Could governments finance deficits by creating money?

 

MMTers often say that financing government spending less taxes by issuing government debt is a policy choice, because they could instead create reserves (electronic money) at commercial banks. Of course only governments that have their own currency can do this, so this option is not available to Eurozone governments for example. If governments could finance deficits by creating money/reserves, would they want to do so?

The textbook answer (see here for example) is that monetary financing is inflationary, which is why most governments delegate reserve creation to independent central banks. This is not because of any crude monetarism: in mainstream macro the idea that there is a predictable and causal link between money creation and inflation died many decades ago, and today is believed by only a few. Instead the textbook story relies on the idea that governments creating money would undermine the ability of central banks to control the short term interest rate. Money financing would force interest rates to zero, and that would be inflationary.

However textbooks are nearly always out of date, and this explanation for why money financing would be inflationary became largely irrelevant when central banks started paying interest on reserves. Reserves are like electronic money held by commercial banks, the quantity of which is controlled by central banks. Today central banks control short term interest rates by paying that interest rate on reserves. As a result, it is possible to create large amounts of money/reserves without this ending in higher inflation.

We know this because of Quantitative Easing (QE), where central banks created large amounts of reserves in order to buy government debt. When they did this after the Global Financial Crisis (GFC) we didn’t get hyperinflation! The idea that recent inflation is a result of the new QE that took place during the pandemic is just silly. What recent experience shows us is that it is perfectly possible for central banks to control inflation even when there is a lot of money/reserves in the system.

So if central banks can create large quantities of money but still control inflation, why cannot governments finance their deficits by creating money? If interest is paid on that money/reserves, and it is clear that central banks have complete control over setting that interest rate, there is no reason to believe that money financing deficits rather than financing deficits by issuing bonds would be inflationary. This is what MMT means when it says bond financing is a policy choice.

Indeed we could go further and say that QE has been equivalent to the money financing of current and past deficits. The fact that this has happened because central banks wanted to put downward pressure on long term interest rates rather than governments choosing to money finance is just about motive. In practice we have ended up in much the same place as if governments since some past date had financed their deficits by creating reserves.

Of course none of this would matter if governments had no reason to be interested in money financing deficits. The obvious reason why they might be is if this form of financing was cheaper than selling debt to the bond market. Creating money/reserves incurs a cost equal to whatever the central bank sets the short interest rate to. Issuing debt could incur much the same cost if that debt was very short term. However governments have the option, which they normally take, of selling longer term debt. That may or may not be immediately cheaper than creating money/reserves, because long term interest rates may be above or below short rates. After the GFC short rates were below long rates, so money financing would have been cheaper and QE made a profit. Currently long rates are below short rates so bond financing would be cheaper at the moment. However over the long term whether the option of borrowing long is cheaper for governments remains questionable. Ellison and Scott found that the UK, which tends to borrow long, would have been better off if it had borrowed short.

The situation becomes much clearer if central banks only pay interest on reserves at the margin, rather than paying interest on all reserves. This would allow central banks to continue to control short term interest rates, but also to pay substantially less interest on the total stock of reserves. I discussed this possibility in detail here, in the context of reducing current losses from QE. An additional reason to pay interest only on some rather than all reserves is that there is no obvious reason why commercial banks should receive large sums of money for reserves when rates are high and virtually nothing when rates are low

If interest was only paid on marginal reserves, then it does clearly become attractive from a public finance point of view to finance deficits by creating money/reserves rather than issuing debt. So why are governments not exploring this possibility? I could equally well ask why mainstream economists are not talking more about this possibility. Maybe I’m missing something obvious here. If so please let me know.

One possible argument that I think doesn’t hold water is that cheaper financing of deficits would encourage governments to be fiscally profligate. The main deterrent to fiscal profligacy when there is an independent central bank is high interest rates, not high debt interest payments.

I want to end by making two additional points. The first is about markets and default. Money financing may appear attractive to those who believe that debt finance constrains government fiscal decisions. The idea is that bond markets could suddenly stop lending governments money, and this inhibits politicians from optimal fiscal policy choices. If politicians think this way they are mistaken, because as I have explained elsewhere the bond market is highly unlikely to stop lending the government money, and if it ever did the central bank would act as a last resort buyer of government debt. This is what happened as the pandemic hit, and after Truss’s infamous fiscal event. [1]

Because governments can create money they never need to worry about being forced to default as a result of a bond market strike. In addition governments having a magic money tree means that bondholders can always get paid interest and their money back. The only formal default [2] that bond markets need to worry about is when governments choose it, because the political cost of servicing government debt becomes too high. We are way away from such levels today, so the following paragraph is strictly of academic interest only.

If a government with an independent central bank that had financed all of its past deficits through money/reserve creation chose to default, how could it do so? Unlike government debt, reserves don’t have to be paid back at a set date. The only sense in which such a government could default is to instruct its central bank to no longer pay interest on reserves, which means that the central bank is no longer independent and loses control of inflation. In contrast, defaulting on government debt is possible while maintaining an independent central bank, and therefore maintaining control of inflation.

My second point is about safe assets. Because governments of advanced economies who issue debt in their own currency hardly ever choose to default, the debt they issue is far safer than any debt the private sector creates. [3] Such debt is invaluable to the financial sector. It allows pension funds greater certainty that they can pay future pensions, for example. This is a very good reason why governments should continue to issue at least some debt. Does that mean governments should always finance deficits using debt? No, because governments can issue debt to buy assets (through a sovereign wealth fund for example) rather than fund deficits.

[1] Politicians may worry about the impact of fiscal decisions on how the central bank sets interest rates, but it is absolutely right that they should.

[2] Bond markets do need to worry about inflation, which is sometimes considered as a form of default, but that gets reflected in interest rates through the actions of independent central banks and arbitrage.

[3] It can be disastrous when the private sector thinks they have created safe assets when in reality they haven’t, as we found out in the GFC.

The Anatomy and Reasons for UK relative Economic and Political decline over the last decade and a half

 

Nothing works anymore, the country is in a mess, worker’s living standards have remained stagnant, public services are at breaking point. Such statements are now commonplace, and are increasingly brought together in articles like this one by Sam Knight in the New Yorker. But is all this the result of 14 years of bad government, or can the blame be laid at the door of one or two specific events like austerity or Brexit?

Economic decline

I want to start with a post I wrote two years ago, where I was already talking about an unprecedented era of UK macroeconomic decline. I focused on comparisons with the US, and here is an updated chart of GDP per head in the two countries.

The divergence between the two countries has grown steadily since around 2010, it has become particularly dramatic since the pandemic. While real GDP per head in the UK has increased by only around 5% over the last 15 years, in the US it has increased by over 20%. As that earlier post showed, this divergence was not a feature of the previous three decades, but instead started around 2010. Between 1980 and 2010 UK GDP per head grew at least as fast as the US.

Comparisons with Europe are less dramatic, but partly for that reason may be more instructive.

If we compare the UK to the EU average (blue and green), the EU recovered more rapidly from the Global Financial Crisis (GFC) recession, but then fell back as the second Eurozone recession began to bite. However from 2016 onwards EU growth exceeded growth in the UK, leaving an 8% gap by 2023. A difference in growth of 8% over less than a decade is a lot. However over the last 15 years growth in France has been similar to the UK, and things have been worse in Italy (not shown above).

GDP per head does not tell the whole story about prosperity, because it doesn’t tell you about the purchasing power of incomes. Here is a comparison of real wage trends over roughly the same period from this source.

In this case the UK ends up well below France, with real wages in 2023 below 2008 levels. Part of the contrast between real wages and GDP per capita is distributional, with the UK government favouring pensioners in particular. However a large part is also about consumers buying many goods from abroad, and these becoming more expensive because sterling has depreciated. Here is the Sterling Euro rate over this period.

We had a large depreciation during the GFC, followed by a gradual appreciation until Brexit, when sterling depreciated again. A depreciation of 20% between 2007 and 2023 will reduce the purchasing power of UK nominal wages by a good few percent.

What does this tell us about why the UK has experienced a decade and a half of economic decline? These comparisons suggest austerity is important. The UK set out plans for large-scale and relentless austerity earlier than the EU, which is why our recovery was relatively slow, but the EU as a whole fell back to UK levels when it embarked on widespread austerity during the 2011-13 period. The US had an excellent recovery from the pandemic because, unlike the UK and Eurozone, it encouraged its recovery with fiscal expansion. As I argued here, deficit obsession, shared by the UK and EU but not (currently at least) by the US, appears to be bad for growth not just in the short term, but continuing into the medium term as well. Evidence also suggests cutting spending in a recession actually increases the debt to GDP ratio.

Brexit also clearly matters. I doubt that it accounts for all of the GDP per head gap that has opened up between the EU as a whole and the UK since 2016, but it almost certainly accounts for a good part. It is also responsible for the 2016 depreciation which reduced the purchasing power of UK incomes. [1]

To conclude, the relative decline of the UK economy since around 2010 is very real and substantial. It is not unique or the worst performance among major European economies thanks to Italy, although it is worth noting that in contrast to the UK Italian growth has been strong since the pandemic. Both austerity and Brexit have played a large part in producing the UK’s relative decline, but other factors (e,g, bad governance generally, poor pandemic management, encouragement of rent seeking from government) may also have played a part. As the New Yorker article notes, austerity itself probably played a key part in ensuring Brexit happened.

Political decline

Of course the current feeling that nothing works anymore isn’t just about a significant relative decline in living standards. It is also about political failure. There is no doubt that this became acute following Brexit. As I have noted many times, support for Brexit sorted those interested in evidence or even common sense from those who were not: some of the former got expelled from the party by Johnson and the latter got to be in his cabinet.

But 2010 austerity was also a failure of evidence based governance, in two crucial respects. First, we had known since WWII that cutting government spending during a recession, where interest rates were stuck at a lower bound, was a crazy idea. The fact that this was also advocated by the Republican party in the US, and a Germany dominated Europe spooked by the Eurozone crisis, should not lend it any respectability. 

Second, substantially shrinking the state without significantly altering thetasks the state is required to perform only makes sense if you believe that there are massive efficiency gains to be had, and again there was plenty of evidence in 2010 that this was untrue. The dire state of most public services today, which is so central to the current national feeling of despair, stems from this fundamental error that began in 2010.

I think it is important to recognise that so much of our current political malaise has deep roots of Conservative party strategy since the fall of the Major government, rather than being something that just happened with Brexit. The contrast with Labour in opposition is instructive. Whatever you might think of Labour’s embrace of some aspects of neoliberalism, it showed a party adapting to electoral failure. Where the subsequent Labour government did differ from Thatcher was in increasing spending on public services and particularly the NHS, and this was clearly popular with most of the public.

The Conservative opposition from 1997 to 2010 took none of this on board. Instead they saw themselves as leaving off where Thatcherism had ended, in an ideological rather than evidence based way. She had ignored the economists when raising taxes in the 1981 recession, so they would go further with austerity, not bothering to note that her fiscal contraction during a recession lasted for only one year and was then reversed. She had shrunk the state so they would do the same, but they ignored the fact that Thatcher mainly reduced what the state did through privatisation rather than starving it of money. Whereas some of Thatcher/Major’s economic policies were popular, those of their successors were not.

In simple terms the Conservatives in opposition moved further to the right on economic policy, rather than shifting left on public spending in a way that Blair/Brown had shown was popular. They understood that good public services were popular, but used the GFC as an excuse to cut spending. Conservative MPs today are much more right wing on economic issues than Conservative voters or members. [2]

Sunak’s strategy of focusing on tax cuts and culture war issues, that today seems so out of touch with the concerns of most voters, also stems from Conservative strategy after 1997. Of course Conservative party members have always been socially conservative, but Thatcher argued for her economic policies on their own terms. In opposition the Conservatives, like the Republicans in the US, saw their culture war as a means of winning despite their economic policies. With the help of the party in the media, they focused on immigration as a means of winning support from voters who were socially conservative but left leaning in economic terms, a strategy that was most successful with Brexit and Johnson’s victory in 2019, but which is now seen by many as the sham it always was.

One other feature of politics that we associate with Brexit and Johnson particularly, and which persists today, may also have its origins in the Conservative’s period in opposition from 1997 to 2010. One notable feature of the attitudes of the average Conservative MP (at least in 2020) is that they are slightly more socially liberal than the average voter, and therefore much more liberal than Tory party members. For most of these MPs the focus on social conservatism and culture wars has to represent a degree of deceit to win power rather than an expression of underlying beliefs or values.

For this reason, the tendency to deceive and lie to gain or retain political power, which reached its summit with the Brexit campaign and which continues today on issues like dealing with refugees, may represent the continuation of a trend that began in those opposition years. We don’t know how much of Cameron and Osborne’s rhetoric of deficit reduction they actually believed, but we do know that they started cutting taxes fairly quickly after 2010, which you wouldn’t do if deficit reduction was really your primary goal.

For these reasons I see the political decline of the last fourteen years as deeply rooted in the way the Conservative party developed since the Thatcher and Major years. One of the reasons for the current feeling of political despair is that the Conservatives under Sunak have almost stopped governing, and instead almost everything the government does seems aimed at trying to rescue some votes.

For completeness I would add two final, more minor, points. The first is that part of the current malaise also comes from an uninspiring opposition, but much of that stems from a First Past The Post electoral system where government typically alternates between the two major parties, and past Labour defeats. In most circumstances, including those today, it makes electoral sense for the opposition to appear ever so slightly more to the left in economic and social terms than the government. Labour too are in the business of winning votes, and in addition are inevitably very cautious of doing anything to lose them.

The second point that needs to be made is that the political decline over the last fourteen years in some part reflects a decline in the quality of our mainstream media. Some of this is obvious, such as the right wing press becoming a propaganda vehicle for Brexit, or the influence the Conservative party has had on the BBC. But it is also the case that the broadcast media, and particularly the BBC, has an increasing obsession with balance at the expense of informing viewers about facts or about the consensus of expert opinion. This has been an important factor in facilitating our political decline. It played a crucial part in the 2015 election, in the Brexit referendum and in the election of Johnson and it continues today. [3] More generally it allows particular members of the elite to present themselves as outsiders, championing ordinary people, and allows political deception and lying as a matter of routine.

When the Conservative led Coalition came to power in 2010, it suggested that cutting public spending rather than improving living standards should become the government’s economic priority. Today we are experiencing the inevitable result, a combination of dire public services and fourteen years of relative economic decline. In an attempt to appeal to voters that wanted functioning public services, they pretended immigration was a major problem. As a result we ended up with Brexit, trying to traffic asylum seekers to Rwanda and a government moving further to the right on social as well as economic issues. Today’s economic and political malaise is a direct consequence of a Conservative party strategy that was conceived after 1997 and implemented from 2010.

[1] The depreciation from 2008 to 2010 is generally put down to the fact that the GFC affected the UK more than most, because our banking sector was relatively large. However, having worked on equilibrium exchange rates, I have always found that justification for such a large depreciation unconvincing. In this respect it is also interesting that once the UK started growing again but the EU did not, sterling began appreciating, such that by 2015 it had regained most of the ground it lost during the GFC.

[2] The fact that taxes have increased as a share of GDP over their time in government is because spending on health has been rising as a share of GDP almost everywhere.

[3] On the few occasions the broadcast media ignored impartiality and took a clear side it backed the wrong cause, including its adoption of deficit obsession after 2010 and relentless pursuit of antisemitism within Labour while largely ignoring Tory Islamophobia and Johnson’s unsuitability to be PM. The latter, together with sections of the Labour right who preferred Johnson to Corbyn, helped ensure Brexit happened and led to many thousands of deaths in the subsequent pandemic.

Why Quantitative Easing is currently so costly

 

Unwinding Quantitative Easing (QE) is currently costing the public a great deal of money. Nearly £50 billion (almost 2% of UK GDP) has been transferred from the Treasury to the Bank of England to cover losses as the Bank unwinds QE (called Quantitative Tightening) since October 2022. That is real money that might otherwise have been spent on improving hospitals, schools etc. (Figures from the latest OBR forecast here, page 120.) It is true that before that QE made the government much bigger profits, but the OBR estimates that once all QE is unwound the net loss will be around £100 billion.

One of the reasons discussion of this has tended to be confined to pages in the Financial Times (see here for example) is that, as with most things finance related, the issue can often get needlessly complicated. In this post I’ll try and make things simpler, and ask whether these losses can be avoided and if not, who is to blame.

First, a reminder of what Quantitative Easing is and why it happened. It involves the Bank of England buying huge quantities of government debt, and paying for this by creating (electronic) money called ‘reserves’ which are held by the major banks. Most of this was done during the recession years after the financial crisis (GFC), but some happened during the pandemic.

Why did the Bank do this? After the GFC the main policy instrument of the Bank, the short term interest rate, was stuck at its lower bound, so instead the Bank was trying to stimulate the economy by putting downward pressure on longer term interest rates. By buying lots of longer term assets like government debt, it hoped it would push up the price of that debt. Most government debt when it is issued has a fixed nominal interest rate, so if the market price of that debt increases, that implies the effective interest rate falls for anyone buying it. [1] As I suggested here, for supply and demand to have any effect on the interest rate for government debt, the Bank needed to buy huge quantities.

As QE was always an emergency measure in a situation where short term interest rates were at their lower bound, it was never intended to be permanent. At some point the Bank would start selling the government debt it held, and using that money to reduce the money/reserves it had created to buy them in the first place. For the Bank the obvious time to start selling is when the economy needed cooling down rather than stimulating, which would also be when short term interest rates were well above their lower bound. That is why we have seen QE being reversed over the last few years.

So why did QE originally make a profit, but is now making a loss? There are two components here. The first is an interest component. The Bank pays the short term interest rate to the major banks on the reserves it created, but it receives the interest rate of the government debt it bought with that money. When short term interest rates were very low, longer term interest rates, including the interest rate on government debt, were higher so the Bank made money by holding this debt. However today the opposite can be true, so the bank could be paying more to the major banks than it’s getting from its holdings of government debt.

The second element involves capital gains and losses. Because the Bank bought government debt when rates were low and debt prices were high, and because it was likely to sell that debt when interest rates were much higher and prices lower, it was likely to sell its debt at a loss. This was understood at the time QE started, so making capital losses is no surprise.

Putting the interest rate and capital gains elements together, we can see why initially QE made the government money, but now it is losing it money. First, any profit or loss the Bank of England makes is picked up by the government. Second, when short term interest rates were low and the Bank was not selling government debt, it made a profit on the interest it received from the government debt. Essentially the government through the Bank was buying back its own debt and saving interest as a result, hardly any of which was going to commercial banks holding reserves because short term interest rates were almost zero.

However, once short term interest rates started rising in 2022, these interest gains started to disappear, because the rate of interest paid to commercial banks on the money created to buy the debt increased by substantially more than the interest the Bank was receiving on government debt. In addition, the Bank was now selling off some of its government debt at much lower prices than it paid for it, so it was making a capital loss. Because the quantities of government debt involved are very large, so is the size of these gains and losses.

Could current losses be avoided? The interest costs could be avoided if the Bank stopped paying the short term interest rate on all the reserves it created. I discussed this possibility here, including suggestions of how this could be done without the Bank losing control over short term rates. Alternatively the government could impose a windfall tax on the banks holding these reserves. How much of either measure would be passed on to bank customers or bank shareholders or bank employees is unclear.

What about the capital losses? I suggested earlier that these were almost baked in from the start, because the Bank would always be buying debt when its price was high and selling when its price was lower. While that is true, whether there is a net loss once interest gains or losses are added in depends on market expectations of future short term interest rates. Although the Bank was buying at a high price, it was receiving a relatively high interest rate in compensation (hence its initial profits). If market expectations about future interest rates when the debt was bought proved correct, then any capital loss would roughly equal the interest gain while the Bank held the debt. [2]

In terms of capital losses, therefore, the worst thing the Bank can do is sell its debt when short term interest rates are unexpectedly high. Interest rates today are indeed unexpectedly high, in the sense that few in 2019 would have expected interest rates at current levels. The problem here is institutional. The Bank has not been charged by the government to minimise its losses from reversing QE, but instead is concerned with meeting its inflation objective.

Who is to blame for these losses? Jo Michell put it nicely when he wrote that the original sin of QE was austerity. We had QE on the scale we did because in 2010 the government reversed Labour’s fiscal expansion. As an expansionary tool QE is undoubtedly inferior to fiscal expansion, which is why austerity was so costly in macroeconomic terms. Fiscal expansion also costs money, but the key difference here is who the money goes to. Most people benefit from higher public spending or a tax cut. In contrast those who gain from the government’s losses from QE are those buying, selling or holding government debt, and currently the commercial banks because they hold reserves.

Austerity from 2010 was enacted by the Coalition government, that rigidly stuck to their spending cuts even when the economy failed to recover. I suspect the politicians at the time ignored any potential future costs from QE because these costs were uncertain and, more importantly, would happen after the next election. As I said at the time, austerity was one of the major macroeconomic policy blunders since WWII, as well as having a devastating impact on public services.

However the Bank of England also oversold the benefits of QE to politicians only too willing to be convinced. Having been given responsibility for managing aggregate demand and inflation, the Bank was reluctant to admit that they couldn’t do this job effectively once short term interest rates hit their floor. This bias within central banks persists even today. As this ECB paper shows, estimates of the impact of QE tend to be much larger if done by researchers in central banks compared to academics.

With QE likely to cost an incoming Labour government large amounts of money that is desperately needed elsewhere, it is time the Treasury cast a more sceptical eye on the advice they receive from the Bank, particularly where that advice may reflect regulatory capture as much as sound monetary policy. Currently it is not clear that monetary policy considerations alone should govern when QE is reversed, and it is also far from clear why commercial banks should keep all the windfall they are receiving from their holdings of reserves. In any future demand led recession, the government should think very hard before agreeing to any request for large scale QE. QE was, and remains, a third best tool for fighting recessions [3], and a first best tool - fiscal stimulus - is easy to implement for any government that controls its own currency.

[1] Suppose the government issues 10 year debt at a fixed 5% interest rate. You buy £1,000 of that, and you get £50 a year for the next 10 years, and then your £1,000 back after 10 years. However, that debt is traded on the market. If after a year interest rates fall to 4%, say, and are expected to stay at 4%, traders will be prepared to buy that debt from you for more than the £1,000 you originally paid, because they will still get £50 a year.

[2] To the extent that the Bank was initially successful at pushing long term interest rates below the price implied by this arbitrage, it will still make a loss.

[3] The Bank should always have the ability to buy large quantities of government debt to resolve market failures (as it did after the Truss fiscal event).

Why raising taxes substantially is critical for the next Labour government to be sure of achieving its missions

 

My series of posts on detoxifying government debt was all about why Labour should not be afraid to increase public investment substantially. Public investment should be matched by borrowing because future generations benefit from individual investment projects. The same is not the case for most day to day (current) public spending. If the economy is not suffering from deficient aggregate demand, it makes sense to match increases in day to day spending with higher taxes. A fiscal rule that does this (often called the ‘golden rule’) makes sense.

That day to day public spending needs to increase substantially should not be in dispute. It is hard to think of any area of public spending that is not suffering badly after years of cuts, without any significant cut in what that spending is designed to achieve. The Institute for Government and CIPFA’s Performance Tracker shows that performance in most services is worse than before the pandemic, and much worse than it was in 2010. Our prisons are full, more people of working age are too ill to work, councils are going bankrupt, and poverty is increasing rapidly because benefits are too low or needlessly restricted. In addition many public sector workers have seen their relative pay squeezed over many years leading to either severe shortages or reliance on workers from overseas.

Additional public investment, together with some reforms, may ease these pressures a little, but they take time and will not be enough on their own to make a noticeable difference to public service provision over a five year period. It is also clear that the majority of voters want to see the next government achieve more in terms of improving public services than marginal increases in efficiency. Over the last six months the Conservative government has put cutting taxes at the centre of its economic offering to the public and their poll ratings continue to fall.

The idea that enough of the electorate will vote against any party proposing tax increases is a political myth, encouraged of course by a media dominated by a right wing press. As this paper by Rosa Hodgkin shows, historical evidence suggests that popular attitudes to personal taxes have not changed much since the late 1940s, and there is no new popular resistance to raising taxes regardless of circumstances. Gordon Brown was incredibly nervous about raising NIC to get more money into the NHS, but it turned out to be very popular. Most voters currently recognise the dire state of public services, and have grown tired of politicians that pretend this can all be fixed without spending additional money.

Yet the next election will be framed by the current government in a magical world where taxes can be continually cut and public services will do better with even less money than they currently receive. The government can pretend this because it knows it is very likely to lose, but thinks tax cuts shore up its core vote (and keeps its own party together) and creates problems for Labour. Labour’s response is to avoid those problems in opposition by accepting these tax cuts, but if they win that makes their problems in government that much harder.

All this means that in the real world the next government will have to raise taxes. The tax cuts announced so far, together with anything more to come before the next election, just satisfy the falling debt to GDP rule adopted by both main parties because projections are based on politically impossible assumptions about public spending. They imply cuts to prison spending when prisons are full so prisoners are having to be released early, and cuts to local authority spending when many councils are on the verge of bankruptcy.

Of course the next government could be lucky, either because growth exceeds the OBR’s projections or taxes are unexpectedly high compared to GDP [1], but they would have to be very lucky to avoid tax increases just to stop the currently terrible level of public service provision getting worse. However, no government should plan on the basis of being lucky. Indeed good governments should have plans that are robust to being unlucky in terms of how the economy progresses.

So if Labour wins the next election they will almost certainly have to raise taxes anyway, just to stand still in terms of public services. This is something Rachel Reeves must know. Any Chancellor who hopes something will turn up is destined to fail badly. There are two paths that Reeves could follow. The first is to hope she can find enough taxes to increase that she hasn’t already pledged not to raise, so she can say that she is not breaking any commitments made before the election. The second path is to break those commitments.

How feasible the first path is will depend on how much further Reeves is forced to go before the election. She has already ruled out raising income tax or personal NIC payments, as well as corporation tax. She has said she has no plans to raise taxes on capital gains, although ‘lack of plans’ is not quite the same as a commitment. We can expect the Conservatives to try very hard to extend the range of taxes which Labour commit to not raising during the election campaign, and may even try to steal more of the small number of small tax increases Labour are committed to, as they did in the last Budget.

The big danger of the first path is that it leaves too little room for Labour to make real progress on its five missions over a five year period, and in particular its mission to get the NHS back on its feet. If the OBR projections for the economy or government finances turn out to be too optimistic, there is a real danger that each Budget Reeves gives will be a scramble to find more tax increases just to stand still. It will seem to voters that taxes are going up, yet there is little to show for it. [2] As a result the first path is very risky in political terms.

In particular, the first path is not robust to uncertainty about growth in the economy. Despite all the detailed ideas and analysis in her recent Mais lecture, Reeves knows that while governments can positively influence economic growth it cannot control it [3]. Year to year growth is influenced by countless factors outside the government’s control. In addition projections of tax receipts for any given level of growth can easily be wrong, as Gordon Brown found out as Chancellor (see footnote [1]).

The second path has the immediate cost of breaking a pre-election commitment, as well as any unpopularity that comes from raising a tax paid by most people. However I expect both are already ‘priced in’ by voters to a considerable extent. However it is a more robust path than the first. It raises more tax, so is robust to a modest deterioration in the economy or public finances. The government still has a chance to achieve its missions and better public services even if growth in the short term is weak.

If economic growth is stronger than expected, as I noted in my last post, additional public investment is in danger of hitting resource constraints, and in particular a shortage of labour. To increase both current public spending (e.g. training more nurses, doctors and teachers) and public investment without hitting these resource constraints requires more modest growth in private consumption, which higher taxes will achieve.

This concern about overheating the economy is also the focus of a recent post by Chris Dillow. He argues that if the economy remains strong this is not the time to be running large fiscal deficits on day to day spending, and I agree. I also agree that in this situation raising taxes only on the rich [4], however desirable that may be on equity grounds, does not solve the macroeconomic problem because most of this money would come out of savings rather than consumption. This is why, if the economy remains strong, what I call the second path Reeves could follow needs to involve taxes on most people. However Chris also argues against the kind of simultaneous increase in spending and taxes that this second path involves.

He has two main objections. The first is that tax rises will go against what Labour have said before the election. But as I have already argued, some tax rises are inevitable after the election under any government, because the public spending assumptions behind recent tax cuts cannot be delivered. If Reeves is unlucky with the public finances in the first few years, she may have to break these commitments anyway. The second objection is that it takes time to shift resources between sectors. However what I call the second path need not involve radical dislocation. What it needs to do is set out a plan for a steady improvement in resources going into the public sector, but also paying public sector workers better, which involves no resource relocation. Labour under Blair/Brown did this for the NHS in the early 2000s when the economy was healthy, and Labour can do it again.

There are three major advantages in Labour choosing the second path, which involves increases in taxes on most voters. First, it is a robust policy, allowing key Labour missions to be completed whatever the state of the economy. Second, most voters will be expecting public service provision to noticeably improve under a new government. Third, better public services are not just desperately needed in their own right, but in the case of the NHS at least would have knock-on benefits for the economy as a whole.

Against these advantages, the cost of going back on commitments made in an election based on your opponent’s fantasy numbers seems small. In political terms, there is no reason why a failed and very unpopular outgoing Conservative administration should be able to saddle a Labour government with underfunded public services for five years. For the electorate at the election after next, few will remember a tax commitment broken five years earlier, but a failure to achieve its missions of restoring the NHS and reducing the child poverty that stifles opportunity will not be forgiven.

[1] The history of the first ten years of the last Labour government is a good example of the latter. During his first set of Budgets Gordon Brown found that tax receipts kept coming in higher than Treasury forecasts. In the remainder of his budgets the opposite was true.

[2] I have in mind here slow growth or low tax receipts given projected growth. In a recession an expansionary fiscal policy is required to support the economy.

[3] A government’s ability to negatively influence growth is much greater, unfortunately, as the UK experience over the last decade and a half shows.

[4] The same is true for ‘windfall taxes’ on specific companies. I have argued that when interest rates are high there is a very strong case  for a windfall tax on banks, but it will not have much impact on aggregate demand.

Detoxifying government debt, part 4. Labour’s inheritance

 

The Labour party has for a long time been fearful about high government borrowing to fund additional public investment. It didn’t start with 2010 austerity. Gordon Brown, probably the best Chancellor the UK has had over the last 50 years, used PFI mainly as a way of getting public investment done without additional public sector borrowing. It didn’t make economic sense at the time, as public borrowing is normally a far cheaper way of financing investment, but it happened because increasing government debt to finance worthwhile public investment was seen as toxic.

In parts 1-3 of this series we have outlined how none of this perceived toxicity stands up to economic scrutiny. It makes no sense to say that the country cannot afford to borrow to invest more, because government debt is also an asset for those who hold it (part 1). How much government borrowing costs depends on expectations of future short term interest rates, not on how much it is borrowing (part 2). The Eurozone crisis of 2010-2 has no relevance to the UK because we have a central bank that will in practice act as a buyer of last resort for government debt, just as it did after the Global Financial Crisis, at the start of the pandemic and in the latter stages of the Truss debacle.

Those who say that the Truss crisis shows that Labour needs to tread cautiously in raising borrowing to invest have to address why Truss provoked a crisis, but all the many other occasions that UK borrowing has risen didn’t. In part 3 we showed why the key mistake that Truss made was to leave open how she intended to cut public spending, at a time when further cuts to spending were politically incredible. But this raised borrowing costs not because markets thought the UK would default, but because it made future central bank decisions about interest rates much more difficult to forecast. [1] That is why increasing borrowing for worthwhile public investment rather than tax cuts is completely different.

But just as an economic analysis shows that Labour has nothing to fear from increased government borrowing to pay for additional investment, it also shows why this perceived toxicity persists. People, including political journalists in the media who have little knowledge of macroeconomics, look for simple analogies, and so think that government borrowing is like personal borrowing. The idea of arbitrage, and that the Truss crisis stemmed from uncertainty about central bank decisions, is seen as too complex, so it is much simpler to just say that Truss tried to borrow too much.

However ignorance is only one half of the story. The other is that this perceived toxicity suits the political agenda of those that dominate media discourse. Hardly anyone asks why it’s seen as good for the private sector to borrow to invest, but problematic for the public sector to do so, because those questions are not posed by journalists working for the right wing media. City economists are viewed as experts when, on average, they clearly have a right wing bias, as well as an incentive to mystify rather than explain. It is not an exaggeration to say that government debt is viewed as toxic because it suits the media to give that impression.

It is very hard for an opposition party to fight against a media narrative. Been there, tried that. On the other hand a newly elected government, particularly in the early honeymoon period, has immensely more power to set the agenda and terms of reference. To some extent whether they use that power depends on whether they see that it will be to their political advantage to use up their political capital in this way. The rest of this post is why it is essential for Labour to do just that, and detoxify borrowing to invest.

The case for substantially more public investment is overwhelming. As John Burn-Murdoch shows here, investment in the NHS collapsed shortly after 2010, and has stayed at a level well below that in peer countries ever since. NHS capital budgets are currently being cut further still. That is almost fifteen years of chronic under-investment that needs to be reversed. As well as basics like new buildings and beds, we also need to invest in resources for more preventative care and preparation for the next pandemic. The NHS is not unusual in this respect, and you can tell similar stories about under-investment in education, where capital spending for the three-year average up to 2023–24 is due to be about 26% lower in real terms than the three-year average in the late 2000s up to 2008–09. You can tell similar stories about the justice system, flood prevention, social housing and so on. The public sector as a whole has been starved of investment over the last fourteen years by design, and our economy has seriously suffered as a result.

In addition, an essential part of improving UK productivity growth and reducing regional inequality involves better transport links outside London. It is ridiculous that we seem almost alone in Europe in being unable to link our major cities with high speed rail, and thereby help relieve chronic congestion in the existing rail network. There seems like there is almost universal agreement among economists that the UK needs more public investment to end its current stagnation, and public investment can often provide a spur to investment more generally. UK public investment is about half the average for advanced OECD countries. On top of all this is the need to invest to mitigate the biggest existential crisis facing humanity, which is climate change.

However politicians often find it difficult to do the right thing if they think it will cause them electoral harm. So I also want to look at the case for immediate and large increases in public investment, financed through higher borrowing, on the very narrow grounds of Labour’s electoral interest.

In other circumstances, it might be tempting for a new Labour Chancellor to try and emulate Gordon Brown’s first few years as Chancellor, by sticking closely to existing (and falling) public investment plans as a signal of prudence and being an ‘Iron Chancellor’. To do that ‘for the markets’ is pointless, as the earlier posts in this series spell out, because interest rates on UK government debt are not determined by the amount a Chancellor borrows or how the markets feel about the Chancellor but by expectations of future central bank decisions. It might impress political commentators, but the electoral cost would be far too high for two reasons.

First, once elected, the public’s expectation that a Labour government will start reversing fourteen years of deliberate neglect will be immense. The example of the left in Germany is used here to suggest what could happen if these expectations are not met because of unwarranted fiscal caution. In 1997 it was just about possible to stick to existing spending plans because public services, although run down, were far from being in the critical state they are in today. Labour inherited a reasonably strong economy, rather than the economy today in which real wages have been stagnant for almost fifteen years.

Second, the whole point of investment is that it takes time before its benefits are perceived, so if a Labour government wants to get credit for additional investment by the time of the 2029 (or 2034) election they need to start increasing it immediately. Delaying that start for a few years in order to gain some media credibility will be pointless if voters don’t see a substantial improvement in public service provision and economic growth.

So Rachel Reeves should ignore claims that greatly increasing public investment will worry the financial markets, because such claims are bogus and because society and the economy desperately needs much higher levels of public investment. She needs to adopt new fiscal rules that are designed to never constrain public investment. Keeping such arbitrary and unjustified constraints in place, and just hoping that forecasts mean these constraints don’t bite, is foolhardy and a waste of the honeymoon period a new Chancellor will almost certainly enjoy.

What may be a more significant problem in substantially raising public investment is lack of real resources. Although the UK is in recession, and GDP per head has been steadily falling through last year, this is not a typical recession which involves lack of aggregate demand, but one caused by sharp cuts to real incomes following higher energy and food prices, as well as labour shortages caused in part by an increasingly sick workforce following Conservative mismanagement of the NHS and Covid pandemic. The labour market is not as tight as it was a year ago, but unemployment remains at levels that are lower than at any time in the last five decades.

This may change by the time the election comes around, but if it does not, then the Chancellor and the Treasury may be in the unusual position of having to prioritise between public investment projects by looking at where the investment comes from and pressure in particular labour markets. Periods of higher investment are often associated with shortages of labour in the construction industry, although the immigration system can be adapted to relieve those pressures, but the CT scanners the NHS desperately needs are likely to come from abroad so their construction puts no pressure on the UK economy. [2]

Labour will inherit an economy and a public sector in a worse state than at any time since WWII. The task they will have to turn things around is immense. It is therefore vital that Labour focus on these real problems, rather than imaginary worries that the media might throw at them. Probably the most effective way to start repairing the damage of the last 14 years is to substantially increase public investment, and the political longevity of the next Labour government may depend on how effectively they do that.

[1] An interesting question is why Hunt's last two fiscal events, which involved tax cuts 'financed' by totally unrealistic cuts to public spending, didn't have a similar effect in raising interest rates. One simple answer is context. Truss's fiscal event was at a time of high inflation and rising short term interest rates, whereas now the main question is how quickly interest rates might fall. Another is that the unrealistic spending cuts proposed by Hunt are sufficiently In the future that their impact on the Bank's decisions will be modest, while under Truss we had no idea when cuts to spending might be attempted.

[2] Chris Dillow uses the lack of spare capacity in the economy to make the case for Labour to keep a tight fiscal stance, but he also argues against the kind of increase in both spending and taxes that I propose here. I cannot do justice to his arguments in a footnote, but he doesn't tackle a key part to my argument, which is that the next government is going to have to break their current pledges of no tax increases at some point over the next five years anyway, and it would be politically better to do so sooner rather than later.

On maxing out credit cards and magic money trees

 

“When you repeat a lie, you spread it.

When you spread a lie, you strengthen it.

When you strengthen a lie, you become an accomplice to it.

In this disinformation age, we must do better.”

George Lakoff

Keir Starmer, in commenting on the recent Budget, said “Britain in recession, the national credit card maxed out, and despite the measures today, the highest tax burden for 70 years”. The analogy of maxing out the nation’s credit card has been repeated by other Shadow ministers. Rachel Reeves, Shadow Chancellor, has joined many Conservative ministers in saying there is no ‘magic money tree’.

Anyone who knows any macroeconomics understands that these analogies are false. The nation does not have a credit card with an externally imposed credit limit that it can ‘max out’, and the UK government does have a magic money tree because it can create money. But are those of us who do know some (or rather a lot) of macroeconomics getting a bit pedantic in worrying about politicians who use these phrases for rhetorical flourish? After all, analogies are usually inexact, and if using inexact analogies gets across points to a lay audience why worry about this inexactitude?

Imagine, for example, if we forced politicians to be more precise. Rather than claiming that the government had ‘run out of money’ and ‘maxed out its credit card’, they would instead have to say that the government had almost hit their self-imposed borrowing limits. Rather than saying you couldn’t promise to spend this or reduce that tax because there is no magic money tree, politicians instead would say need to say that the government could create more money or borrow more, but that would add to aggregate demand which would risk higher inflation and so force the Bank of England to raise interest rates. You can see why speech writers, and authors of lines to take, prefer talking about credit cards and money trees, things most people can relate to that don’t involve macroeconomics.

Now of course those who know some macroeconomics will say that these false analogies were used by a Conservative government to persuade first the media and then voters to embark on the ruinous policy commonly known as austerity that began in 2010. But surely today’s Labour politicians would argue that purpose matters, and if these false analogies can be used for good, to finally get the party that imposed austerity out of office, why not embrace it. Use the enemies’ weapons against them.

Indeed, those who complain about politicians using these false analogies are in danger of being hypocritical. After all, the word austerity was originally used to describe the post-WWII situation in the UK, where rationing continued and didn’t finally end until the mid-1950s. Wasn’t co-opting that term to describe some (any?) cuts in government spending just the kind of rhetorical inexactitude involved in talking about magic money trees and national credit cards? Doesn’t using the term austerity create all kinds of difficulties. For example, is cutting government spending during a boom ‘austerity’? Are tax increases in a recession an austerity policy?.

OK, enough of playing devil’s advocate. I want to set out here why I think it’s important for people in the public domain to avoid false analogies, and in particular the false analogies discussed above. Let me start with the money tree, which any government with its own central bank has. Furlough during the pandemic was to a considerable extent financed by the Bank of England creating money (by creating what are called bank reserves). More generally, if a government really wants to do something it can, by creating money or borrowing. That is why money was borrowed or created during the pandemic.

So why do politicians say there is no money tree at their disposal? Because they don’t like telling the truth, which is that they don’t want to break their fiscal rule, or they don’t want the additional spending or tax cut adding to aggregate demand and leading the central bank to raise interest rates. That is a trade-off where many voters might take a different view, so it is much easier for them to say there is no money. It is a way of disguising a political choice, and not being honest about these choices.

So ‘there is no magic money tree’ is normally said by Chancellors or Prime Ministers who want an easy excuse for not spending money or cutting taxes. It is a straightforward deception to give politicians an easier life, and therefore it is difficult to defend its use. The phrase ‘maxing out the nation’s credit card’ is more often used by politicians attacking the borrowing record of others. Yet it too suggests politicians have less choice than they actually have. In this case it perpetuates the idea that governments can only borrow so much, and that they are currently hitting that limit.

This is nonsense. There is a limit to how much UK governments can borrow, but it is way above levels of debt ever historically recorded. (Debt was 2.7 times GDP after WWII.) [1] But it sounds more dramatic to say a government has maxed out its credit card than to say it is leaving insufficient headroom to meet its own fiscal rules. In the case of 2010 austerity, talking about maxing out the nations cedit card was a way of frightening people into believing it was more important to cut the deficit than help a fragile economic recovery. So again we have politicians deliberately misleading for political gain.

It really shouldn’t matter whether the politicians in question are those you support or not, when what they are doing is just wrong. Saying it is for a good cause is a poor excuse. Would you support a politician lying if it was for a good cause? What about the claim of hypocrisy by those happy to use the term austerity? I have some sympathy with that, and where the meaning is ambiguous I try to be clear about what I mean by the term. But co-opting an old word for something new is not the same as using false analogies, and there is not a huge difference between restricting parts of private consumption (1940/50s rationing) and restricting the consumption of public goods.

The use of these false analogies probably wouldn’t matter too much if we had an informed and informing media that was quick to correct these attempts to mislead. Unfortunately the complete opposite is the case. Because much of the media views macroeconomics as too complex and boring for its viewers, it laps up these incorrect attempts to relate fiscal policy to household budgets. I have discussed this at length in my book and many posts over the last twelve years.

Sometimes this media environment gives politicians little choice but to follow. But that is not the case with phrases like ‘no magic money tree’ and ‘maxing out the nation’s credit card’. No one is forcing politicians to use these phrases. Instead it is their own choice to do so. If they know they are false analogies that just mislead the public they shouldn't use them. If they don’t know that they are false, I'm afraid that is even worse.

[1] People will stop lending to a government that can create its own money if they think that government will choose to default (or if they think the government will direct the central bank to substantially increase inflation). That in turn happens when the political cost of raising taxes to pay the interest on debt exceeds the considerable political cost of default. Some of these issues are discussed in a paper by Corsetti and Dedola that I discussed here