The Economic Policy of the Next UK Government

At this moment in time, it appears that (barring any major blunders) the UK will elect Conservative government at the next election. Several readers have asked me to discuss Conservative economic policy, so this post is a response to those requests. Before starting, I should emphasise that I do not have any particular loyalty/affiliation/position which predisposes me to any of the contenders in the election. In particular, regular readers will be aware that I have a libertarian 'lite' point of view, and none of the UK political parties come close to such a perspective. I am therefore looking at policy from the point of view of which party has the least negative approach.

The problem in making the comparison is that any comparison with the Labour Party will flatter the party with which the comparison is made. It would be difficult to do much worse than the current government. In particular, as regular readers will know, there is the ongoing problem with current policy of printing money and fiscal incontinence in conjunction with previous fiscal profligacy. The debt in the UK is soaring, and the only thing propping up the issuance of debt is the Bank of England's purchase of gilts through the weasel worded quantitative easing (printing money).

It might be noted that the Conservative party were unwilling to challenge the fiscal profligacy in the past, with their formulation of 'sharing the proceeds of growth'. As such, their past policy was to follow Labour into a fiscal black hole, by promising to match and continue the policy of growth of government expenditure. It now seems that the Conservatives have accepted that the current levels of government expenditure are unsustainable, and are starting the process of adapting their policy according to this point of view. For the most part, I will be using the Conservative policy document on the economy (available for download from the Conservative website here) as this is a clearer statement of their intent than speeches or the opinions of commentators. It is written by David Cameron and George Osborne, and is therefore a good indicator of policy.

However, before examining the policy document, there is one piece of news that I find very encouraging. David Cameron, the Conservative leader, has spoken out against the current practice of printing money:

Without mentioning the central bank, Cameron told his party’s conference in Manchester that he opposed creating money, saying “sometime soon that will have to stop, because in the end, printing money leads to inflation.”

As a result, he has been subjected to criticism, in particular from David Blanchflower, who recently left the Bank of England Monetary Policy Committee:

David Blanchflower, who left the bank’s Monetary Policy Committee in May, said Cameron’s speech yesterday was “bizarre” and if put into practice may tip the U.K. into a “depression.” Shamik Dhar, a former Bank of England economist, said “at best this is wrong and at worst downright dangerous.”

Regular readers will know that I have been firmly against printing money from the outset of the policy, and I therefore see the discussion of an end of the policy as a very encouraging point. However, it is highly unlikely that the policy can continue up to the point of the next election, so this is a moot point. This is also a wider problem in the consideration of Conservative policy. Whilst they are currently offering policy considerations (as they must), it is not entirely clear what kind of economy they might inherit. For the moment, I will put this to one side, and look at their policy as if it might be implemented now.

The first section of their document is titled 'Fiscal Responsibility', which is an encouraging start, and they appear to be serious about the idea in principle. In particular, they are proposing the establishment of an independent oversight body, similar to the US Congressional Budget Office (CBO), which will report on the fiscal sustainability of government fiscal policy. As a statement of intent, this is a positive, and inclusion of private finance initiatives on the government balance sheet are all well and good. However, it might be noted that the US is still firmly on a path of fiscal profligacy despite the CBO. Also, whilst this is a positive, the UK already has independent oversight in the form of the Institute of Fiscal Studies, which is genuinely independent.

More worrying is that the remit of the organisation will be to look at fiscal policy and consider the sustainability of the policy 'adjusted for the cycle', and a proposal that there is 'a balanced current budget adjusted for the cycle'. It is in this statement that the major concern arises. Whilst the policy discusses the consideration of uncertain forecasts, it still allows for governments to borrow money based upon assumptions of some kind of knowledge of where the economy might be in the 'cycle'. It therefore ignores the fundamental solution to fiscal responsibility, which is that, barring disaster such as war, government should have no need to borrow.

After all, the government has a massive tax base, and should therefore be able to fund activity out of current income. In particular, if the government wishes to instigate a counter cyclical policy, it should save for a rainy day, a phrase that is included in the policy document. However, their policy implies that a government can save for a rainy day, and still borrow when the rainy day arrives. Why not simply save during the good times, and spend the saved money when the rainy day arrives? There is no need for government to borrow, except in times of war or disaster. It might be noted that, as a result of past borrowing, it will be a long, long time before a government is able to actually save money for a rainy day, as they will have a long period of paying down current debt.

Section 2 of the document is also headed with an encouraging title, which in this case is 'Financial Responsibility'. However, within the document are many worrying ideas. Perhaps the most worrying aspect is that the policy sees a transfer of considerable responsibility to the Bank of England for financial stability. As I have pointed out in previous posts (e.g. here - a long post), the regulatory framework and monetary policy of central banks made a significant contribution to the financial crisis, and giving them more power appears to be a perverse solution to future financial stability.

One of the cornerstones of the policy is that the Bank of England will have responsibility for spotting market-wide risks. This sounds very appealing in light of the disaster that has overtaken the financial system, but assumes that the Bank of England can actually see the risks in advance. As I have endlessly pointed out in past posts, the Basel rules (the foundation of bank regulation) included provisions such as very low capital adequacy ratios for lending into OECD banks, and for lending to OECD governments. With regards to the former, the OECD banks were the ones that were found to be insolvent, and the non-OECD banks were the ones that came out of the crisis relatively unscathed. In other words, the understanding of risk in the financial system was 100% wrong. Furthermore, there are now question marks over the sustainability of OECD government debts, which are still treated as zero risk.

The question here is very simple. If the central banks and regulations based upon their view of risk were so wrong in the past, why on earth should they get it right in the future?

On a more positive note, the policy discusses giving the Bank of England new powers to deal with banks when they are failing. However, there is no mention of the real problem, which is the so called 'too big to fail banks'. I have largely argued against regulation, but do believe that regulation should deal with the problem of 'too big to fail' banks, and that means breaking up 'too big to fail' banks, and ensuring that no bank is of a scale that it might create a systemic risk. The one lesson of the financial crisis that cries out for new regulation is the one area that is ignored.

Instead of dealing with the underlying problem, the Conservative policy instead moves into the emotive area of 'Tackling Reckless Bonus Structures'. If the policy were to address the issue of 'too big to fail', there would be no need to tackle reckless bonus structures, as excessive risk by a bank would result in insolvency, and the insolvencies would act as a warning to other banks. The point here is that banks must be small enough such that governments feel no need to ever rescue them when they fail.

Another problem that is not addressed is the ongoing ability of banks to pay organisations to rate their standing and rate their products. Again, the Basel rules encouraged this practice by having the ratings provided by the bank paid ratings agencies used as the basis of capital adequacy. The simple solution is that financial institutions should not be allowed to pay any organisation to rate anything. Ratings should be paid for by the purchaser of the product, not the seller. In allowing the banks to pay for ratings, the development of a market for independent ratings is throttled. Again, with an encouragement of genuinely independent ratings agencies, there would be no need for regulatory interference in banking bonuses. Excessive risk would be punished by independent ratings.

Another policy outlined in the policy document is closely related to this problem. The Conservatives are proposing tighter regulation of consumer credit. Some of their proposals, such as greater provision of information, and a cooling off period for store credit cards are very good. However, they fail to tackle one of the central problems of the provision of financial information, which is that the providers of the information are often working on commission from the financial institutions. Once again, the financial institutions are paying for ratings of their products, and this should be made illegal.

Another problem they fail to tackle is the provision of so-called interest free credit. I describe this as so-called, as it is an impossibility. The only way that interest free credit might be offered is if the cost of the credit is loaded onto the selling price of the item. Under such circumstances cash buyers are subsidising the credit of others, and this is an encouragement of indebtedness. It is a fraud to describe any retail credit as interest free, as all credit has a cost (even if a cash rich retailer offers this, there is an opportunity cost). The same might be said of teaser rates, and a whole host of methods that encourage consumers into excessive debt through provision of distorted information and downright fraud (e.g. self-cert mortgages in the hands of commissioned advisers).

With regards to taxation, the picture is more encouraging. As I identified in a previous post, the taxation system is far too complicated at every level. The Conservative policy recognises this and proposes the establishment of an Office of Tax Simplification which will be tasked with the simplification of the whole tax system. Of particular note is that there will be significant oversight of the taxation system, including a commitment to preventing 'stealth' taxation. This is a worthy aim, and it just remains to be seen whether the new organisation can actually deliver on the ambition inherent in the office's name.

A more problematic area is the discussion of tax reduction. Whilst there may be arguments for and against any level of taxation, the discussion of tax reduction is a purely academic debate. In the current fiscal situation, it is unlikely that any reduction in the overall level of taxation might take place. As such, the discussion of tax reductions looks to be disingenuous. For example, they discuss a reduction in corporation taxes, but also propose a raft of so-called green taxes. In doing so, they will likely give with one hand, only to take away with another.

The instigation of the 'green' taxes also has potential to add to the complexity and cost of the management of taxation, thereby potentially undermining the stated aim of tax simplification. The real answer to the problem of taxation is genuine simplification, and I outline how this might be achieved in a post here (I have since come up with ideas as to how the proposed system could be streamlined, and will post on this at some time in the future).

The final section of the policy document again has an appealing title, which is 'A More Balanced Economy'. The analysis of the problem is very sound, as they identify that most of the 'growth' in the economy has been related to government, housing and retail/wholesale and related activities, and note that manufacturing has 'flatlined'. They do not however note that the 'growth' that these describe is actually resultant from borrowed money, so not real growth at all, but rather foregoing of future growth. It is the great myth of GDP growth, which does not represent real growth at all (see here for why).

As a solution to the unbalanced growth, they look at the essential infrastructure of the UK, including diverse policy areas such as education, welfare reform, and road building. As such, their proposals are that reform in the infrastructure will encourage improvements in the balance of the UK economy. This is a difficult proposal to evaluate without an evaluation of each individual policy and, even then, it would still be difficult to determine cause and effect in terms of the re-balancing of the economy.

One point that they do not discuss is the UK economy in terms of the world economy. In particular, there is no discussion of the mercantilism practices of countries such as China, which actively result in unfair competition in manufacturing, and also in the theft of intellectual property. Whilst the emerging economies will, in all cases, be tough competitors, the mercantilism policies utilised undermine the potential for re-balancing the UK economy. This is perhaps the single most important area of policy, how to deal with mercantilism, but it is not addressed in any form.

There is one area of the policy document that will actively work against the redevelopment of manufacturing, which is the implementation of so-called green policies. These appear throughout the entire policy document, and are largely focused on the issue of carbon dioxide emissions in relation to the idea of man made global warming. At this point, I should mention that I am a man made global warming skeptic, so you may wish to bear this in mind. However, even if believing that global warming is man made, there is a fundamental problem in the implementation of 'green' policy; it will fall hardest on manufacturers who are large energy users. These companies will be faced with increasing costs due to the green policies, and this will undermine their competitive position. This will result in outcomes that will work against the re-balancing towards manufacturing.

The reasons for these outcomes are very simple; not all countries are going to follow the same level of 'green' policy, and those that implement the strongest policy will provide competitive advantage to those that follow the weakest policy. In such a situation, all that will happen is that the carbon dioxide emissions will simply be displaced from the 'green' country to the competitors with less 'green' policy. In many cases, this will lead to higher emissions, with countries like China being less efficient in their energy utilisation. In other words, without binding standards across every country, 'green' policy will simply shift manufacturing overseas, and will likely increase overall output of carbon dioxide overall. Unless there are universal standards, this is simply a policy to encourage further declines in manufacturing.

In this analysis, I have outlined a broad brush view of the proposals of the economic policy of the Conservative Party. However, I have only covered a fraction of the detail, and have been selective in what I have examined. I would therefore suggest that you read their document in full, to see the many points and detail that I have not included. It should also be noted that some of the details have yet to be filled in by the Conservative Party.

With regards to my overall assessment, I view their approach as a positive in comparison with current policy, but that is an assessment that commences from a low benchmark. Overall, I see the policy as tinkering with the current system, with a few improvements here and there, and some profoundly negative policy, such as the 'green' elements of the policy. The most encouraging idea is the simplification of taxation, which is a long overdue reform, but I have reservations about whether this will not see new complications enacted in, for example, the implementation of 'green' policy.

Altogether, what is really lacking is a radical rethinking of the underlying principles of what government, and government institutions, are actually there for. I have discussed several reforms which address these fundamental issues (such as the post linked to earlier on taxation). I am not proposing that the posts that I have presented on reform are the only answers, or that they are the best answers, but in each post I have asked what the underlying purpose of the government is for the area under discussion.

What is lacking in the conservative policy is this questioning. What are education, welfare policy, tax policy supposed to do, and how might they be achieved? Instead, the Conservative policy document commences with an assumption that, somehow, what is policy today is the starting point, rather than starting thinking from the principles of what policy in each area needs to finally achieve. It is policy built upon the legacy of what has gone before, rather than asking what the policy should deliver, and then proposing how that delivery might be achieved. It is the reason for the tinkering approach, rather than a root and branch examination built upon the underlying purpose in the policy.

As I have emphasised throughout the blog, the world is changing fast, and is becoming a far more competitive place. There are many good points in the UK system (from my point of view), such as the universal access to healthcare. In order to be able to afford such benefits, the rest of the system must be addressed, as well as how those benefits are delivered. I have, for example, linked to the post on tax reform. One of the aims of this reform is to free up huge amounts of potentially productive labour that is currently tied up in the complexity of managing the tax system. It is only if these root and branch reforms are made that the UK will be able to continue to afford to continue in the provision of state funded healthcare. I have also posted on reform of the health service, the provision of unemployment benefits, and education.

In a tougher world, these kind of deep rooted reforms, with likely better proposals than mine, are the only way that government might actually be able to afford to continue with the many benefits that the UK has formerly provided. In some respects, the Conservative policy is going in the right direction, but I suspect that, by the time they reach government, their policy will need to face up to a much harder reality, a reality imposed by a tougher world. The UK is not as wealthy as it still appears, and is still living on overseas borrowing. At some point, that borrowing must stop, and only radical reform will allow for the UK to continue with a good lifestyle when exposed to the real level of wealth in the economy. Quite simply, there will be no room for fat.

There remains in the Conservative policy a belief that the UK is wealthier than it actually is. They are confusing the living standard that has been supported by debt with the living standard that will be imposed when the debt stops. This is perhaps the reason for their timidity. It is this failure to face up to the underlying reality of the UK economy that really leaves me unconvinced. However, perhaps by the time they reach government the reality may be so plain, that they will indeed adapt? On this I can only speculate.