Policy Research in Macroeconomics

Ann Pettifor on Austerity, Osbornomics and what Labour should be doing

Economist Alex Little interviewed PRIME Director Ann Pettifor for his blog alittleecon.wordpress.com. Ann´s answers pinpoint the state of the economy in the UK. WE thought we would share it with PRIME readers.

1. We are starting to see growth return to the economy. The Government says we are ‘turning a corner’. Do you agree with this assessment?

Austerity can do a great deal of harm to the economy, but try as they may, politicians and neoclassical economists cannot kill it off. And sure enough the patient shows signs of life. All the same, the policies applied by Chancellor Osborne and his deputy Danny Alexander, in particular the slashing of public investment after 2010, extended, quite unnecessarily, the longest post-crisis slump since records began. Sixty-six months after the crisis the economy remains 2-3% smaller than it was in 2008. Sixty-six months after the 1929 crash, the economy was bigger by 5-8%.

This failure should not surprise us. Both Treasury politicians take a hands-off approach to the finance sector, and both are determined to shrink the public sector. The pro-cyclical application of austerity was an ideologically driven no-brainer for both men. Neither would have been willing to restrain the ‘irrational exuberance’ of the finance sector with a touch of austerity during the boom years; but both endorsed austerity during the slump.

As a result Chancellor Osborne and his deputy will go down in history as the Jehova’s Witnesses of economics. Unlike the Obama administration they have preferred ideology and prayer to the well-tried and tested economic medicine of fiscal stimulus in a slump: a point well made by Tim Harford in the Financial Times, Dr. Osborne’s bitter medicine.

As a result, unemployment remains unacceptably high – a reckless waste of Britain’s investment in the nurturing, health and education of 2.49 million people – 7.7% of the economically active. The immeasurable pain and anguish caused by unemployment, the family breakdowns, the mental health effects; the personal and social dislocation suffered – all these will remain as deep scars on our society and will blight their futures. A shocking 1.09 million of Britain’s young people are not in education, employment or training, according to the ONS. 584,240 young people were classified as unemployed between April and June, 2013. While political leaders may enjoy prospects, for the young prospects are bleak.

Nevertheless employment has remained surprisingly buoyant. The pre-crisis decline in wages and the post-crisis slump has proved that wages after all are not so ‘sticky’. As Shaun Richards notes, UK real wages are now falling at an annual rate of 2% if based on CPI and 2.5% if based on RPI – “as the real wage crisis builds.”

GDP is just 2.2% higher today than in Q2 of 2010 (when the Coalition Government came to office). Given that UK population is increasing at about 0.8% per year, this means that GDP per head of population is completely flat, following the big drop in 2008/9.

Not much to write home about there.

And while the flickers of increased economic activity now evident are heartening, questions must be asked about how this very weak recovery will be sustained? By household and company borrowing?

I don’t think so.

British individuals, households, firms and banks are still heavily indebted, and the Chancellor has done little to help debtors pay down, clear or re-structure that debt – a hangover from the pre-crisis credit bubble.

So far from borrowing from banks, individuals and firms are saving, and effectively lending to banks, according to data from the Bank of England. There are two exceptions. Borrowing for mortgages has risen. Borrowing from non-standard financial institutions – e.g. payday lenders – is also up from £4bn in February to just over £5bn in August, according to the Bank of England. This latter increase is not significant in itself, but because such borrowing is at higher (and sometimes obscenely high) rates of interest, and because wages are falling, signs that consumers are turning to pay day lenders in larger numbers, are worrying.

Nor has the government worked to re-structure the broken banking system – and so SMEs continue to be starved of credit and overdrafts. This means that SMEs wanting to employ new staff, or to improve and update their businesses, fund investment out of cash flow, erratically.

By contrast, business is better-than-usual for bankers. Not only are they too-big-to-fail, and too-big-to-jail, but the British government now actively subsidises their lending on existing housing – and in the process inflates house prices. And the Chancellor is the banker’s strongest ally in Brussels where attempts are made to limit bonuses and tighten regulation.

Will recovery by powered by business investment? I don’t think so. The ONS recorded the lowest ever capital spending by the private sector, in the first half of 2013.

And what of public investment? Will that sustain this ‘recovery’? Hardly. Under Labour between 2007 and 2010 public net investment increased by £7bn. In 2011 under the coalition government public investment fell by £9.7bn and was slashed once more in 2012 by another £9.6bn. Predictably, the deficit remains far higher than the Chancellor and his deputy intended.

Will exports drive the recovery? Total exports since Q2 in 2010 (when the coalition came to power) have risen by about £9bn in real terms (ONS) whereas imports have gone up by nearly £8bn. In the second quarter of 2013 there was an uptick in exports, matched by an uptick in imports, with a deficit of £5bn. However, the uptick in exports is not a trend, and it will take several quarters of export rises to convince economists that this sector will drive recovery.

So not much to sing about there.

Total industrial production makes up 15% of the economy (and includes manufacturing, oil and gas; electric, gas, steam and air; water supply and sewage). At the end of June 2013 industrial production was 4.2% below what it was in 2010.

Manufacturing is down 0.5% since 2010. North Sea Oil and Gas is down by a massive 25%. Construction is down 5.8% since 2010.

Not much joy there then.

Total services (which make up 78% of the economy) have risen by 4.4% since 2010. Health and social work are up by 7.4%; real estate is up 5% and wholesale and retail up by 5.7%. The finance and insurance sector has shrunk by 2.9% since 2010.

However the big rise in services is driven by professional, scientific and admin services, up 14.1% since 2010.

So we have scientists, the creative industries and administrators to thank for the growth in services, driving the recovery.

Is the rise in services sufficient to fuel and sustain recovery? I would be encouraged if it were not for the overhang of private debt that will once again threaten Britain’s large numbers of private, individual, household and corporate debtors when interest rates begin to rise. There were signs of interest rates tightening in the bond markets over the summer. Any further signs of recovery are bound to trigger rises in rates and these will, as before, lead to rises in mortgage rates and choke back any sign of recovery. In September the Federal Reserve seemed prepared to ‘taper’ its $85bn monthly (QE) purchases of assets from the financial sector, but was deflected from its strategy of unwinding QE by rises in long-term bond yields – which similarly pose a threat to recovery in the US.

2. We’re repeatedly told that government debt is our biggest problem. But private sector debt is still almost 450% of GDP. Despite this, a lot of the Coalition’s economic policies seem to be about encouraging more private sector debt. Is there any reason to believe that government debt of around 90% of GDP is more dangerous than the much larger private sector debt?

By simultaneously presiding over cuts in incomes, the Chancellor has made it harder for debtors to pay down their debts. Indeed falling incomes have led to a growth in household debt and a boom in payday and other risky lending. Private household debts have not been de-leveraged on any meaningful scale. Instead they are held in suspense – at about 140% of UK GDP. Low interest rates are used to lull private debtors into complacency.

The overhang of household, corporate and bank debt is a buffer that is likely once again to choke back any recovery – as it did in 2009 and 2011.

The ONS reports that household incomes fell for the first time in 20 years by an average of £615 in 2011. Under the Cameron government there has been no period when pay has not fallen in real terms. The last time pay rose higher than inflation (CPI) was in the period January to April 2010, according to the ONS.

From this year benefits will only rise by 1% – less than current inflation levels, slashing the living standards of the most vulnerable. This too will drive more people into the arms of payday lenders and loan sharks – worsening debt at the lowest levels of income…

Unlike Mrs Merkel, who compared the fiscal budget with the private household of a Swabian housewife, I say that there is a huge difference between public debt and private debt. The key point to understand is that private and public debts are redeemed differently. Private debt is largely repaid from incomes, currently falling in the UK. However, budget deficits can be solved by various means. One crude measure is to impose austerity, cut government spending, and increase public sector saving in line with increased private saving. With both the private and public sectors saving, spending into the economy is cut sharply, which is bad news both for private firms trying to sell their wares, but also for Her Majesty’s tax collection officers. No wonder Britain’s firms and corporations are hoarding cash! Customers are not coming through the door, and the customer-of-last-resort – the government – is refusing to step into the breach.

Another more sustainable measure is for government to invest in employment. If government would undertake infrastructure investment to increase economic activity, including employment, and to raise incomes – hey presto, the budget deficit would fall, and the public finances would be restored to sustainability.

3. Now we have seen a moderate rise in growth, the government say they feel vindicated and that this proves that austerity has ‘worked’. Do they have a point?

This “recovery” is hardly based on austerity. Academics tried in recent years to prove that a high level of government debt causes economic slumps. Some renowned orthodox economists, like Professors Reinhart and Rogoff, were so keen to make what is effectively an ideological point, that they misused excel tables. However, the empirical evidence we have suggests the opposite: Austerity harms the recovery, whereas fiscal stimulus increases economic activity in a slump. This has been shown by – among others – Taylor and Jordan in their recent publication.

The problem of continuing high deficits despite austerity only reinforces my argument. Public spending cuts cannot help recovery nor can they fix the deficit. Instead, they cut economic activity and reduce tax revenues.

4. Whenever one of the main parties (usually Labour) proposes a new policy, the other parties immediately demand to know how it would be paid for. Tax rise or spending cut elsewhere. What do you think of this debate? For example, I’ve heard you talk of Labour’s announcements on childcare and the youth jobs guarantee as being ‘salami slicing’. Could you explain what you mean by that?

The Labour Party will only discuss its plans in microeconomic terms. By this I mean that it offers its plans for the future – e.g. banning the bedroom tax, and simultaneously explains what tax revenues would be used to compensate for the abolition of the tax.

This causes Labour to fall into the microeconomic trap set by the Chancellor: namely that public spending can only be financed by existing tax revenues – not by increased economic activity, rising employment and the revenues associated with increased economic activity.

This approach boxes in policy-makers – which is what it is intended to do.

Labour would be much better off by arguing that its central objective would be to increase employment – and to do this by using public sector investment to increase private sector as well as public sector employment. For example, investment in retrofitting Britain’s housing stock would be stimulated by public sector funding for this purpose. But the retro-fitting would be undertaken by the private construction sector, and would be labour intensive, while at the same time increasing energy efficiency and saving on household bills – which would increase household income.

The public sector investment could be financed in just the same way as the bailout of the banks was financed: by resources issued through the government’s nationalised banks: the Bank of England, the RBS and Lloyds Bank. The BoE can work with the UK Treasury and the Debt Management Office who would issue bonds for financing for example, the retrofitting of Britain’s housing stock. These bonds can be purchased by the Bank of England at a very low and even negative rate of interest. And the tax revenues that accrue from the retrofitting process would then be used to repay the low-cost debt incurred by government.

RBS and Lloyds Bank can be encouraged to lend to firms and SMEs at very low rates of interest. If they fail or refuse to do so, government can withdraw taxpayer-backed guarantees, and access to Bank of England low rates.

This method of financing is much to be preferred to the current approach of financing every opposition policy from the existing and declining tax base!

It’s not complicated!

Update: The Conservative Party deleted its pre-2010 speeches from their online archives. However, we think that Chancellor Osborne´s Mais speech is an important basis from which to judge the performance of the Conservative-led coalition government, against its promises. Therefore, we make the speech available here:

Speech George Osborne: Mais Lecture – A New Economic ModelRt Hon George Osborne, Wednesday, February 24 2010

Thank you for inviting me to give this annual Mais lecture. Few Mais lectures have been given at a time when the challenges facing British economic policy makers were so difficult and complex as they are today.

Britain has emerged – just – from the longest and deepest recession in living memory, but growth is proving painfully slow to return.

The overhang of private debt in our banking system and our households weighs heavy on future prosperity.

And the public finances are the worst they have ever been in peacetime, with the largest budget deficit in the developed world.

This lecture is about these present problems and the urgent need to take us into a brighter future. But consider this one stark fact about our recent past.

We are coming to the end of the first full Parliament since the Second World War when national income per person has actually declined.

Even through the dark days of the 1970s and the recessions of the early 1980s and 1990s, every full Parliament saw our GDP per capita grow.

But not this Parliament.

When people ask the famous question – “are you better off than you were five years ago?” – this will be the first election in modern British history when the answer from the government must be ‘no’.

My argument today is simple.

Britain has been failed by the economic policy framework of the last decade.

It promised stability, prudence and an end to the cycle – it delivered instability, imprudence and the biggest boom followed by the deepest bust.

We need to head in a completely new direction.

We have to move away from an economic model that was based on unsustainable private and public debt.

And we have to move to a new model of economic growth that is rooted in more investment, more savings and higher exports.

This will require new policies and new institutions.

I want to talk about three crucial components of this new model. First, a new approach to macroeconomic and financial policy, where we seek to contain credit cycles as well as target price stability. Second, a new fiscal policy framework, with an independent Office for Budget Responsibility to ensure that public debt is sustainable. And third, a supply side revolution that releases the pent up enterprise and wealth creation of our country, encourages a nation of savers, and addresses the long term structural weaknesses that no government has ever properly tackled – like poor education and a welfare system that traps people in workless poverty. In order to ensure that a Conservative Government is accountable, I have set out eight clear benchmarks for economic policy against which I expect to be judged, together with the concrete measures we will take to achieve them. If they are met over a Parliament then we will have begun to build a new British economic model. I also want to explain today why starting to build this new economic model is not something we can put off until next year. We have to get on with it. There is no choice between going for growth today and dealing with our debts tomorrow. Indeed we will not have any meaningful growth unless we show we can deal with our debts. For it is the lack of a credible plan to deal with the deficit that is already pushing up market interest rates, undermining the monetary stimulus that is supporting the economy, and sapping the confidence of investors and consumers. It is the lack of a credible plan that has the credit rating agencies threatening to downgrade us unless action is taken urgently. This is the reality of the situation we are facing. Those who say we should simply ignore the markets are siren voices, luring us onto the rocks. For an economic policy maker to rail against the unpredictable nature of financial markets is like a farmer complaining about the weather. A loss of market confidence could force dramatic tax rises and spending cuts that were indeed savage and swingeing. That would represent a loss of economic sovereignty. And those cuts would be far larger than the actions that are needed now in order to retain our economic freedom in the first place. Far better to be prepared and protect ourselves against the storm.

THE DANGERS OF DEBT Before I set out the shape of this new economic model, let us first understand the nature of that storm. No one doubts that there were massive failures of financial regulation over the last decade. No one seriously defends the fiscal rules, once spelt out in a Mais Lecture like this, which proved unable to prevent the Government running a budget deficit at the peak of the boom. But we will not draw all the right lessons for the future unless we understand the deep macroeconomic roots of the crisis. Much has already been written about what went wrong. Much more is yet to be written. Perhaps the most significant contribution to our understanding of the origins of the crisis has been made by Professor Ken Rogoff, former Chief Economist at the IMF, and his co-author Carmen Reinhart. In a series of papers and now a book, they have demonstrated in exhaustive historical and statistical detail that while it always seems in the heat of the crisis that ‘this time is different’, the truth is that it almost never is. As Rogoff and Reinhart demonstrate convincingly, all financial crises ultimately have their origins in one thing – rapid and unsustainable increases in debt. As they write, “if there is one common theme… it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks that it seems during a boom.” So while the specific financial innovations and failures of regulation that contributed to the credit crunch were new, the underlying macroeconomic warning signs were depressingly familiar from many dozens of crises in the past. In this context, all the signals were flashing red for the UK economy: a rapid increase in household and bank balance sheets, soaring asset prices, a persistent current account deficit, and a structural budget deficit even at the peak of the boom. Our banks became more leveraged than American banks, and our households became more indebted than any other major economy in history. And in the aftermath of the crisis our public debt has risen more rapidly than any other major economy. So while private sector debt was the cause of this crisis, public sector debt is likely to be the cause of the next one. As Ken Rogoff himself puts it, “there’s no question that the most significant vulnerability as we emerge from recession is the soaring government debt. It’s very likely that will trigger the next crisis as governments have been stretched so wide.” The latest research suggests that once debt reaches more than about 90% of GDP the risks of a large negative impact on long term growth become highly significant. If off-balance sheet liabilities such as public sector pensions are included we are already well beyond that. And even on official internationally comparable measures of debt, we are forecast to break through 90% of GDP in just two years time. Indeed, baseline projections produced this month from the Bank for International Settlements show the scale of the adjustment that is needed to avoid that risk. Once the costs of an ageing population are accounted for, they calculate that UK debt will rise to 200% of GDP in just 10 years without significant adjustments – that’s higher than any other country except Japan. The interest payments on that debt would rise above 10% of GDP within ten years and to almost 30% in 30 years – the highest of all the countries they analyse including Greece and Ireland. The BIS were amongst the few organizations who can credibly claim to have warned about the risks of a global financial crisis, and now they are highlighting the next source of risk. As they argue, “persistently high levels of public debt will drive down capital accumulation, productivity growth and long-term potential growth potential.” In the short term, governments should not be “lulled into complacency by the ease with which they have financed their deficits so far” – especially those with relatively weak fiscal frameworks and a high degree of dependence on foreign investors. For an economy like the UK with such high levels of private debt, increases in market interest rates would be particularly devastating to the prospects of a private sector recovery. We have been warned.

MONETARY AND FINANCIAL POLICY The long term implications for our economic policy framework of the crucial role of rapid debt accumulation in causing economic instability are profound. It forces a fundamental reassessment of the way we conduct both monetary and fiscal policy. Let me begin with monetary policy. In his famous Mais Lecture of 1984, Nigel Lawson argued that monetary policy should be the main tool of short term macroeconomic management while fiscal policy should be set for the medium term. Over time that became the consensus, and it was later explicitly endorsed by the Labour Government. The monetary policy framework developed too, from the adoption of inflation targeting by the Conservatives in 1992 to the granting of independence to the Bank of England five years later. Nigel’s original insight remains valid today. The next Conservative Government will keep the inflation targeting framework because the benefits of anchoring inflation expectations remain substantial. I have said before that in office we will review, in cooperation with the independent Bank of England, what modifications are appropriate to ensure that housing costs are once again properly reflected in the target – this process is already underway at a European level but there may be a case for accelerating it. But given the fragility and uncertainty in financial markets, let me make it absolutely clear that we have no plans to change the CPI inflation target, and we will maintain the current arrangements and protocols for making decisions around quantitative easing. I don’t want there to be the slightest suspicion that the next Conservative Government might try to inflate its way out of the previous Government’s problems. But it is now clear to everyone that narrow inflation targeting is not in itself sufficient for macroeconomic stability. Given what we now know about the way that unsustainable increases in debt can cause devastating financial crises, we must be as concerned about credit cycles as we have been about business cycles. Alan Greenspan and others made the case for ignoring credit bubbles and then ‘mopping up’ when they burst. But even Alan now concedes that this approach has been shown to have unacceptable costs. So as economists like Robert Shiller and others have argued, we need a more sophisticated understanding of how financial markets actually work, including the psychology that drives them away from stable equilibria. And we need an approach that actively seeks to identify emerging imbalances and takes action to reduce them. The question is what tools are needed to do that. In the UK, inflation targeting succeeded in anchoring inflation expectations, but the very design of the policy framework meant that responding to an explosion in balance sheets, asset prices and macroeconomic imbalances was impossible. Because the tools needed to deal with these imbalances had been taken away from it, the Bank of England became excessively focused on controlling consumer price inflation to the exclusion of other variables, as the Bank itself has acknowledged. And the Financial Services Authority became a narrow financial regulator almost entirely focused on rules-based regulation. They had neither the capacity nor the inclination to stand back and make difficult judgments about the macro context and the growth of systemic risks. To be fair they too have also be commendably candid about those failures. So, while much has been made of how the tripartite system led to a fatal lack of leadership when the crisis broke, the much greater failure was in the years leading up to the crisis as the imbalances built up. Crucially, this failure was hardwired into the institutional design of the framework, and no amount of tinkering with new committees and new statutory obligations will fix it. Indeed we are in danger of making similar mistakes in the aftermath of the crisis, with too little consideration of the impact of higher capital and liquidity requirements on overall financial conditions and the pace of recovery. And despite everything we know about the aftermath of banking crises, there is still no single institution that is responsible for ensuring that the monetary transmission mechanism is functioning as it should, so that policy rates are properly passed through to businesses and consumers. So we need a wholly new framework. Some have questioned our decision to put the Bank of England in charge of macro and micro-prudential supervision. I see it as absolutely fundamental to a new economic framework for monitoring and controlling the growth of private debt in our economy. Only independent central banks have the broad macroeconomic understanding, the authority and the knowledge required to make the kind of macro-prudential judgments that are required now and in the future. Of course they must operate with a mandate from, and accountability to, the elected Government, similar to the existing inflation targeting system. But this new role will inevitably require a degree of judgment and discretion that goes beyond the narrow rules-based system that failed either to spot or prevent the crisis. And, because central banks are the lender of last resort, the experience of the crisis has also shown that they need to be intimately familiar with every aspect of the institutions that they may have to support. So they must also be responsible for day-to-day micro-prudential regulation as well. That case is particularly strong where the banking system is highly concentrated as it is in the UK, where the boundary between micro and macro-prudential regulation is not easy to define. For example, who could deny that the micro-prudential regulation of a large international bank like Barclays, RBS or HSBC has in and of itself significant macro-prudential implications for the UK economy? Since we’ve been making this argument about a new model of financial regulation, the intellectual tide has turned decisively in our favour. The arguments we have made are the same as those that lie behind the direction of reform at the Federal Reserve and in the Bundesbank, and they are argument now publicly supported by the likes of Jacques de Larosiere, Ben Bernanke, and Stanley Fischer – the eminent monetary economist and Governor of the Central Bank of Israel. The precise tools of macro-prudential regulation must now be the subject of intensive debate, international coordination, and ultimately experimentation. They may include variable risk weightings for different asset classes, adjustable capital and liquidity requirements, and even more direct interventions in lending behavior, but we should rule nothing out at this stage. We should also recognize that no system of supervision and regulation will ever eliminate failures. That’s why we must keep up the pressure for reform so that our banking system itself is more robust to failure and the damage that failure inflicts on the broader economy is minimised. It would be a tragedy if we ended up with a banking system that is even more concentrated, riskier and more prone to moral hazard than the one we had before the crisis. More and better quality capital, credible resolution procedures, living wills and more competition are all important parts of the solution. But I also believe we should pursue international agreement for a levy on the banking system, similar to the levy on wholesale funding proposed by President Obama or the levy already implemented in Sweden, as well as for structural reforms to prevent retail banks with implicit taxpayer guarantees from engaging in the riskiest activities such as large scale proprietary trading. These would not have prevented the crisis on their own, and they cannot be a substitute for a better underlying macroeconomic and regulatory policy framework. But together they would help to create a system that is more robust to failure.

FISCAL POLICY These are the new tools and institutions that we need to control the growth of private debt in the future. They are a key component of moving to that new model of economic growth. But the bigger risk to our economy now stems from an explosion in public debt. To entrench economic stability for the long term, we need fundamental reform of our fiscal policy framework. There is wide agreement among economists on the need for more independent scrutiny of fiscal policy to replace the discredited fiscal rules. Conservatives first proposed that independent scrutiny more than five years ago. We have now set out in detail how that scrutiny will be performed by an Office for Budget Responsibility. Let me say a little bit more about this Office, because I don’t think people have fully appreciated what a radical departure this represents from the way Chancellors have put together Budgets in the past. Everyone can see how the fiscal rules created in 1997 failed catastrophically. They did nothing to prevent the Government from running a current budget deficit at the peak of the boom. To coin a phrase, we didn’t fix the roof when the sun was shining. The flaws in the fiscal rules are now well known – they were backwards looking, so that past surpluses could be used to justify present deficits, and they were adjudicated by the Treasury with no independent oversight, undermining their credibility. But there is also an emerging recognition in the academic literature that any system of rules is likely to be unsatisfactory – either so general as to be ineffective, or so complex as to be inflexible and impossible to enforce. Instead there is growing support for the concept of fiscal councils that can bring independent and forward-looking scrutiny to bear on governments. Institutions of this kind now exist in Sweden, Denmark and the Netherlands. I believe that just as we need to move away from narrowly defined rules towards greater judgment in financial regulation, the same is true in fiscal policy. The benefits of fiscal councils for sustainable fiscal policy could be as profound as those of independent central banks for monetary policy. Evidence suggests that many of the same time-consistency problems that lead to inflation bias when politicians are in direct control of monetary policy can lead to deficit bias in fiscal policy. Of course the analogy is not exact – unelected bodies should not be given independent executive power over the levers of fiscal policy because of the fundamentally political distributive consequences of decisions over spending and tax. But the power of a fiscal council to hold politicians to account for the fiscal implications of their tax and spending plans should not be underestimated. These powerful arguments, and the steady erosion of public trust in official forecasts, lie behind our proposals for an independent Office for Budget Responsibility. The OBR will be made up of a three person committee, accountable to Parliament, and a small secretariat of economists and public finance experts. It will be responsible for publishing independent fiscal forecasts at least twice a year around the time of the Budget and PBR, based on existing government policy at the time. And the committee will publish a recommendation for the amount of net fiscal tightening or loosening it judges necessary for the Treasury to have a better than 50% chance of achieving a forward looking mandate set by the Chancellor. If the Chancellor choses not to abide by that recommendation he or she will have to explain their reasoning to Parliament, but it would be a brave Chancellor who chose to do so. At least once a year, the OBR will also publish a comprehensive assessment of the true long term sustainability of the public finances, including off balance sheet liabilities such as public sector pensions, PFI and the likely costs of an ageing population. For the first time we will have a transparent national balance sheet. The Office for Budget Responsibility will be up and running on a temporary basis for the first Budget of a Conservative Government, much as the Monetary Policy Committee initially functioned for a year without underpinning legislation. Sir Alan Budd has agreed to chair the Office for Budget Responsibility during this period. No one can doubt his independence, and I want to thank him for taking this important task on. Whether I thank him in a couple of years’ time is another matter – but that is the whole point. So this is how we will entrench fiscal responsibility for the long term, but we also face an immediate fiscal challenge. In the last two weeks, disagreements within the economics profession over how quickly to tackle the record budget deficit have been thrust into the spotlight. Before I address those disagreements, it’s worth remembering that there are broad areas of agreement that didn’t exist even six months ago. There is a recognition that the scale of the deficit and the rapid increase in the national debt cannot safely be ignored, and that public expenditure will have to be cut. That is something we Conservatives have been saying since the start, and we had to face down those who said that cuts were never going to be necessary. There is also general agreement now that Britain needs a more credible medium term plan to deal with the deficit, as both the IMF and the OECD have argued. The Governor of the Bank made this point yet again yesterday, as did the signatories of one of those letters to the Financial Times last week. So when it comes to identifying the problem, the need to set out a more credible plan, and the case for having that plan independently monitored, there is broad agreement. Where disagreements remain is on the details of the timing and pace of deficit reduction. The economists who signed those two letters cautioning against early action are reasonable people who care deeply about the future of the British economy. But while I respect their position, I take a different view – a view shared by the equally eminent economists who wrote to the Sunday Times, many leading business figures and crucially by international investors. And that view is simple. A credible plan is not really credible unless you’re prepared to make a start on it this year. Otherwise we are trying to persuade people that we will be virtuous, just not yet – and when you’ve been as irresponsible as Britain has been, that isn’t easy. That is my hard-headed assessment. And it is driven by three things: The nature of confidence; the realities of financial markets; and the practicalities of government. Let me take each in turn. First, confidence. Those who recommend delay argue that when private demand is weak, cutting government spending too quickly risks undermining the recovery. In its most simplistic form this argument fails to ask why it is that private demand is weak. Modern economics understands the importance of expectations and confidence. Businesses and individuals look to the future, and while they are not the perfectly rational creatures assumed by the theory of Ricardian equivalence, uncertainty over the future paths of tax rates and government spending does play an important role in their behaviour. This is particularly true when it comes to consumer spending and business investment, and as the Governor has made clear, the Bank of England tries to take these effects into account when making its forecasts. So a credible fiscal consolidation plan will have a positive impact through greater certainty and confidence about the future. Businesses can expand safer in the knowledge that an out of control budget is not going to lead to ever higher taxes. Consumers can spend safer in the knowledge that mortgage rates will remain lower for longer. To be fair, a more sophisticated version of the argument for delay also takes into account the complex interaction between fiscal policy and monetary conditions. It says that at the moment, and for as long as policy and market interest rates remain low, fiscal tightening should be as gradual as possible because there is little scope for more accommodating monetary conditions to accompany it, either through lower market interest rates or through the reaction function of the Bank of England. And only as and when monetary conditions begin to tighten can the pace of fiscal consolidation be accelerated. But even this, more nuanced, version of the case for delay is too complacent. For it brings me to the second consideration: the realities of financial markets. Experience shows that market adjustments tend to be neither smooth nor gradual – instead reassessments are more likely to be sudden and brutal. The luxury of waiting for monetary conditions to tighten before embarking on fiscal tightening may not be one that we are afforded. That is why the experiences of other countries right now, not just Greece but also Ireland, Spain, Portugal, Poland and others, as well as examples like Sweden and Canada in the past, are so important. If markets start to lose confidence in a country and interest rates are driven up, recovery is undermined and the inevitable cuts to spending end up being deeper and more savage than would have been necessary to maintain market confidence in the first place. Take a look at the measures the government was forced to implement across the Irish sea. That is not a risk that I am prepared to take. Already the yield spread between 10 year gilts and 10 year German bunds is more than 90 basis points, compared to 70 basis points for Spain and 110 basis points for Portugal. In the most extreme cases, countries that lose the confidence of markets effectively lose their sovereignty. As Goran Persson, the Social Democrat Prime Minister of Sweden who eliminated a huge budget deficit following a financial crisis and a deep recession in the early 1990s, used to say, “a country in debt is not free”. This is why credibility is so vital. Far from accepting “as binding the views of the same financial markets whose mistakes precipitated the crisis in the first place”, as one of last weeks letters to the FT put it, establishing credibility does exactly the reverse – it buys you more freedom from the very real constraints of financial markets. How much better to make difficult decisions about spending on your own terms and at your own speed than to have them forced upon you on somebody else’s terms? So undermining credibility by giving the impression that cuts can be avoided, or by suggesting that unexpected improvements in the public finances will lead to more spending, only makes deeper cuts more likely. But the decisive case for making an early start on reducing our record deficit is not only based on confidence and the need to establish credibility. It also draws on an understanding of the realities of government – in particular institutional inertia and the difficulty of real reform. These considerations don’t appear in most economists’ models. Economists usually talk about fiscal tightening in billions of pounds or percentages of GDP, but cutting spending is not simply a matter of numbers in a Budget Red Book. It is a myth, perpetrated by politicians, that all Ministers have to do is sit in their Whitehall offices pulling levers, and things change on the ground. More often than not, the levers aren’t connected to anything. Real change that drives up productivity is a difficult process. If unstable financial markets do force emergency cuts, then those are precisely the conditions in which their impact on the poorest in society and the quality of public services is likely to be greatest. As Gordon Brown told his party conference when he was Shadow Chancellor: “Losing control of public spending doesn’t help the poor.” Making an early start, on your own terms, creates the space for better targeted cuts. It will give more time for public sector reforms to take effect so that lower spending is delivered through greater efficiency not cuts to the front line. And it makes it easier to preserve public support for difficult decisions by protecting the poorest and most vulnerable. A key lesson from the successful examples from around the world of fiscal consolidation is that you must be able to demonstrate that ‘we are all in this together’ in order to maintain a coalition for action. So that is why we will make an early start – in order to bring confidence to the economy, establish the credibility with markets that buys you time, and to ensure that spending cuts are well targeted. Let me explain how a new government will do that. There will be three clear phases to our plan of action. Phase One involves finding out the truth. Within days of taking office we will establish our new independent Office for Budget Responsibility. We have put in place the plans and the people to be ready to do that on a non-statutory basis, until the legislation is in place to make it permanent. The Office will help us publish a truly independent audit of the public finances before the first Budget. So everyone will know the true state of the nation’s balance sheet. And everyone will be able to see independent forecasts for growth. Only then will anyone know the true scale of the fiscal challenge that faces whoever forms the next government. Phase Two is the Budget. This will take place within 50 days. It will set out the overall fiscal path and spending totals that we will stick to over the years ahead. As I have made clear, our aim will be to eliminate the bulk of the structural current budget deficit over a Parliament. That is what the Governor of the Bank of England has called for and I agree with him. The Budget will set out some of the cross-cutting measures on pay, the cost of Whitehall, the review of the pension age, and the largest public sector pensions, that will help to put our public finances on a sustainable footing. Crucially, the first Budget will also contain measures to boost enterprise, encourage new jobs and show that Britain is open for business. We will take targeted steps to reduce some budgets in-year – and we have set out some specific examples – in order to build credibility and make a start on reducing the deficit. The scale of these steps will be informed by that proper audit of the nation’s finances, that independent assessment of growth and discussions with the independent Bank of England about the scope for monetary policy to remain supportive. At the same time the rest of government will be embarking on the major structural reforms to the public services that will, over time, deliver the lasting productivity gains that drive real value for money. Phase Three is the Spending Review Over the Summer we will work flat out to conduct the detailed departmental Spending Review for the years after 2011 that the current government has simply refused to carry out, and publish that results of that review in the Autumn. The only possible reason why the Treasury has not already produced a Spending Review is that the Government do not want to spell out the difficult decisions that even their own spending plans imply. We will not hesitate to take the difficult decisions to get Britain working.

A NEW ECONOMIC MODEL So this is the new economic framework for monetary and fiscal policy that we need to ensure that private and public debt are sustainable in the future. But given that we cannot go back to the last decade’s debt-fuelled model of growth, the question I am asked most often at the moment, is “where is the growth going to come from?” The answer is the final part of this new economic model. The economics profession is in broad agreement that the recovery will only be sustainable if it is accompanied by an internal and external rebalancing of our economy: in other words a higher savings rate, more business investment, and rising net exports. Economic theory and evidence both suggest that the macroeconomic policy combination most likely to encourage that adjustment is tight fiscal policy, supportive monetary policy and countercyclical financial regulation. But that on its own will not be enough. We need a program of supply side reform that is no less urgent or radical than the reforms of the 1980s and 1990s. When our households, our banks and our government are so indebted, raising the real rate of return on investment is the only sustainable route to prosperity. All the evidence suggests that Britain’s trend rate of growth has declined over the last decade. And as we saw in the 1980s and 1990s, supply side reforms can take some years before their full effect is felt. But a new government presents a golden opportunity to set out a new direction and harvest some of the long term benefits up front. By embarking upon a series of reforms that will raise the real return on investment, we can raise the rate of investment right now. That’s why I have pledged that a Conservative Government will use the opportunity of a change of government to send the signal that Britain is once again open for business. And in order to bring some accountability to economic policy, I have set out eight benchmarks for the next Parliament against which you will be able to judge whether a Conservative Government is delivering on this new economic model. So we will maintain Britain’s AAA credit rating. We will increase saving, business investment and exports as a share of GDP. The plans I announced at the weekend to sell in due course the government’s stakes in RBS and Lloyds will help to encourage millions of people to start saving and investing for the future, often for the first time. We will improve Britain’s international rankings for tax competitiveness and business regulation with specific measures on corporation tax and regulatory budgets. We will reduce youth unemployment and reduce the number of children in workless households as part of our strategy for tackling poverty and inequality. We will raise the private sector’s share of the economy in all regions of the country, especially outside London and the South East. And we will reduce UK greenhouse gas emissions and increase our share of global markets for low carbon technologies. But perhaps the greatest challenge is reforming the public sector itself. The part of our economy that is responsible for delivering this framework for economic success is the one that has performed the worst of any sector over the last decade. Public sector productivity has actually fallen since 1997. Indeed if productivity in the public sector had grown at the same rate as in private sector services we could now have the same quality of public services for £60 billion less each year. A radical program of public sector reform is not just a fiscal necessity, it is vital if we are to deliver the world class education and welfare services that support a competitive economy. So we will raise productivity growth in the public sector by increasing diversity of provision, extending payment by results, giving more power to consumers and improving financial controls. We will expect productivity improvements to match the best of the private sector. And crucially, the Treasury will return to its core role of ensuring value for money for the only interest group it should represent – taxpayers. There will be no more empire building or attempts to interfere in every area of government policy. How can I put it in a topical way? You will have a Chancellor and a Prime Minister united with the common goal of unleashing the forces of enterprise.

CONCLUSION Delivering the new economic model that I have set out today will not be easy. Britain cannot run away from its problems. And if we fail to learn the lessons of the last decade we are doomed to repeat them. We have to deal with our debts to get our economy back on its feet. The core values that we need to apply are responsibility and accountability. Over the five years that I have been in this job I have put fiscal and financial responsibility at the heart of my approach. I resisted the calls to offer up front unfunded tax cuts. I said that an economy built on debt was living on borrowed time – and so it was. I have also been straight with the British people about the challenges ahead. I said that whoever won the election would have to cut spending. And I have set out the benchmarks against which we can be held accountable. Our ambition is nothing less than a new economic model for Britain. Let us move from an economy built on debt to an economy that saves and invests for the future.

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