The UK Mid Year Budget Statement

The mid-year budget statement has prompted concerns about the UK economy. It is a classic case of 'incrementalism' and fiddling. For example, see here for benefits reform and the silliness of framing the limited reform with the discussion of 'Mummy Tax'.

This is gloomy pre-statement commentary from Alexander Heath in the Telegraph:

Psychologists call this cognitive dissonance; unkind folk would see it as plain cowardice. What is clear is that such self-deception has reached epidemic proportions when it comes to the economy, and has contaminated all major political parties as well as many professional forecasters.

In the absence of shock and awe supply-side and tax reforms, which are not on the cards, our long-term growth prospects are bleak. George Osborne’s greatest problem, as he prepares to deliver the Autumn Statement, is that the British economy is stuck in a rut.

He has grasped something of the reality. In the UK, we are now starting to see something of the negative spiral that follows in the wake of attempts to incrementally cut government borrowing growth in the face of an economy that is structured around servicing the growth in borrowing (sorry, for the convoluted sentence). However, this from the WSJ:

The U.K Treasury painted a grim economic picture, acknowledging that growth was weaker than the government expected and that a tough austerity plan would drag on longer than planned.

Treasury chief George Osborne, who presented his closely watched twice-yearly economic update Wednesday, delivered a triple whammy of bad news. He conceded the economic recovery was taking longer than expected; that he would likely fail to meet a key self-imposed debt goal; and that government cost cutting would continue until 2018, three years longer than initially planned. At that point, the U.K. will have experienced eight straight years of austerity.

Mr. Osborne and the Conservative-led coalition government is halfway through its five-year term. Having come to office promising to fix Britain's weak economy, Mr. Osborne is under immense pressure to demonstrate that his strategy is working ahead of the next general election, due 2015.

Except for the misuse of austerity, it is a reasonable summary. The pressure is no doubt building to get the money printing presses running again:

Sterling edged up from one-month lows against the euro on Wednesday after a gloomy UK budget statement which traders said was in line with expectations.

But forecasts from finance minister George Osborne that Britain would miss its debt-reduction and growth targets left the currency looking vulnerable.

Analysts said the poor UK economic outlook might revive prospects of more monetary easing by the Bank of England and increase the risk of a credit agency cutting the UK's top-notch rating, both of which would be negative for sterling.

 The OBR is taking a negative view, saying that:

The independent Office for Budget Responsibility predicted the UK economy would shrink slightly this year and grow less over the next four years than it had forecast in March. Robert Chote, chair of the watchdog, said: "What's striking is the weakness of the recovery over an extended period of time."

I hope that, for regular readers of this blog, that the 'weakness of the recovery' is in fact unsurprising, and that they already realised that the UK economy has only now just started an unavoidable process of shrinkage i.e. any economy which is structured around servicing debt growth cannot shrink the debt growth without negative consequence. Worryingly, the current state of affairs is leading to threats to the UK credit rating:

The chancellor's statement did nothing to dispel fears that the UK could be stripped of its triple A credit rating. Both Moody's and Fitch, two of the three major rating agencies, put negative outlooks on the UK's rating this year.

Whilst the ratings agencies are generally hopeless, they are still important. They make a major difference due to their role in banking regulation and their pronouncements have real impacts. I seem to recall that George Osborne placed the credit rating of the UK as one of the drivers for his policy, so any significant downgrade would certainly add to the pressure now being placed upon the government. This is Bloomberg's view on the mid-year budget statement:

In lieu of real change, he proposed a set of well-intentioned but ultimately insignificant policies, restricted by the need to make the package as a whole fiscally neutral. Osborne did not need to be this cautious.

The chancellor did act to redirect government money in a few ways likely to produce growth. He said he’d reduce the nominal rate of corporation taxes to 21 percent from 24 percent in 2014 (compared with 35 percent in the U.S.). He also increased by a factor of 10 the amount of capital investment that U.K. companies can make exempt from taxes each year, to £250,000 ($402,300) from £25,000.

Osborne scraped together £5 billion to spend on schools, transportation, and flood defenses. He also set up a body to eliminate the regulatory gridlock that’s blocking development of shale gas in the U.K. and promised tax breaks for exploration, ahead of a new policy aimed at increasing Britain’s production and use of natural gas. These are all intelligent ideas that may boost construction and employment in the near term, and growth in the longer term.

I am inclined to agree that there was no real change, but suspect that, if shale gas lives up to its promise, then this will have very significant impacts through the potential to lower energy costs; a factor in living standards but most importantly in the cost of manufacturing. However, this will not really have any major impact for several years, and before it will be a positive contributor to a more competitive economy and better living standards. In the short term, there may be a small impact through increased investment, with the activity that follows from this, but it will not be enough to significantly lift the economy. As such, although a positive, it does little to address the problems in the short term.

Nor will the rest of the measures. The problem that will now face the government will be the political pressure to reverse course. For example, I disagree with Bloomberg's view, which is inevitably echoing around the media, that the government should give a 'modest boost' to the economy by relaxing budget constraints. The one thing that the government should not do is relax on this issue.  
Regular readers will know my answer is to take more aggressive measures on government spending, at a cost of short term pain, in order to avoid a worse situation in the future. However, I accept that the real pressures mounting for the government to loosen will make this nearly impossible at this moment in time.

As a pragmatic compromise, instead, the government should follow what is (in some respects) sometimes good advice, but which is given as advice for the use of additional borrowing (i.e. the projects will increase borrowing). Rather than funding through additional borrowing, those projects which address genuine problems in infrastructure should be given as a priority but as a priority that displaces current levels of spending on consumption based services provided by the government. 
In other words, the government should cut spending to fund investment (and I mean investment in the sense before the distorted use of the word as a synonym for government spending). Where there is genuine need for certain types of infrastructure (and I here accept the current reality that government will fund this), it is a better way to use borrowed money than borrowing for consumption.This will require cuts in services, and the answers I give on how to cut remain the same.The answer is to ask which services are a priority, and then to make choices according to the priorities.

In my mind, this is best achieved by asking the question of whether service x or y is really the role of the government, and cutting anything which is not a core government function. It is a question of 'luxury' over 'necessity'. The economic question is 'what can the UK afford?' but the answers as to what is necessity and luxury are political questions. The other answer is the one that I have discussed previously in my sections on reform. Having established the priorities, how can they be delivered in a way that is cost effective, but also hold to the principles on which they were established? As an example, I have proposed reforming benefits, such that there is still a (generous) safety net for those who are confronted by bad luck / unexpected difficulties, but where the costs of the system are minimised.

As the situation stands, the UK is continuing down a road which does not address the fundamental problems of the UK, with reductions in borrowing growth that will not address the underlying economic problems, and without the kind of substantive reform necessary to lay a real foundation for economic recovery. I believe that I long ago expressed the concern that the UK government would try to resolve the UK's economic problems with incremental cuts and policy measures, and this is exactly the path being followed. The trouble with this approach is not just that overall debt continues to grow whilst the economy shrinks, but also the problem is that the inevitable contraction in the economy leaves the government open to pressure to reverse course mid-term. It is, in summary, self-defeating even when taking a political perspective.

I can never make up my mind what prevents the solutions that are possible to help resolve the problems of the UK economy; is it lack of courage, political consensus or lack of imagination, or the economists whispering 'easy' solutions in the ears of politicians. Perhaps it is all of them. I started the post with Alexander Heath's article, and who proposes cowardice; in light of the self-defeating nature of incrementalism, perhaps he is wrong? Perhaps it is just lack of imagination?