Chancellor's 'Reset' Leaves UK Economy Exposed And Vulnerable

Philip Hammond has missed his first opportunity to formulate a proper response to the country's long term challenges; with a target that is not flexible enough to allow for significant, proactive investment. There is still much work to do.

The Chancellor has made good on his promise to 'reset' his targets for borrowing, but the new target represents a missed opportunity.

Today's headline spending announcement by the Chancellor is bitter-sweet. Sweet, because the damaging and unnecessary target to produce an overall budget surplus in 2020 has been abandoned. Bitter, because the first opportunity to properly respond to the economic challenges of our time with smart new fiscal policy has been missed.

Scrapping Osborne's plan for a £10 billion surplus was always a fait accompli. There was only ever a 50 per cent chance that this target would be met anyway. Now, with all forecasts for growth being revised down in view of the Brexit vote, a 'reset' of spending policy was inevitable.

As IPPR has previously argued, the real question was always whether we would see a 'good' reset or a 'bad' reset.

Today, Philip Hammond set out his intention to target the cyclically adjusted deficit. Put simply, he wants the government to commit to balancing the books in the next parliament, excluding any borrowing required to cover temporarily higher welfare spending and lower tax receipts brought about by a weak economic outlook. In this parliament, he will aim to keep cyclically adjusted borrowing below two per cent of GDP.

This represents a dramatic departure in government policy from the past six years. The previous Chancellor, George Osborne, repeatedly ignored consensus economics by pulling significant cash out of the economy in search of a surplus on the overall budget.

Hammond's new targets are an improvement. Allowing the government to borrow two per cent of GDP in 2019/20 gives greater flexibility in the short- to medium-term. But, in terms of the longer-term picture, today's announcement is closer to a bad reset than a good one. Ploughing on in search of a balanced budget leaves the UK economy over exposed and ill-equipped to deal with the challenges of the coming decades.

To understand why, we need to consider how past policy has got us to where we are. In the past, slow or negative growth has been tackled largely through monetary policy: lowering interest rates to incentivise consumers and investors to take out credit in order to maintain levels of spending in the economy, reducing economic contraction and speeding up recovery.

Yet historically, interest rates have tended not to recover their pre-recession levels before being cut again in response to the next downturn. As a result, the economy has simply adjusted structurally to cheaper and cheaper levels of credit. Each subsequent downturn has required interest rates to fall further and further, and starting from an ever lower base each time - like an antibiotic slowing losing its potency.

Since 2009, this has culminated in interest rates reaching their floor, or 'effective lower bound', beyond which further reductions (notwithstanding the recent cut in interest rates to a record 0.25 percent) bring little or no material benefit to the wider economy (see graph below taken from IPPR's latest report on the economy, Out of Shape: Taking the Pulse of the UK Economy).

With interest rates now at close to zero, the ability to incentivise families and firms to spend their way out of the next recession using even lower rates is now exhausted.

It is also an especially bad time for monetary policy to lose its impetus. The UK on average experiences a recession once every ten to 14 years. But with increasing uncertainly over access to the European single market, the threats to growth are now considerable and immediate.

But what has this got to do with government spending targets and the 2016 autumn statement? With interest rates at the effective lower bound, there are two remaining options available to policy makers to combat the next economic shock - whether Brexit-induced or otherwise.

The first is unconventional monetary policy. But interventions such as quantitative easing (QE) can prove regressive (disproportionately advantaging the wealthy) and poorly targeted, and the extent to which they are effective relies largely upon market mechanisms that work less predictably during recession - precisely the time in which they are most likely to be called upon. Further experimentations during the throes of recession, such as with negative interest rates or so called 'helicopter money', are also unlikely to be the most reliable way of protecting jobs and livelihoods, as chances are much of the money would be spent on imported consumer goods.

The remaining option, then, is government spending. Depending on the amount of spare capacity in the economy, spending on investment has a high multiplier effect on GDP, more than paying for itself through higher growth and tax receipts in the future. Unlike QE, fiscal policy is most effective therefore during a downturn in the economic cycle. But a long-term target to balance the cyclical budget gives little space to borrow to invest.

IPPR has consistently called for fiscal targets that allow government to use current ultra-low borrowing costs to finance significant new investment. Extra spending should be targeted at both digital and physical infrastructure, in order to boost long term productivity in the economy.

Now, with the launch of the Commission on Economic Justice, IPPR is bringing together a new coalition of voices to help generate more long term, fundamental solutions. These will include the right combination of tools for the Treasury and the Bank of England to respond to poor growth when interest rates are so low.

Philip Hammond has missed his first opportunity to formulate a proper response to the country's long term challenges; with a target that is not flexible enough to allow for significant, proactive investment. There is still much work to do.

Alfie Stirling is Senior Economic Analyst at IPPR


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