A future chancellor needs flexibility

The political pressure for Labour to accept George Osborne’s spending envelope will be intense. In a new essay from the forthcoming Fabian Review magazine, General Secretary of the Fabian Society, Andrew Harrop, explains why its crucial Labour should resist the political pressure to do so and outlines some future spending scenarios. For more on the the Fabian Society Commission on Future Spending Choices click here

Labour is the party of reckless spending and economic incompetence; that’s the line peddled by the Conservatives and it could sink Labour’s chances of winning the 2015 election. So the solution is simple, isn’t it? Labour should just outsource fiscal policy to George Osborne and sign up to his spending plans for the early years of the next parliament. There are a fair few people within the Labour party who subscribe to this view but it would be a disaster. It will harm the economy, further undermine the welfare state and might not even help Labour’s election chances, if voters sensed the party lacked a positive alternative to austerity.

But nor can the party promise to reverse most of the cuts and spend lots more money. Labour must have a clear plan for closing the deficit which can withstand the political pressure that any deviation from the Conservative course will bring.

The challenge then is for Labour to find a middle way, between hugging close to Osborne and the path of fiscal denial. The idea of accepting Conservative fiscal plans comes straight out of the 1997 playbook. It’s credited as a political masterstroke, which laid to rest the ghost of the 1992 shadow budget. But when we look back, with the hindsight of data that was not all available at the time, the economic wisdom of the policy is highly questionable.

In the late 1990s, by holding back spending as the economy boomed, Labour presided over the tail of the longest and deepest fiscal retrenchment in modern British history. A public sector deficit of 7.6 per cent of GDP in 1993/94 turned into a surplus of 4.1 per cent in 2000/01. It’s now obvious that Labour’s contribution to this contraction went too far. By the time Labour came to power in 1997 the budget was already in balance, so by adopting the Conservative spending plans the party created a surplus of unprecedented magnitude. The national debt fell by a quarter in just four years, from around 40 per cent to 30 per cent of GDP, far below Gordon Brown’s own ceiling for sustainable debt. And the proportion of the economy devoted to public spending, which had sunk below 40 per cent of GDP in just three of the previous 30 years, plummeted to 34.5 per cent.

All things considered, it was overkill, and there was little that could be done because the party was locked into plans which had been taken over by events. If the right had been in power perhaps we’d have seen massive tax cuts and a perpetuation of the threadbare public sphere Britain endured in the 1990s. But of course Gordon Brown and Tony Blair did not want a denuded, mid-Atlantic welfare state and rightly switched on the spending taps. But as the size of the public sector returned towards its post-1945 norm, what followed was an increase in real spending of 50 per cent in just five years. Inevitably, not all of the money was well spent, and looking back it’s hard not to come away thinking that Labour’s record would have been stronger with steady, gradual spending rises over the whole of Blair’s decade in power (see figure 1).

Circumstances today are very different but the lesson is that flexibility is one of the most important tools in a chancellor’s armoury and should not be cast away lightly. The story applies in reverse for George Osborne, who has seen the economy perform worse not better than expected. He has trapped himself by committing too firmly to his own 2010 plans and will not change his mind ‘when the facts change’. As a consequence, he’s locked into a spending path which sucks money out of the economy when demand and investment is desperately needed. Why would Labour want to accept a Conservative plan, hatched in 2010, which it didn’t agree with even at the time?

The case for rejecting Osbornomics becomes even clearer when you look at the numbers in his latest budget. If you believe his figures, the chancellor is planning annual cuts to public services that are greater than anything he has inflicted so far. Figure 2 shows that, apart from the ‘protected’ areas of schools, the NHS and international development, public service current spending would fall by almost one fifth in two years, resulting in a total cut of 35 per cent since 2011/12.

The idea of public spending cuts on this scale is frankly unbelievable and if George Osborne were to return in 2015 you can bet he would find a way to ease the pain, through welfare cuts or tax rises. With a pledge to match Tory plans, Labour would be unable to go for the latter and the party would find that any welfare savings it could even contemplate would raise nothing like the money needed to prevent the decimation of public service budgets.

There are three possible scenarios for the economy after 2015 and in none of them do Osborne’s plans make sense.

First, it is just about conceivable that the economy might return to strong growth, as you would expect after a ‘normal’ recession. Were we to have several years of annual growth at over 3 per cent, our fiscal problems would simply melt away of their own accord as they did in the 1990s. At that time the rapid improvements in the public finances went alongside real spending increases each and every year.

More likely is the second scenario: we will creep back to trend growth of a little over two per cent a year. In this eventuality, an incoming chancellor will still need to keep a tight rein on spending, but will have more flexibility than Osborne would have us believe. In particular, by deviating a little from the Conservatives’ plans, Labour could promise an end to retrenchment in public services. From a political perspective, this would create the critical election dividing line: under Labour spending might not rise by much, but the huge cuts would be over. No doubt there would be tough decisions and reductions in certain services to pay for expansion elsewhere, but the overall message would be clear. For it turns out that freezing department budgets in real terms is surprisingly affordable, because the ‘unprotected’ areas suffering the deepest cuts make up quite a small proportion of public spending: ending the cuts would require an increase to overall public spending of around one per cent each year.

It would be for a future chancellor to decide whether to pay for this extra spending through tax rises or borrowing, but the important point is that an annual spending rise of one per cent is totally consistent with sound public finances.

Figure 3 shows that if GDP growth is in line with the Office for Budget Responsibility’s projections, under this plan it would take just two years longer to reach George Osborne’s current target for government spending as a share of GDP.

The graph also shows the limits of what is possible: annual spending increases of two per cent do not produce the same result and can only be contemplated once deficit reduction is complete or growth is very strong indeed.

My third scenario for 2015 is that the economy continues to flatline, with growth somewhere around one per cent. In this context it would be hard to increase everyday public spending, because without decent growth even George Osborne’s cuts do not lead the overall deficit to fall. But after eight ‘lost’ years, the case for Keynesian fiscal interventions would be very strong and a future chancellor would want the flexibility to introduce temporary invest-ment spending on a massive scale. Nor should Labour rule out using social security as well as temporary tax cuts to pump money into consumers’ pockets.

Rejecting the Conservative spending plans need not be a case of good economics but bad politics. For although there are risks (‘tax bombshell’ posters and all) there is equal risk in failing to offer a robust alternative to the millions who are unclear about what Labour stands for and think all the parties are the same. Labour needs to create fiscal space so it can set out signature policies to show politics can offer hope, whether that’s guaranteed jobs, affordable homes or a new early years service.

On the other hand if Labour follows Osborne’s spending plans, we know, as the last budget demonstrated, what will happen to public services budgets – and we can imagine the consequences for people who rely on services the most. We don’t know what will happen to the economy, but under none of the scenarios do Osborne’s plans look necessary or wise. So Labour should plan on the basis of modest increases to overall spending, which would in turn lead to roughly flat budgets for public services. But this should only be a starting point, not the party’s last word on spending, for in such uncertain times a future chancellor needs flexibility above all. Labour must not repeat George Osborne’s stubborn mistakes.