Labour & the deficit

Ed Miliband’s claim that government borrowing owes more to the global financial crisis than to Labour’s over-spending has met with a - ahem - sceptical response.
It is certainly true that Labour were running a large deficit even before the crisis. But there is, I think, a defence of this.
It starts from the premise that, in the mid-00s, business investment was low, as there was a dearth of investment opportunities. As McKinseys put it: “The investment rate (investment as a share of GDP) of mature economies has declined significantly since the 1970s.”
This lack of investment, however, coincided with high profits, with the result that companies ran an increasing large financial surplus from 2001 onwards. As a matter of national accounts arithmetic, the counterpart to this is that there had to be government borrowing; my chart shows that the government surplus/deficit is to a large extent the mirror image of the corporate surplus/deficit. 
To put this another way, the fact that companies were not spending all their revenue tended to reduce aggregate demand. Government stepped in to fill this gap. Labour’s deficit was, then, a reasonable macroeconomic strategy - a counter-cyclical response to weak private demand.
Now, you might reply to this that I’ve got the correlation ass backwards - it was public spending that crowded out private spending.
One fact refutes this - between 2001 and 2007, long-dated index-linked gilt yields halved, from over 2 per cent to around 1 per cent. This is inconsistent with the notion that government borrowing raised borrowing costs and thus hit private investment. It’s also inconsistent with the notion that high borrowing was freaking out financial markets. It is, however, entirely consistent with the idea that a global savings glut - the flipside of the investment dearth - was depressing interest rates.
What’s more, core CPI inflation (that is, excluding food and energy) was roughly the same level in 2007 as it was in 2001-02 - around 1.5 per cent. This suggests that increased government borrowing was not creating inflationary pressure, but was instead filling the hole in aggregate demand that a lack of private investment was creating.
So, I don't think Labour can be blamed for running an excessive deficit. Of course, you might argue that it was wrong to increase spending rather than to cut taxes. I have some sympathy with this view. But it is a separate argument from the rather feeble claim that Labour was irresponsible to create a large deficit.

Comments

[David Massey]

But was this a deliberate strategy? I guess I'm asking if government spending rose in part because of automatic stabilisers are because of a concious decision at the Treasury to increase spending?

[AB]

By definition there will always be a counterpart to a fiscal deficit just as there is a domestic counterpart to a current account deficit. It doesn't mean it was a good idea to run a structural fiscal deficit. The charge still stands that the government was overoptimistic about 1. the cycle and 2. the elasticity of revenue with respect to that cycle, and these were not phenomena that were only recognisable in retrospect. If that meant assuming a lower rate of trend growth for the economy, so be it.

[Luis Enrique]

"To put this another way, the fact that companies were not spending all their revenue tended to reduce aggregate demand. Government stepped in to fill this gap"

is it really right to say there was an output gap - the GDP was somehow too low - pre-2007?

it makes sense for a government to step in an fill a gap if it's expected to be temporary, or if stepping in makes it so, but it doesn't necessarily make sense for a government facing an economy where the 'natural' level of investment has fallen to attempt to compensate for that.

[Keith]

Human nature is such that all Governments are likely to be optimistic about demand and the structural position.

Criticism of Labour on this is hindsight insight which exagerates the rationality and perspicasity of Governments and voters. The rational expectations myth persists despite for example the permanent deficits in the USA from Tax cuts for the rich and the military industrial pork barrel. Care to bet with your own money when the USA will balance its books?

[Hal]

You write: "It is certainly true that Labour were running a large deficit even before the crisis". What????? According to your own graph the deficit was 2-3% right up to the start of 2008. This is a very *small* deficit, one that is sustainable practically indefinitely.

In fact given an average GDP growth rate of 2-3%, borrowing wouldn't even increase as a % of GDP! How on earth can you call this a large deficit?

[Luis Enrique]

for those who haven't seen it, Martin Wolf's take on this was pretty good I thought:

http://www.ft.com/cms/s/0/3074d7ba-5ec0-11df-af86-00144feab49a.html#axzz1AMt1nSeK

here the relevant bit:

Can we not at least blame Mr Brown for the bloated public spending and grotesque fiscal deficits? Yes, but also only up to a point. Between 1999-2000 and 2007-08, the ratio of total managed spending to GDP did rise from 36.3 per cent to 41.1 per cent. But the latter was still modest, by the standards of the previous four decades. The jump to a ratio of 48.1 per cent, forecast for this year in the 2010 Budget, is due to the recession. Nominal spending is currently forecast at 3.5 per cent higher in 2010-11 than forecast in the 2008 Budget. But nominal GDP will be 10.3 per cent lower and tax revenues 16.4 per cent lower.

Mr Brown evidently failed to foresee the possibility of a huge recession. The compound annual rate of growth between the first quarter of 1997 (before Labour won power) and the first quarter of 2008 was 2.9 per cent. Then came the slump, with gross domestic product in the first quarter of 2010 close to 11 per cent below its previous trend level ... Did anybody else foresee such a disaster?

[Jim]

Anyone who rides a 10+ year property boom, all the while claiming to have 'abolished boom and bust' deserves all the opprobrium he gets.

Labour got lucky mainly through things completely outside their control.
1) They inherited an economy just about in perfect condition, ready to start delivering tax revenue like an oil well.
2) They benefited from the China effect - lower priced imported goods kept the natural tendency for the UK economy to overheat every 7 years or so under control, allowing interest rates to remain low.
3) The global economy was in the middle of a 15-20 year boom.

A monkey could have been Chancellor from 1997-2007 and still have looked like a financial genius.

[Alice Cook]

The case against Labour is a little bit more sophisticated than the one you suggest in your post.

Under Labour, government expenditure as a percent of GDP increased. Initially tax revenues were buoyant, and the overall fiscal deficit did not increase sharply. However, the underlying primary deficit experienced a dramatic reversal, particularly from 2000 onwards. The fiscal position weakened sharply under Labour. It is just wasn’t so obvious when looking at the headline numbers.

These fiscal policies also made the UK particularly vulnerable to an adverse shock, which is exactly what happened in 2007. Northern Rock collapsed, tax revenues crashed, and the deficit exploded.

Currently, the UK tax base is insufficient to cover government expenditures. Public debt is growing at the rate of 8 to 10% of GDP a year. That cannot continue for more than another year or two. The country understands this, and most people recognize it is time to cut government expenditures and put an end to the Labour spendfest.

As for “savings glut” – over the last decade, the UK private sector had a savings ratio just a tad above zero, the government was also running large deficits. The current account deficit was also consistently negative. So at the aggregate level, the UK was dis-saving.

But why are we talking about this? The matter is settled. Labour lost the election, having failed to persuade the electorate of its economic strategy.

This is last year's debate. Fiscal consolidation is the order of the day.

However, I will say one obvious thing in Gordon Brown's defence. He prevented the UK from joining the euro. For this, we must all be eternally grateful.

Alice Cook

http://cloudedoutlook.blogspot.com

[Thebeefery.blogspot.com]

This argument that Labour weren't as irresponsible as we thought is fine if you don't consider PFI - which is exactly what they'd want really. With those three letters, any notion of us having had a responsible government over the last few years goes out the window.

[Tom]

"With those three letters, any notion of us having had a responsible government over the last few years goes out the window"

Which is why it's still being used by the current government presumably (the trains for Crossrail are to be a PFI, £1bn to £1.9bn).

If anything, PFI is *more* attractive now, as the core get now pay later feature is a useful antidote to angry people wondering where their new hospital is, whatever party is in power. Labour's crime was using it (and rigging the numbers) when there was no actual need to beyond Treasury dogma and the appalling situation of bringing in private sector sharks to advise on giving public money to their own companies (and that's continuing under Osborne too, I can tell you from personal experience).