Rediscovering prudence

Gordon Brown and Alistair Darling

Alistair Darling’s memoirs have reignited the debate about Labour’s alleged mismanagement of the public finances. Nick Pearce examines how the party can restore faith in its economic credibility

When George Osborne announced huge cuts in public spending last year, he said they were necessary to restore confidence in the economy and ensure that the economic recovery was strong and sustainable. At the time, critics – including the Labour leadership – warned him that his attempts to eliminate the structural deficit over such a short timescale would put the economic recovery at risk and could even make the deficit worse as a result.

Looking at the record so far, his critics are clearly having the better of the argument. Over the last year, the economic recovery in the UK has almost ground to a halt. Real GDP increased by just 0.2 per cent between the third quarter of 2010 and the second quarter of 2011; real sales volumes have been flat over the last year and manufacturing output growth has fallen from five per cent to two per cent. The outlook is equally gloomy. Surveys of business confidence, which are the best short-term indicator of economic activity, suggest orders to manufacturing have fallen sharply and that producers are now cutting output in response. The service sector activity index has just recorded its second largest fall. Meanwhile, falling yields on UK government bonds indicate weakness, not strength, as investors mark down their expectations for medium-term growth.

These are the facts on the ground. Opinion polls tell a different story. They show that the public believes spending cuts are necessary and, further, that Labour is to blame for the deficit that has caused them. The media debate surrounding the serialisation of Alistair Darling’s memoirs has only served to solidify this public perception that Labour’s mismanagement of the public finances was to blame for the huge increase in the deficit. If economic growth continues to disappoint, the coalition’s reputation for economic competence will be severely dented, but it does not follow that Labour’s reputation will be restored as a result. Labour has much work to do before the electorate will trust it on the economy again.

What should be its strategy? Most importantly, Labour needs to give a clearer, more honest appraisal of what caused the deficit. During the recession, the UK lost 6.4 per cent of output (peak to trough), compared to 6.8 per cent in Germany. Yet our deficit reached 11 per cent of GDP in 2009-10, compared to only 3.5 per cent in Germany in 2010. A well-timed and widely admired stimulus package in Germany helped minimise job losses through employment subsidies, but the structure of the German economy and the resilience of its revenue streams account for the bigger part of the difference in the deficits each country accrued. The UK entered the global recession, not only with optimistic forecasts of government revenue, but a tax base dangerously dependent on unsustainable sources of economic activity, in particular the housing market and financial services, and with an insufficiently broad base of tax collection. Labour did not grossly overspend in its latter years in office, as its critics claim (although doubtless it should have been running a small surplus in 2007-8). But it had allowed unbalanced economic growth and structural weakness in the tax base to develop, and this left the UK overexposed when the global economic crisis eventually hit.

Labour’s return to fiscal prudence should not therefore be constructed on an apology for overspending, as some have argued. That would be tactically mistaken and substantively wrong. Instead, it should do two things. First, it should acknowledge that its political economy had been too laissez-faire in respect of the key sources of wealth creation. While productivity, skills and investment all rose between 1997 and 2010, and Britain developed strong comparative advantages in areas such as business services, pharmaceuticals and higher education, our economic growth was too reliant on debt-financed consumption, the housing market, and financial services. So when the electorate demands to know how Labour can be trusted with the public finances again, a key part of the answer must be that a Labour government will build its fiscal resilience on stronger, more sustainable economic foundations. This must entail developing modern industrial and innovation strategies, ensuring investment in key business sectors, through a state investment bank and financial services reform, and putting greater emphasis on measures to increase the share of GDP going into the wage packets of working people, who punished Labour at the last election for stagnation in their living standards. None of that is easy, but the recognition of the need for a new political economy is an essential starting point.

Second, Labour has to set out a path to fiscal prudence based on a resilient tax base, full employment and higher levels of efficiency and effectiveness in public spending. As the Office of Budget Responsibility has recently shown, the UK’s tax base is weakening just as demands on public expenditure are set to rise as our society ages. Revenues from oil and gas, vehicle excise and tobacco and fuel duties are all set to fall by up to £29 billion within 20 years. At the same time, increased health and social care costs of an ageing population add something like six per cent of GDP of spending pressures. In these circumstances, and with the prospect of spending constraints stretching into the next decade, a credible fiscal policy must be founded on a broad and resilient tax base and tough choices about spending priorities. For Labour, that means accepting that the VAT rise is here to stay; that public investments should be focused on simple, clear offers to families on services like childcare that help increase the employment rate; and, finally, that public service reforms must lead to greater efficiency and cost-effectiveness if demographic pressures and popular expectations are to be met. Any new golden rules for the public finances must be grounded in these economic realities, fiscal choices and public service priorities.

A credible economic prospectus will also require a more definitive position on spending cuts. One view inside the party holds that it will take time for the electorate to reappraise Labour’s economic record and that there is simply no point in reckoning with the past until the next general election gets closer. In the meantime, Labour must simply attack the government for its failure to stimulate higher economic growth and stick broadly to the line that it would halve the deficit over the parliament. Anything else just blurs the key dividing lines.

Others believe that Labour must respond to economic events as they unfold and adapt its line accordingly. So they support Ed Balls’ call to stimulate demand in the economy in the short term, but believe it should be part of a new and more pragmatic approach to deficit reduction. This would retain the aim of halving the deficit over the next four years, with further efforts to eliminate it over the following four years. But it would also develop a framework that allowed for more rapid deficit reduction when economic growth is strong and slower deficit reduction when, as now, growth is weak. This should be accompanied by an acknowledgement that cuts are justified in lower-priority benefits or services, such as the winter fuel allowance or concessionary fares, in order to demonstrate seriousness of intent, as well as fairness, in bringing the public finances under control.

In many ways, this is an economic strategy that would be familiar to continental social democrats. It links a willingness to rethink the political economy and to intervene in shaping the structure of the economy with a determination to prioritise spending on key public services, like childcare, that support full employment and higher family living standards, while keeping expenditure firmly under control, so that the UK is more resilient in the face of the pressures that we can predict as well as the shocks that we cannot foresee.

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Nick Pearce is director of IPPR

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Photo: Downing Street

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  • Anthony Sperryn

    You talk about a state investment bank, but I think you ought to look very carefully at the concept of “bank”. The common perception of “bank” is a bit like Father Christmas – showering money about for good causes.

    In reality, as we now ought to realise, banks are businesses that depend on a very high level of borrowing (and, in recent times, chicanery) to try and extract a margin of profit from their customers.

    Have you thought of using the concept of a sovereign wealth fund (“SWF”) to pay for the worthy investments that need to be made? Such a fund would not engage in the borrowing that almost caused the downfall of our financial system.

    It may mean we have to save up before we spend, but it ought to mean that we become more sophisticated in assessing the returns from the investments the SWF made.

    Getting started may be hard, because we have squandered a large part of our North Sea wealth (by treating income from the exploitation of that resource as spendable income, rather than as a return of capital), in contrast to Norway, which has built up a substantial SWF with its oil and gas riches. Norway’s SWF has become an income-producing financial cushion, which helps the country’s people to the extent they can be helped in the context of the capitalist system.

    It may still be possible to start a British SWF and a starting point might be to shift HM Treasury away from its “cash in/cash out per financial year” attitude to the public finances.

  • Mickelmas

    Farmer Giles has a sizeable acreage of fertile soil perfectly suited to pastoral production. As an expert in husbandry he decides to invest the majority of his resources into cattle breeding for both milk and beef. Year on year farmer Giles sees his return on his investment increasing geometrically – until one day his farm (along with the vast majority of other cattle farms around the world) is struck down with ‘foot and mouth’ disease and he is forced to slaughter his cattle. Apart from the emotional impact felt by these farmers their businesses are brought to the brink of ruin. The future is bleak.
    Three years on, members of the IFH (Institute For Hindsight), publish a report blaming farmer Giles for relying on pastoral farming when he should have known that ‘foot and mouth’ would sweep across the globe. God knew what was to happen, why didn’t farmer Giles and all the other farmers?
    I sympathize with farmer Giles (along with Gordon Brown and Alistair Darling) in that they made the right decisions at the time for the good of their investment. Their husbandry was correct but fate stepped in. Unlike insurance companies, governments cannot incorporate ‘Act of God’ exclusion clauses into their policies.
    To counter the erroneous view apparently held by most of the public that Labour cannot be trusted with the economy (as expressed by Nick Clegg this week – so it must be untrue) Ed Milband and Ed Balls have to stop slagging off Brown (which only provides fodder for the opposition) and does nothing to enhance Labour’s credibility. The concept of ‘mea culpa’ for past ‘mistakes’ is the worst form of PR and can only lose voters. What will Ed’s message be next week? I fear it will be too apologetic, too media-friendly, too Union-distant, too occupied with minutiae (anti-stalking etc), too weak on criticism of coalition policies (because he has not formulated his own) and, perhaps most importantly, too weak on speaking up for our working class who are being unjustly penalised for the actions of others.

  • Mickelmas

    Farmer Giles has a sizeable acreage of fertile soil perfectly suited to pastoral production. As an expert in husbandry he decides to invest the majority of his resources into cattle breeding for both milk and beef. Year on year farmer Giles sees his return on his investment increasing geometrically – until one day his farm (along with the vast majority of other cattle farms around the world) is struck down with ‘foot and mouth’ disease and he is forced to slaughter his cattle. Apart from the emotional impact felt by these farmers their businesses are brought to the brink of ruin. The future is bleak.
    Three years on, members of the IFH (Institute For Hindsight), publish a report blaming farmer Giles for relying on pastoral farming when he should have known that ‘foot and mouth’ would sweep across the globe. God knew what was to happen, why didn’t farmer Giles and all the other farmers?
    I sympathize with farmer Giles (along with Gordon Brown and Alistair Darling) in that they made the right decisions at the time for the good of their investment. Their husbandry was correct but fate stepped in. Unlike insurance companies, governments cannot incorporate ‘Act of God’ exclusion clauses into their policies.
    To counter the erroneous view apparently held by most of the public that Labour cannot be trusted with the economy (as expressed by Nick Clegg this week – so it must be untrue) Ed Milband and Ed Balls have to stop slagging off Brown (which only provides fodder for the opposition) and does nothing to enhance Labour’s credibility. The concept of ‘mea culpa’ for past ‘mistakes’ is the worst form of PR and can only lose voters. What will Ed’s message be next week? I fear it will be too apologetic, too media-friendly, too Union-distant, too occupied with minutiae (anti-stalking etc), too weak on criticism of coalition policies (because he has not formulated his own) and, perhaps most importantly, too weak on speaking up for our working class who are being unjustly penalised for the actions of others.

  • Mickelmas

    Farmer Giles has a sizeable acreage of fertile soil perfectly suited to pastoral production. As an expert in husbandry he decides to invest the majority of his resources into cattle breeding for both milk and beef. Year on year farmer Giles sees his return on his investment increasing geometrically – until one day his farm (along with the vast majority of other cattle farms around the world) is struck down with ‘foot and mouth’ disease and he is forced to slaughter his cattle. Apart from the emotional impact felt by these farmers their businesses are brought to the brink of ruin. The future is bleak.
    Three years on, members of the IFH (Institute For Hindsight), publish a report blaming farmer Giles for relying on pastoral farming when he should have known that ‘foot and mouth’ would sweep across the globe. God knew what was to happen, why didn’t farmer Giles and all the other farmers?
    I sympathize with farmer Giles (along with Gordon Brown and Alistair Darling) in that they made the right decisions at the time for the good of their investment. Their husbandry was correct but fate stepped in. Unlike insurance companies, governments cannot incorporate ‘Act of God’ exclusion clauses into their policies.
    To counter the erroneous view apparently held by most of the public that Labour cannot be trusted with the economy (as expressed by Nick Clegg this week – so it must be untrue) Ed Milband and Ed Balls have to stop slagging off Brown (which only provides fodder for the opposition) and does nothing to enhance Labour’s credibility. The concept of ‘mea culpa’ for past ‘mistakes’ is the worst form of PR and can only lose voters. What will Ed’s message be next week? I fear it will be too apologetic, too media-friendly, too Union-distant, too occupied with minutiae (anti-stalking etc), too weak on criticism of coalition policies (because he has not formulated his own) and, perhaps most importantly, too weak on speaking up for our working class who are being unjustly penalised for the actions of others.

  • http://mattbrennansblog.wordpress.com/2011/10/12/labour-and-the-economy-what-we-actually-got-wrong/ Labour and the economy – what we actually got wrong | Matt Brennan's Blog

    [...] Darling’s book. I thought it was excellent. I’ve just read this follow up article by Nick Pearce in Progress. It makes the point that the deficit didn’t come about because of investment in public [...]

  • Hal

    It seems we are a long way from recognising that running a large deficit is a necessary and appropriate response to a recession. Labour is shooting itself in the foot – and doing the public a disservice – by swallowing the right-wing agenda of deficit elimination and smaller government.