Set the economy free to meet tough challenges ahead

Despite the cuts, the coalition government will raise the national debt by almost £500bn over this Parliament. This is just the official debt. When other liabilities such as pensions are included, the total debt is already £5 trillion and heading higher. This amounts to a staggering £80,000 per person in the UK.

If the government thinks the cuts will solve the problem, it is deluding itself. In real terms, public expenditure will fall by just three per cent by 2015. Spending on politically sensitive areas such as health and welfare will be maintained, while the foreign aid budget will actually be increased. More money will also have be spent on interest payments as the debt continues to rise.

Recent tax rises won’t solve the debt problem either. Indeed they may even make it worse. When tax rates are already high, increasing them further tends to reduce the amount raised.

Take the 50p rate of income tax. This will deter hard work and encourage tax avoidance strategies. It will also make it harder for UK-based firms to attract top international talent. Some companies may even decide to move elsewhere.

Higher taxes destroy wealth and make both individuals and the government worse off. With little room for manoeuvre on tax rates and cuts, the Chancellor hopes that economic growth will deliver the extra revenues needed to balance the books. But if the recovery falters, the public finances could be in deep trouble again.

Worryingly, there are several reasons to be pessimistic on the economy. The massive surge in government spending under New Labour is thought to have knocked at least one per cent a year off Britain’s trend growth rate. An increasing share of resources has been devoted to inefficient public-sector projects rather than the private-sector investment.

The situation is worsened by a rapidly ageing population. The importance of the “grey vote” makes it far more difficult to reduce public spending on the elderly, and they have largely been shielded from the cuts so far.

Yet without a more radical approach to issues such as public sector pensions and healthcare, government debt levels are likely to carry on growing and there will be upward pressure on taxes.

On top of serious demographic challenges, there are several less predictable factors that could drag down growth. These include the euro crisis and rising oil prices. After unsustainable booms, large parts of Europe now face a prolonged slump. Britain will inevitably be affected by these problems, particularly if taxpayers end up funding bailouts of major countries such as Spain and Italy.

A 1970s-style oil crisis could be even more serious than continued turmoil in the eurozone. Political upheaval in North Africa and the Middle East has already helped send prices to record highs, raising costs for businesses. Britain’s North Sea Oil reserves previously offered some protection from this kind of shock. But they are dwindling rapidly – a trend likely to be speeded up by George Osborne’s short-sighted windfall tax on oil and gas production.

Higher energy costs will also result from the government’s environmental policies. Around £200bn will be diverted into power projects such as offshore wind farms over the next decade, largely to meet ambitious climate change targets. As a result, businesses outside the energy sector will be starved of investment capital. Their growth will be further hampered by higher fuel bills and it may also be necessary to raise taxes to address rising fuel poverty.

These extra costs will pile on the misery for struggling small enterprises already suffocated by red tape. But rather than deregulating, the coalition has added yet more burdens. Examples include the Equality Act, the extension of paternity leave, new controls on migrant workers and increases to and extensions of the minimum wage.

With so many reasons to be negative about the UK’s growth prospects, it would hardly be surprising if government forecasts prove too optimistic. The consequences could be dire. A slower than expected recovery would mean the deficit remained at unsustainable levels. This could undermine the government’s credibility on the financial markets, pushing interest rates higher. In the worst-case scenario, Britain could be caught in a Greek-style debt spiral, having to borrow more and more money just to afford interest payments.

Radical action is therefore needed to lower government debt, particularly given the risk of a serious external shock within the next few years. The cuts need to be deeper and should be combined with a systematic programme of deregulation. Rather than paying lip service to the growth agenda, the coalition needs to reject decisively the wealth-destroying policies that hamper businesses.

13 April 2011, Yorkshire Post

Euro crisis no surprise to economists

They were warned. In the late 1990s, eminent economists queued up to explain the flaws in the euro project. Chief among them was Nobel Prize winner Milton Friedman, who in 1999 – the year the euro was born – predicted that “sooner or later, when the global economy hits a real bump, Europe’s internal contradictions will tear it apart”.

But the fatal conceit of EU policymakers triumphed. The euro was a key plank of their long-term programme to centralise power at supranational level. Given this agenda, it is unsurprising that the EU’s response to the current crisis has been to further emasculate member states. Following the bailouts, the fiscal policies of Greece and Ireland are severely constrained. In the longer term, a similar approach may be rolled out across the Union.

The Stability and Growth Pact was supposed to prevent governments getting into too much debt. Budget deficits were to be under 3 per cent of GDP, while national debts were supposed to be under 60 per cent of GDP. But the pact proved impossible to enforce. Several countries – including Germany – broke the agreement, with no sanctions. Others only satisfied the criteria through creative accounting.

Stricter EU controls on government borrowing – for example a new Stability and Growth Pact with real teeth – clearly have the potential to reduce the economic problems associated with government debt. But policymakers are deluding themselves if they think this approach will solve the fundamental problems of the eurozone.

Applying a one-size-fits-all monetary policy to a huge geographical area with different cultures of saving and debt, different banking systems and different economic conditions, will inevitably blow up inflationary bubbles where interest rates are inappropriately low. The effect is exacerbated by the implicit bailout guarantee given by eurozone membership, which reduces the risk premium demanded by lenders.

In Ireland and southern Europe, a fake boom based on credit rather than productivity growth led to a huge misallocation of resources – particularly into property markets. Wages rose rapidly, especially in the construction sector.

Once the supply of credit dried up, this house of cards collapsed. And the countries that experienced inflationary booms now face a very painful adjustment process. Bad investments must be liquidated and wage rates will have to fall by around 25 per cent to become competitive with the core nations of the eurozone. This is horrendous. It suggests countries such as Greece and Portugal face a fall in living standards comparable to that suffered in the United States during the Great Depression.

Worse still, high levels of employment regulation in southern Europe are a huge obstacle to the necessary correction in wage rates. The likely result is mass unemployment. Southern Europe is also cursed with traditions of social unrest and hostility to economic liberalism. Moreover, rapidly ageing populations will put extra pressure on public finances, while environmental policies threaten to undermine vitally important tourist industries by dramatically increasing the cost of air travel.

Yet recovery is still possible and the EU could do a great deal to help southern European countries bounce back. In particular, it could undertake a systematic programme of deregulation, rescinding directive after directive to lower dramatically the costs of doing business. The EU can also encourage member states themselves to reform, for example by liberalising labour markets. But so far the response to the economic crisis has involved more regulation, not less. For example, many more restrictions have been placed on financial markets, which are crucial to the investment that drives recovery.

The absence of a deregulation agenda raises the question of whether the eurozone should be broken up, with some countries re-adopting national currencies – though perhaps still allowing the euro to be used as legal tender. The new currencies could fall in value, allowing wage rates to fall without overt cuts in pay. However, the devaluation option – which happened repeatedly in many countries before the euro – arguably encourages reckless tax and spend policies.

A break-up could also lead to mass defaults on euro-denominated government debt in those countries that left the zone. Much of this debt is held by banks across Europe. Default could trigger their collapse and demands for yet more bailouts. Break-up of the euro would also be deeply humiliating for politicians and bureaucrats who have staked so much on the project and a European centralisation agenda that appears to have no reverse gear.

There are large political incentives to maintain the status quo. Struggling countries will continue to be propped up by subsidies and the fundamental flaws in the euro will remain. The EU may increasingly become a transfer union which redistributes resources from more successful countries to failing ones. Necessary adjustments will be delayed and eventually the economies of the stronger nations may be undermined.

For the last twenty years, Western Europe has suffered from slow growth and rapid relative decline. The euro crisis threatens to speed up the region’s descent into economic irrelevance.

23 March 2011, PSE

Osborne’s Budget chips away at the top of an iceberg

In this year’s Budget, George Osborne had the opportunity to bolster economic recovery by removing barriers to growth. Alongside some welcome proposals, he unfortunately also introduced a series of gimmicks that do little to address the high levels of tax and regulation that severely hamper entrepreneurs.

Perhaps most disappointingly, the Chancellor failed to reverse several recent tax increases that are on the wrong side of the Laffer Curve (counterproductive tax rises that lose the Treasury more than they raise). Room for manoeuvre is limited but George Osborne really should have been more specific about abolishing the 50p Income Tax Rate and should have reversed the increase in Capital Gains Tax. The reduction – and announced future reductions – in corporation tax are, of course, welcome.  

While there was talk of deregulation – for example, through tax simplification and the reform of the planning system – the proposals  are insignificant in terms of the overall burden of red tape. Hugely expensive regulations to meet environmental targets, for example, remain in the pipeline.

There has also been no serious attempt to address youth unemployment. Radical liberalisation is desperately needed here, including the abolition of the minimum wage and the removal of reams of burdensome employment law. The announced expansion of subsidised apprenticeships will do nothing to address the fundamental problem that state intervention has priced low-skilled young people out of the labour market.

The approach to business growth echoes the interventionist policy on employment. Twenty-one enterprise zones will be created with tax relief for firms locating in them. Enterprise zones have been tried before, of course. They create economic inefficiencies by artificially distorting the spatial pattern of economic activity. Businesses outside the zones also face higher taxes to pay for the tax breaks and activity may simply be displaced from one area to another. Worse still, the political imperative to make a success of the zones may encourage further government subsidies (for example, the c. £6 billion spent on transport infrastructure to regenerate London Docklands). Against this, the proposals to marginally liberalise the planning system more generally may bear some fruit.  

If Osborne had been serious about removing barriers to growth he would have turned the whole of the UK into a low-tax, low regulation ‘enterprise zone’. As it stands, the 2011 Budget is a missed opportunity to liberalise the economy.

23 March 2011, IEA Blog

Bad news for social democrats – the Swedish model doesn’t work

Classical liberals can point to numerous examples of robust economic growth coinciding with low taxes and light-touch regulation: Britain in the 18th and 19th centuries; the US before the 1930s; and more recently Hong Kong since the 1960s. Of course, it must be conceeded that these examples were far from night-watchman states and the role of government remained significant in certain areas. But the general hypothesis that economic liberalisation aids the production of wealth receives further empirical support from the large number of countries that have experienced rapid growth after adopting free-market oriented reforms – from China in the late 1970s to some of the ex-communist nations of central and eastern Europe in the 1990s.

The history and geography of wealth creation is far more problematic for supporters of big government. Yet they often claim empirical support from the economic success of Scandinavia and Sweden in particular. The latter is said to combine a very large state with high levels of prosperity. But unfortunately for social democrats, the economic history of Sweden appears to be far more consistent with the classical liberal analysis than their interpretation.

Sweden enjoyed significant relative economic success in the first half of the 20th century. In this period, Sweden had a very small state by modern standards. In 1937, for example, state spending in Sweden constituted just 16.5% of GDP (see Crafts, 2002), lower than China today, while in the UK it was far higher at 30%. Even in 1960 – just after Sweden had overtaken the UK in GDP per head – state spending in Sweden was still only 31% of GDP – lower than in Britain. 

In relative terms, economic growth has been sluggish in Sweden since the early 1970s, since the size of government there had become really huge. For example, per capita GDP in Sweden was 16% higher than the UK in 1980 (and public spending accounted for a mammoth 60% of GDP), but only 3% higher in 2008. Indeed, Sweden suffered a severe fiscal crisis in the early 1990s, so high was the level of state spending, and radical reforms had to be introduced in an attempt to curb the growth of government.

While one should be cautious about drawing too many conclusions from growth statistics, Sweden’s economic record certainly fails to falsify classical liberal theories on the relationship between government intervention and economic prosperity.

13 January 2011, IEA Blog

Why raising VAT destroys wealth

In the context of Britain’s fiscal crisis, today’s rise in VAT from 17.5% to 20% may be seen by some as a necessary evil. Moreover, indirect taxes such as VAT are often regarded as less harmful than direct taxes such as income tax. Certainly, the economic effects of rises in VAT are dispersed and difficult to quantify. Nevertheless, it is important to recognise the negative economic impacts of raising VAT. Indeed, there are good reasons to be sceptical that raising the tax will deliver significant additional revenues in the long term.

Increasing VAT prevents mutually beneficial exchanges from taking place – trades that are no longer worthwhile at the higher rate. Thus there is an immediate welfare loss. But the repercussions are far more profound. In particular, raising VAT will have a negative effect on productivity growth. Increasing its rate reduces the economic incentives to trade and therefore hampers the division of labour and the associated productivity gains from increased specialisation, economies of scale and so on. General tax revenues will suffer eventually as lower productivity growth reduces overall output.

Further harmful effects include reduced work incentives, as individuals can buy less with every extra pound they earn, and a greater distortion between vatable and non-vatable goods. Given that most of what people earn is spent, an increase in VAT has much the same effect on incentives as an increase in income tax – it reduces real, take-home pay.

A higher rate of VAT also encourages individuals and firms to conduct business in the informal economy. Accordingly, the “black market” tends to be larger in countries with high rates of VAT, even in cultures where corruption is relatively weak, as in Scandinavia. Yet investment is a problem for informal businesses – they cannot expand like formal businesses, for example. Black market businesses also expend resources on avoiding detection, corrupting officials, paying participants a risk premium and so on. Furthermore, an expanding informal economy may encourage draconian and costly countermeasures by tax authorities, which also impose additional costs on legitimate businesses.

4 January 2011, IEA Blog

Hammond’s Soviet-style rail policies

When Transport Secretary Philip Hammond announced last week that the government would procede with three big rail projects – High Speed 2, Crossrail and Thameslink – it was a bit like a Soviet commissar boasting how many new tractors he would be sending to favoured collective farms.

These schemes are almost entirely state-directed: taxpayers will pay for the infrastructure and officials will determine the details of the routes. And like so many socialist grands projets, the returns on the “investment” are likely to be negative, since taxpayers will in all likelihood have to provide substantial operating subsidies to support the new train services (as has been the case with High Speed 1). In addition to these direct costs, there will also be significant deadweight losses resulting from the associated taxation.

As well as imposing enormous costs on taxpayers to fund uneconomic rail schemes, it is also telling that the government has actively prevented major private-sector investment in new transport capacity through its airports policy and its prohibition of Heathrow expansion.

Students of Austrian economics will not be surprised that the misallocation of resources by the state is endemic in the transport sector. Transport is subject to a very high degree of central planning by politicians and bureaucrats, with new rail schemes representing just one example. And Austrians have explained why central planning authorities are incapable of making efficient resource allocation decisions.

In particular, central planners are hampered by the absence of relevant market prices and therefore find it very difficult to calculate accurately costs and outputs (see Mises, 1949, p. 696). While there are prices on Britain’s railways, these are severely distorted as a result of huge government subsidies, the regulation of many fares, the imposition of an artificial structure on the industry, planning controls and so on. A scheme that appears to have positive economic benefits may only do so as a result of other layers of harmful state intervention.

Moreover, since government decision-makers do not own the capital they are allocating they have less incentive to act responsibly or show initiative. They lack the “commercial mindedness” of entrepreneurs (see Mises, 1935). It is also worth mentioning the insights of public choice theory on the behaviour of politicians and bureaucrats – in particular how decision-making processes tend to be captured by concentrated interest groups such as the rail lobby at the expense of dispersed taxpayers.

If the government wishes the UK to have an efficient and competitive transport sector that does not burden taxpayers and which fosters prosperity by lowering the costs of trade, it should reject the central planning mentality, remove distortions, and shift the supply of infrastructure to the private sector.

1 December 2010, IEA Blog

Bonfire of the quangos is mostly hot air

There are over 1,000 quangos in the UK. Today’s news that 192 of them are to be abolished appears to be concrete evidence that the coalition is taking radical action to reduce the role of government and cut the deficit. But then one reads the small print.

In reality most of these quangos will be abolished in name only. Their functions, and in all likelihood their staff, will simply be transferred to other government bureaucracies. The Regional Development Agencies, for example, will be transformed into Local Enterprise Partnerships with some of their responsibilities offloaded to BIS. Rather than abolishing a pointless layer of government, the coalition is rebranding it. With this process repeated across the quangocracy, it is far from clear that there will be big savings in expenditure.

The underlying problem is arguably the government’s attitude to regulation. Unless it takes serious steps to rescind the huge volume of legislation introduced in recent years, the coalition will find it difficult to scale back the associated bureaucracies. This relationship between regulation and quangos is clearly seen in the field of financial regulation where the government’s attempts to increase the volume of regulation will lead to one quango evolving into three or more. The important role of the European Union in the regulatory sphere is another obstacle to cutting many of these agencies.

The “fairness” agenda also appears to have hampered the process of scaling back the quangos. It is notable, for example, that the Low Pay Commission, which advises on the level of the minimum wage, has survived. A genuinely liberal government would of course abolish the minimum wage, together with the bureaucracy that goes with it – just as, in another Conservative age, the wages councils were abolished. Even a prudent socialist administration could save money by replacing this quango with a simple inflation-linked formula.

Cutting the quangocracy is in many ways an open goal. Many of the agencies have low profiles and are not highly valued by the public. The coalition’s failure to use this opportunity to achieve a significant reduction in the role of the state therefore augurs badly for next week’s Comprehensive Spending Review.

14 October 2010, IEA Blog

David Cameron’s conference speech lacked intellectual coherence

David Cameron’s conference speech has arguably provided observers with important insights into the ideologies helping to drive coalition policy. Worryingly, there were strong elements of collectivism and egalitarianism in the Prime Minister’s address.

His discussion of “citizenship” was highly collectivist. He spoke of leading the change from “unchecked individualism to national unity and purpose”, a phrase which could easily have been uttered by a fascist despot, while the conference’s theme is “let’s work together in the national interest”.

Then there were the references to “fairness”, protecting the NHS, ensuring that those with “broader shoulders” bear the brunt of the deficit reduction programme (despite the fact that they have not been the main beneficiaries of the public spending splurge) and that children from the poorest backgrounds go the best schools. A whole host of interventions were lauded, on regional aid, high-speed rail, carbon capture and bank lending to small businesses. Yet there was also some anti-government content in his criticisms of New Labour’s record, as well as talk of decentralisation, free schools and transferring power from the state to society, leaving an overall message that lacked intellectual coherence.

Notwithstanding the rhetoric, there are several alternative interpretations of Cameron’s approach. One view is that he is genuine conservative who supports free markets but deploys the language of egalitarianism and collectivism in order to maintain the successful rebranding of the Party away from Thatcherism. A second hypothesis is that Cameron and his close confidantes are “progressives” who through an entryist strategy have successfully taken over the Party in order to move policy in a leftward direction. Another possibility is that neo-conservativism – an ideology which combines some facets of conservatism with a strong collectivist element – is influential in Cameron’s thinking. Finally one shouldn’t neglect the insights of public choice theory: there are strong incentives to satisfy interest groups as well as maintain voter support, while the need to satisfy Lib Dem coalition partners complicates matters. Ideology is often subsumed by political expediency.

However, recent policy decisions suggest that collectivist ideas are proving very influential within the Conservative-led coalition. There is a strong emphasis on redistribution, exemplified by the “fairness” agenda and by decisions to raise capital gains tax and to cut child benefit for higher-rate taxpayers, while raising child tax credit payments to workless households. Last week’s Equality Act imposed significant new costs on private businesses and was imbued with the kind of politically correct “cultural Marxism” that would have made it completely unacceptable to a genuinely conservative administration.

More generally, the first months of the coalition have been marked by huge tax rises and a raft of costly new regulations. The former might be justified by the politics of deficit reduction, but the latter signal that the new government’s economic philosophy is decidedly interventionist. If a free-market Cameron is failing to prevent new extensions of state power then this suggests weakness. If such policies have been directed from the top it suggests collectivism has poisoned the very heart of the Conservative Party.

6 October 2010, IEA blog

Equality Act shows government isn’t serious about deregulation

The Equality Act came into force yesterday. It strengthens anti-discrimination law and will make it easier for members of specified groups to win claims for discrimination, harassment and unfair dismissal. As such, the Act represents a further attack on the property rights of business owners, as well as a significant imposition in terms of the additional costs of legal advice, tribunals and so on.

This type of employment legislation also means that underproductive employees will be retained rather than replaced by more productive workers. The Act will make it even more costly to dismiss members of groups that have effectively been given special legal privileges by the government. The regulatory burden is likely to be disproportionately heavy on small businesses that lack specialist human resources and legal departments.

In the long term, the legislation may well prove to be counterproductive. The risk of costly future legal action may encourage employers to find surreptitious ways of discriminating against members of privileged groups during the recruitment process.

However, perhaps more worrying than the negative economic impact of this legislation is the message it sends about the coalition’s attitude to enterprise. The imposition of significant new costs on firms suggests that, despite some encouraging rhetoric, this government isn’t serious about deregulation.

The sad thing about this particular legislation is that it is completely unnecessary. For example, the IEA publication, Should We Mind the Gap?, showed that inequality of pay has little if anything to do with discrimination. Attempts to deal with inequality in this way just reduce the range of opportunities available to those groups that are considered disadvantaged.

2 October 2010, IEA Blog

Big government is here to stay

24 September 2010, Public Service

Public sector workers are understandably concerned about the outcome of the Comprehensive Spending Review (CSR). Trade union leaders have recently spoken of strikes and civil disobedience against planned cuts.

Yet such reactions are mostly based on rhetoric rather than reality. The fine print of George Osborne’s Emergency Budget reveals that government spending in real terms will remain more or less steady over the next five years. Indeed, when ministers speak of cuts, they often mean a reduction in previously planned increases in expenditure. The Treasury’s optimistic forecasts for economic growth are the key to the coalition’s deficit reduction programme rather than any dramatic scaling back of public services.

Nevertheless, since the budget for the NHS has been ringfenced, many of the mammoth welfare costs are politically untouchable, and because debt interest payments are likely to rise significantly, there will be immense pressure to make savings in some areas.

The history of previous “post-recession” periods suggests that capital expenditure will be a major target. We have already seen the cancellation of hundreds of school building projects and this will be just the start. Social housing grants to councils and housing associations will be pared back still further. And while expensive transport schemes such as Crossrail and High Speed 2 probably won’t be abandoned, their timelines may well be extended and their specifications reduced. A similar strategy is likely to be applied to major defence items such as Trident. The rate at which new hospitals are commissioned is likely to slow to a trickle as the NHS budget is diverted to “front-line” services to cope with the needs of ageing baby-boomers.

Another focus will be big IT projects, which in recent years have been plagued by delays, huge cost overruns and embarrassing failures in implementation. The Treasury has estimated total government IT spending at about £16 billion a year, and this clearly a relatively easy expenditure item to slash without significant political repercussions.

Such a policy will, however, mean ending the cosy relationship between departments and a small number of large IT companies. Similarly, the firms that rely on government contracts in defence, transport, education and so on, are likely to bear the brunt of economies in these areas rather than public sector workers.

The UK’s network of quangos will be another focus of the CSR. There are over one thousand of these agencies in the UK and a programme of rationalisation is certainly on the cards. Many quangos have a low profile and their roles are not well understood by the public. This makes them an easy target when political expediency rather than economic efficiency is the overriding determinant of where the axe falls.

Having said this, a significant proportion of quangos are very difficult to abolish. Some perform the basic functions of government, such as HM Revenue and Customs and HM Courts Service, while others are effectively required in order to implement European Union directives. It was instructive that the coalition was unable to remove an unnecessary tier of government by abolishing the Regional Development Agencies (RDAs). Instead, it is replacing them with Local Enterprise Partnerships and transferring some of the RDAs’ responsibilities to the Department of Business Innovation and Skills.

This pattern is likely to be repeated across government following the CSR. Quangos will certainly be abolished and ministers will speak of radical action being taken to tackle the deficit and reduce the role of the state. But in practice most of the staff and nearly all of the functions will be transferred to other agencies. There appears to be no genuine appetite within the coalition for the kind of attack on red tape necessary to slim down government bureaucracy significantly.

In conclusion, most public sector workers have little to fear from the findings of the CSR. There will be high-profile casualties, but the era of big government is definitely here to stay. Even if union predictions of 200,000 job losses in the near term come to fruition, this will represent well under 5 per cent of the total public sector workforce.

The coalition’s lack of radicalism may be reassuring to government workers, as well as the millions dependent on welfare benefits, but it also means that policymakers are doing little to create the kind of low-tax, low-regulation environment where entrepreneurship can flourish. The deeper issue of Britain’s rapid relative economic decline is not being addressed and as a consequence both public and private sector employees will be poorer in the long run.