The IFS: viewing the economy through wrong end of a telescope

– Prof. Roger Farmer, NIESR, November, 2016, Three Facts about Debt and Deficits

Today the Institute for Fiscal Studies produced a review of political manifestos prepared for General Election 2017. Predictably, the respected, and largely independent IFS researchers review the tax and spending proposals of the different parties with little regard for the wider economy. This skews their perspective, and their approach to analysing the economy. It is as if IFS staff consistently peer at the British economy through the wrong end of a telescope, distorting their analysis. In other words, they view the government’s budget in much the same way as a household might assess the impact of income and expenditure on a family’s budget.

This is plain wrong. Any assessment of a party’s taxation and spending policies cannot be based on the ‘household fallacy’ – that government budgets are like household budgets and must balance. Instead tax and spending plans must be analysed in the context of Britain’s wider, but still very sluggish economy. While a household may or may not be affected by the wider economy when its members try to balance income and expenditure, a government budget is always directly affected by the wider economy. If I can be forgiven for adding to, and mixing metaphors, it is possible to think of budget deficits in terms of a see-saw. The deficit rises when the economy is weak, and falls when the economy is at full, skilled, productive and well-paid employment.

Ten years after the implosion of the private financial system Britain has still not fully recovered from the crisis. This is not remarkable. It’s a direct consequence of both the crisis, and of Treasury policy decision-making from 2010 onwards. Today, even while the economy appears to be moving towards full employment, nominal wage growth has slowed. Inflation has risen which means that real wage growth rates are negative. In other words, inflation is stealthily cutting real wages. Falls in real wages impact negatively on the private retail, construction and other sectors of the economy.

To compound this prolonged weakness in private incomes, rates of private investment are at dismally low levels, leading to low levels of productivity.  In international league tables, Britain’s levels of investment are at rock-bottom as a share of the economic cake. I would reproduce the World Bank’s international league table on where Britain stands in terms of investment as a percentage of GDP, if it were a) not so far down the list – 124th of 151 countries – and b) if it were not so embarrassing. These low levels of investment can partly be blamed on Britain’s dysfunctional banking and financial system.

Low levels of investment, a dysfunctional banking system, falling real incomes, low productivity – this anaemic state was exacerbated by George Osborne’s and the Treasury’s conscious decision (from 2010 onwards) to engage in a form of blood-letting, by cutting public spending and contracting the economy further.

This helps to explain why GDP growth at 2% per year is still below the 2.8% rate of growth that preceded the crisis. To the consternation of the Office for Budget Responsibility (whose staff also tends to view the economy ‘through the wrong end of a telescope’) GDP growth is far below the optimistic levels regularly predicted.

This is the depressing context that must inform any IFS analysis of a political party’s spending and taxation plans – but that does not.

Given this context, how does the Labour manifesto stand up to scrutiny? Very well, I would argue, because Labour clearly recognises that the economy is still in a dire state, and understands that because of our broken banking system, the private sector is not able to invest in skilled, well-paid employment that would revive wider private sector activity, income and productivity. Given private sector weakness Labour is right to insist that any democratic government accountable to an angry electorate must step in to revive a structurally weak, and still deteriorating, private economy.

By investing and spending into the economy, the government will generate income – for construction workers and companies building new railway lines, hospitals and wind farms; or for doctors, carers or policemen.

Those incomes will be taxed – and revenues returned to the government with which to pay for the investment. Then, thanks to the multiplier, those with incomes will spend into the private sector. That in turn will generate income, including profits, for the private sector, but also government revenues from VAT and corporation taxes. In other words, investment in construction workers, doctors and carers will ultimately pay for itself – thanks to the multiplier.

Now I doubt the IFS applies the multiplier in its calculations and analyses, which is why it is so downbeat about the outcomes of spending.  (We know for certain that OBR does not – despite international organisations such as the IMF now acknowledging the importance of the multiplier.)

That omission might explain why IFS staff are so concerned about ‘the cost’ of raising the minimum wage. There is not only a cost to the minimum wage – there is also the benefit of the income (both private income and tax revenues) generated and the application of the multiplier when that wage is spent – invariably in the private sector. If WHSmith were to pay a higher minimum wage to its workers, we know with absolute certainty that those workers would spend their new-found income into the economy in ways that would ultimately benefit the private sector, including WHSmith – but also the government.

We have learnt to our cost that the multiplier works in reverse. As George Osborne and the Treasury tried hard to slash public spending – especially on the poor – the multiplier went negative.  In other words, the
contractionary effects of ‘fiscal consolidation’ or ‘cuts’ had a ripple effect. The negative effects were greater than the actual cut in spending itself.

As the National Institute of Economic Research explained in their Report on The Economic Landscape of the UK,

…public sector spending cuts had an impact on aggregate demand which checked the expansion of the private sector but also ..reduced export demand. The result was a replacement of the lost public sector jobs by new private sector jobs but no job creation over and above this level, with the economy remaining at the initial depressed state.

Only when the Institute of Fiscal Studies turns the economic ‘telescope’ around – and views political parties’ plans in the context of the wider “depressed” economic landscape are we, the voting public, likely to get a more rigorous analysis of the likely impact of a political party’s plans.

This article first appeared at Prime Economics.