Policy constraints on UK/SW growth in the 2010s

Policy constraints on UK/SW growth in the 2010s Professor John HudsonUniversity of Bath j.r.hudson@bath.ac.uk

Fiscal Policy and the Multiplier • Fiscal Policy involves the use of government spending and tax rates to control the economy at a macro level. • For example if growth is low and unemployment high either taxes can be cut of government spending can be increased.

The Multiplier Both will increase GDP. What is more there is a multiplier effect at work. Thus if the Government increases road building by £1 billion this will add to the economy and road builders wages who in turn will spend that money on consumer goods, e.g. eating out. This will then add to the income of the waiters and cooks who in turn will spend some of that income.

The impact on taxes • Potentially at least – there has been a debate on this for 50 odd years – GDP will increase by more than the £1 billion • Similarly the net cost to the government will be less than £1 billion because of increased tax revenue.

Unchartered Territory • For me the main surprise in the last 2 years is the extent to which the government (many many governments) were willing to spend and increase the money supply to protect the economy, not from recession but depression. This has led to:

Rising Public Debt • The debt problem has been exacerbated by falling government revenue from lower incomes and falling asset prices (reduced stamp duties). • Thus one forecast is, even with corrective measures in place, that the government debt will approach 100% of GDP by 2014

General Government Debt % GDP 2007 2010 2014 • France 63.8 85.4 96.3 • Germany 63.4 84.5 89.3 • India 80.5 85.9 78.6 • Japan 187.7 227.0 245.6 • UK 44.1 81.7 98.3 • USA 61.9 93.6 108.2 • Source IMF October 2009 • People may say we are only a little worse than France, but it is the speed we have got there which causes concern.

Now the Reckoning • But we live in an unforgiving world ruled not by governments but the market. There is a limit to how far governments can borrow, before the market gets nervous and starts to raise interest rates. • This is what Greece has just discovered.

Credit Default Swaps (CDS) • Part of the risk can be perceived from looking at these. They are a derivative, relating to the riskiness of an asset. • With respect to sovereign (i.e. country) debt they are an indication of the riskiness of the country, on the probability of it defaulting on its debt.

This indicates that the UK is viewed as more risky than most OECD nations.

Although not quite on a par with Greece, Spain and Portugal.

This is why government cuts and tax increases are under way (IFS)

Planned Revenue Changes since 2007-8 • From April 2010, a 50p rate of income tax on income above £150,000 and withdrawal of the personal allowance (PA) from incomes above £100,000, • from April 2011, restriction of tax relief on their pension contributions for anyone who saves in a pension whose gross income is above £130,000 and whose income plus any employer pension contributions is assessed to be over £150,000; • from April 2011, a 1p rise in employee and employer rates of National Insurance (NI), with an increase in the point at which NI is paid benefiting lower earners; • above-inflation increases in fuel duties each April to 2013 affecting motorists.

Plans to cut expenditure are more vague although we can see some evidence in university and local government cuts (IFS)

Below is one forecast of what will happen to the debt burden (IFS)

Why the scenarios? • In this case because of the potential impact of the debt burden on the interest rates we will have to pay. • The IMF estimate that a persistent increase in debt of about 20 percent of GDP would raise debt service costs by more than 1½ percent of GDP in G-20 countries. • This is what the different scenarios represent.

Still Too Optimistic? • It is based on annual growth of well above 2% pa and I do not believe that is probable. • It is not clear whether this fully takes account of the aging of the population which will reduce income and raise expenditure.

Risks as perceived by IMF • At a minimum, there is a risk that the public debt issuance in the coming years could crowd out private sector credit growth, gradually raising interest rates for private borrowers and putting a drag on the economic recovery. • A more serious risk is from a rapid increase in interest rates on public debt. • Finally, there is the risk of a substantial loss in investor confidence in some sovereign issuers, with negative implications for economic growth and credit performance in the affected countries.

So whoever wins the election cuts will be made! • Although there may be differences at the margin whichever party is in power we are likely to see taxes rise and public sector spending fall. • Conventional wisdom too suggests that governments like to get the nasty things out the way early in its life, hoping it will reap benefits later when we approach an election. • There will be sharp cuts and tax rises in 2011 at the latest and the strong possibility exists that they will be substantially more severe than already announced. • Even if government spending overall would stay constant, increasing debt repayments mean cuts have to be made elsewhere.

What will be cut? • The situation is so serious I see few red lines lasting for more than one or two years. • Everything that can be cut will be cut. • Defence. The UK’s world role will have to be scaled down. We will have to, if we want to retain influence, work within the framework of allies.

Law & order & Defence expenditure as a % of GDP

Public health spending % of GDP, not that high, but the share of the public sector is!

TAXES • All taxes will be under threat to rise, including VAT and income tax. • But in a competitive market place governments may be constrained in terms of how out of line with neighbouring countries the tax structure gets, both VAT and income taxes. • Carbon taxes will be particularly vulnerable to increases as they allow the government to pretend it is for environmental reasons.

Further Negative Impacts on Economy • North Sea oil is running out, • The long-term future of the UK as a financial centre is not clear • The UK is not an ideal base for manufacturing with low cost competitors attracting firms who were previously based in the UK (Cadburys at Keynsham going to Poland is just one example).

Pot Pourri • Interest rates to rise (will impact on local authority debt repayments) • University fees to rise considerably • The retirement age increased within the next five years

Total Final Demand: = C↓? + I↓? + G↓ + X↑? Keynesian policy in reverse. • The tax rises will impact negatively on consumers expenditure. • Governments will cut spending and this will cut GDP. • Investment will be held back because of a sluggish economy and rising interest rates. • Then there is the multiplier, but the multiplier in reverse gear. Expenditure cuts will have multiplier effects causing further cuts in GDP.

The economist’s & political debate • Cut hard now and risk going back into recession. • Cut later with the risk of interest rates rising, but with the hope that the economy ‘has built up sufficient momentum’ not to go back into recession when the cuts happen. • Not an argument about if to cut, but when.

The SW Risks • Aerospace • Areas around military bases • The car industry around Swindon • Because of the financial crisis per se, the financial sector in the SW particularly Bristol and Bournemouth-Poole. • Because of the multiplier effects and consumer cutbacks as well as retail trends, the retail sector including the new shopping centres at risk • Marine engineering may be susceptible to the planned tax increases focused on those with incomes greater than £100,000 pa.

The SW Risks • Transport projects will be hit, maybe even some currently in the pipeline cancelled. Particularly bad news for remoter areas of region. • Construction industry in the doldrums. • At some time the pension crisis may bite hitting the retirees in the region. • There is increasing pressure on the caring sector with the rising elderly population, but pressure on resources. • AND of course all the public sector, health, education, local authorities, weather centres….

The SW: Optimism? • Food & drink • ICT • Tourism • Creative industries • Bio-medical

How Long will the problems last? • Japan has been caught in an economic crisis, and indeed political crisis, since the early 1990s, almost two decades. • I do not see economic situation getting better in the next five years. • But I believe we will not resolve the problems for at least a decade. Beyond that is too far to see.

Only part of the picture • The public debt problem comes at a time when the UK economy has substantial structural problems. • We need to reorientate the economy to replace the declining industries. • In this respect we should not be cutting back on our research capacity and attempting to encourage entrepreneurial activities. • We also need to focus on the education deficit in particular those who have already graduated with too few skills. • Government spending should be focused on promoting the competitiveness of the UK economy.

Investment in knowledge % GDP – not good enough.

My forecast: UK growth to average under 2% p.a. in 2010s. • In this we have focused on fiscal and monetary policy, but… • Regulation, including environmental regulation, imposed on firms slows down growth in the short term at least. • That includes of course regulation aimed at the financial sector. • Also quantitative easing may lead to inflation over the next five years.

Policy constraints on UK/SW growth in the 2010s