collateral Guardian, Robin Wells (24/4/12)
Political risk returns to eurozone debt crisis Financial Times, Richard Milne (23/4/12)
The rise of Europe’s austerity foes Business Spectator, Karen Maley (23/3/12)
Europe: A crisis of the centre BBC News, Paul Mason (24/4/12)
Is Hollande enemy or prisoner of finance? BBC News, Robert Peston (23/4/12)
President Hollande and the IMF BBC News, Stephanie Flanders (23/4/12)
French Bond Yields Test Hollande’s Economic Fealty Bloomberg, Mark Deen and Anchalee Worrachate (24/4/12)
Dutch and French politics bring us back to reality BusinessDay (South Africa), Ron Derby (24/4/12)
Crisis topples governments like dominos Deutsche Welle, Bernd Riegert (24/4/12)
Eurozone leaders push for growth BBC News (25/4/12)
Additonal articles (after 6 May)
Francois Hollande to set France on new course after win BBC News (7/5/12)
Europe elections: German Chancellor Angela Merkel welcomes Francois Hollande but warns Greece The Telegraph, 7/5/12)
A Merkel-Hollande bust-up? Less likely than you might think Guardian, Philip Oltermann (7/5/12)
Merkel Rejects Stimulus in Challenge to Hollande BloombergBusinessweek, Patrick Donahue and Tony Czuczka (7/5/12)
François Hollande’s chemistry with Angela Merkel crucial for Europe Guardian, Ian Traynor (7/5/12)
Q&A: End of austerity? BBC News (7/5/12)
Austerity and the people’s verdict Guardian letters, Shanti Chakravarty and others (8/5/12)
Europe: The big debate BBC News, Stephanie Flanders (11/5/12)
European Economy: Economic data Economic and Financial Affairs, European Commission
Eurozone Statistics ECB
French Economic Statistics INSEE, National Institute of Statistics and Economic Studies
Netherlands Statistics CBS, Statistics Netherlands
- Why do investors worry about the pursuit of Keynesian expansionary fiscal policies? Are their fears justified?
- How important is it for countries, such as the Netherlands, to retain their AAA credit rating?
- What determines bond yields?
- Do a search to find the policies advocated by M. Hollande. Assess the likely economic impact of these policies.
- What conditions are necessary for the pursuit of a tough austerity line to achieve economic growth in (a) the short term of 12 to 18 months; (b) the longer term of several years?
- Is an increased use of public-private partnerships a solution to finding a way of delivering greater infrastructure expenditure without increasing the short-term deficit?