Magic Money Trees

‘There is no​ magic money tree,’ Theresa May said during the election campaign when confronted by a nurse complaining about low pay. Yet now that the Conservatives need the support of the DUP to give them a working majority, suddenly the magic money tree appears: £1 billion of additional spending has been promised to Northern Ireland. Can austerity survive such hypocrisy?

The government’s budget deficit (‘public sector net borrowing’) currently stands at around £50 billion, in which context £1 billion for Northern Ireland is small beer. And in truth the Tories have been combining spending cuts with tax giveaways for some time now. But this episode encapsulates something that the election result made clear: austerity has become a vote loser for the Tories. Austerity, we are told, is now dead. The implication for some is that if the Tories stop the cuts designed to reduce the government deficit, they can win the next election. But this fails to acknowledge two points: first, how difficult it will be politically for the Tories to abandon austerity; second, that even if they were to stop trying to reduce the deficit they wouldn’t in fiscal terms be doing any more than standing still.

The deficit in the financial year 2016-17 was about 2.5 per cent of GDP. The key measure of economic sustainability is the ratio of government debt to GDP (the existence of a deficit means that debt is growing, but so is GDP). A deficit of around 2.5 per cent of GDP is enough to stop the debt to GDP ratio rising, even if real GDP growth is disappointing over the next few years. As the markets are quite happy to buy UK government debt – and there is absolutely no reason they shouldn’t be – there is no economic problem with ending austerity.

One political problem is that the chancellor, Philip Hammond, recently described the current deficit of 2.5 per cent as ‘not sustainable’. Hammond, probably with support from senior Treasury civil servants, wants to start reducing the government debt to GDP ratio as soon as possible. For the moment he appears secure in his job (the strong rumour before the election was that May would sack him once she had won a clear victory), so ending austerity would require him to eat his words. The more serious political issue, however, is the Tories’ reputation for economic credibility. Cameron and Osborne won the 2015 election in large part because they scored much higher with voters on the question of who would be better, Tories or Labour, at running the economy. They did not gain this reputation because of their record on economic growth or increased living standards. The UK’s recovery from the global financial crisis was the slowest for a hundred years, and real wages had undergone an unprecedented decline. The Tories were thought to be more credible because of austerity.

The narrative that much of the public came to believe is that the Tories were ‘clearing up the mess Labour had left’. The Tories may be administering austerity, but Labour had caused it to be necessary. Osborne pulled off the trick of reducing economic competence to a single economic measure: the government’s budget deficit. Only the Tories had taken ‘the difficult decisions’ to bring the deficit down. Economists like Paul Krugman and me argued that in fact it was the height of incompetence to start bringing the deficit down so early in the recovery, but our voices were largely drowned out by what I call ‘mediamacro’, one of whose tenets is that the government is just like a household in needing to balance its books.*

If the Tories abandon deficit reduction now, they risk losing their reputation for economic competence among those who voted for them in 2017. What may happen instead is that Hammond relaxes his targets a little, but keeps the aim of decreasing the deficit by 2020. He tried something similar after the EU referendum, postponing the date by which he expected to balance the budget, but keeping most of the spending cuts designed to get us there.

The second problem with abandoning deficit reduction is that, at best, it does no more than maintain public services at today’s levels. There will be nothing to match the largesse of Labour’s 2017 election manifesto. The current target for 2020 is a deficit of 1 per cent of GDP. If Hammond relaxes austerity by raising the target to 2 per cent of GDP, that gives him about £20 billion more to play with. That sounds a lot, but more than half of it would be required merely to keep the NHS standing still. Abolish the planned cuts to welfare spending and schools, and there wouldn’t be anything left. Of course the Tories would have more money to play with if they were willing to increase the deficit, but that would risk handing the mantle of economic competence to Labour.

If the reason for Labour’s unexpectedly good 2017 election result was that many voters were fed up with current levels of spending on public services, merely leaving those levels unchanged will hardly be a vote winner at the next election. Labour will always be able to offer more than the Tories in the way of public spending increases because they are prepared to put up taxes. The Labour manifesto pledged almost £50 billion of extra spending, funded by additional taxes of the same amount. This higher spending has nothing to do with relaxing austerity in the sense of increasing the deficit – current spending is balanced under these proposals – but it does straightforwardly represent an increase in the size of the state.

The Institute of Fiscal Studies argued that in practice Labour’s tax measures would fall short of raising the amount required, but that is irrelevant to the point I’m making. Labour’s manifesto was attractive because they were prepared to put up taxes, not because they were abandoning austerity. In many cases these were the same taxes that the Conservatives reduced between 2010 and 2017, most obviously corporation tax, which Labour proposed returning to its level of 2011.

This goes to the heart of an apparent contradiction in the Tories’ austerity policy that has been there since its inception in 2010. All the rhetoric has been about the necessity of cutting spending in order to reduce the deficit. Yet Osborne also cut taxes: corporation tax in particular, but also inheritance tax. It isn’t unreasonable to argue that the true political rationale for pursuing ‘austerity’ was to permanently reduce the size of the state. The pretext was necessary because making the state smaller as an end in itself has never been very popular. The British Social Attitudes survey asks people whether they would prefer lower spending and lower taxes, higher spending with higher taxes, or to keep the mix the same as it is now. No more than 10 per cent of the population have ever said they wanted tax cuts funded by lower spending. The number wanting higher spending and higher taxes reached a low point of 30 per cent in 2010, but by 2016 it had risen to 48 per cent (44 per cent wanted no change). During the period the Tories have been in power there has been a steady increase in those wanting a larger state. They won in 2015 despite this, because on balance their policy of reducing the government deficit mattered more: it made them appear competent relative to Labour, and for years Labour had made the mistake of not challenging the Tory narrative.

Conservatives might say that the share of total taxes in GDP hasn’t changed much since 2010, so where’s the evidence that they have been trying to reduce the size of the state? The problem here is best illustrated by the example of the NHS. Because of such factors as an ageing population and the introduction of new but expensive treatments, the share of NHS spending in GDP rose steadily between the 1950s and 2010. The Tories tried to reverse that trend, and predictably it has caused chaos. As voters indicate a wish to spend more of their income on health, that is bound to mean that the size of the state will rise over time, and the tax share with it. The Tories will not be able to compete with Labour’s offer in terms of additional spending unless they are prepared to undo the tax cuts they have made over the last seven years; relaxing austerity while trying to retain their waning reputation for economic competence won’t allow them to improve the current level of public services; and then there is Brexit. On the economic front the Tories have no obvious good moves left.