Brexit & austerity

Nick Clegg spoke for many critics of Labour’s ambiguity towards Brexit when he said:

You cannot end austerity if you don't end Brexit. Ending austerity and proceeding with Brexit are incompatible with each other.

There’s some truth in this. Brexit means slower economic growth than we’d otherwise have, which in turn means less growth in tax revenues and hence in potential public spending.

The question – one which is surprisingly rarely asked in all political contexts – is: how true is it?

To get an idea of this, let’s remember some basic fiscal maths. The primary deficit (that is, government borrowing excluding debt interest payments) required to stabilize the ratio of government debt to GDP is given by the equation:

D*[^(r-g)/_(1+g)]

Where D is the debt-GDP ratio, r is real interest rate and g the real annual growth rate.

Let’s put some numbers into this. Let’s say that g is 1.5%. This is 0.8 percentage points less than its rate over the last 50 years, to reflect the damage done by Brexit: the OBR assumes it to be 2%, so I’m being more cautious than them. And let’s say that 20-year index-linked gilt yields rise by a percentage point to minus 0.5% by the time Labour takes office in 2022. The OBR envisages D being 83.6% then.

Plugging these numbers into our equation tells us Labour could stabilize the debt GDP ratio with a primary deficit of 1.6% of GDP. But current plans are for a surplus of 0.9%.

Labour could therefore borrow 2.5% of GDP more each year and still stabilize borrowing, even If we assume Brexit hurts economic growth. Clegg is therefore mostly wrong. Ending austerity and proceeding with Brexit are not incompatible – unless you assume a very big hit indeed to growth from Brexit or a very large rise in gilt yields.

Note here that I’m using bog-standard orthodox economics: I’m not arguing here that Labour need monetize borrowing.

How, then, might we rescue Clegg’s claim?

You could argue that fiscal policy should aim at reducing the debt-GDP ratio if (as the OBR assumes) the economy is on its trend path in 2022. This, though, requires you to argue that the current ratio is too high, which I think takes some doing and is independent of the Brexit debate.

Alternatively, you might argue that much bigger borrowing would be inflationary. This, though, runs into two objections. One is that the flat Phillips curve suggests that higher aggregate demand might add less to inflation than previously thought. The other is that, to the extent that inflation does rise, it can be offset by tighter monetary policy. To argue against ending fiscal austerity thus requires you to argue for the mix of loose money and tight fiscal policy. This is a worthwhile debate, but it’s largely orthogonal to Brexit*.

In fact, from one perspective Brexit makes a Labour government more necessary. Insofar as Brexit reduces trend growth, we need policies to offset the damage. The Tories offer nothing here, whilst some of Labour’s policies do: infrastructure spending; a state investment bank, encouraging coops and so on. Granted, we should be sceptical here not so much because these are lousy policies but simply because it’s so damned hard for governments to raise long-term growth. But we should at least try, and Labour at least recognises the problem.

* FWIW, I think there’s a case for a mix of tighter money and looser fiscal policy, in part to get us away from the ZLB quicker, and in part to dampen down house prices, high levels of which are an economic menace.

Comments

[Sesh Nadathur]

A couple of related questions about this.

You assume the hit to GDP growth is just 0.8% annually after Brexit, which is lower than most other estimates: a lot of the numbers I see say more like 2%, the University of Leuven study out just yesterday says 4.5% in case of hard Brexit, and so on. How sensitive are your conclusions to these numbers?

The OBR number you quote (of 2% growth) is only for 2017. In 2018, for instance, they forecast only 1.6%. How likely do you really think 1.5% annual growth is over the next decade, given the current expectations of a very hard Brexit? Are you choosing the most optimistic numbers possible to make your numbers work out, or does your calculation still hold even with more pessimistic Brexit scenarios?

How much of the headroom for extra borrowing gets eaten up by lower tax receipts after Brexit, and how much is actually left for any increases in spending?

[chris]

@ Sesh: 0.8% pa adds up to 8%ish over 10 years - close to NIESR's estimate of the long-run impaact. I'm assuming steady slower growth, rather than a cliff-edge fall. But the latter would justify higher borrowing.
I'm not sure I'm taking optimistic numbers, especially as I'm assuming higher gilt yields when much slower growth might well reduce them.
The big problem with my numbers is that if GDP is 8% lower then public spending will be lower even if borrowing rises by 2.5%ish of GDP, In the long-run, therefore, borrowing alone can't offset the damage done by Brexit.

[Patrick Kirk]

Chris wrote probably the best article on Brexit before the vote: http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2016/02/brexit-how-big-an-issue.html

People who seem to be arguing that he is not pessimistic enough now really ought to read it all but especially the last paragraph which includes " I fear we’ll be hearing too much hyperbole and misplaced certainty and not enough perspective and doubt" No-one knows what Brexit means yet so its bonkers for Nick Clegg to be pontificating about it being worse that the austerity he helped inflict on the country.

[Sesh Nadathur]

Thanks for the reply. Makes sense. I think your point (or Jonathan Portes' point) about Brexit causing spending to fall even if borrowing rises is the important one (and sort of related to my final question). Surely that argues strongly in Clegg's favour?