Don’t Believe the U.K.’s Economic Policy Plans

An analysis of public spending ahead of the May election

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There is a British election looming on the horizon. Before scrutinizing each party's economic plan, it's worth taking another look at the policies contained in the coalition government's final budget. While it's the baseline against which the three main parties are comparing themselves ahead of the May 7 vote, none of the parties would carry out this plan if governing alone. Over the past few years this projection has become a less and less useful guide to what policy might actually be implemented, and the current form has been contorted so that it can be judged to meet the targets the coalition government has set itself.

The first of these is for public-sector debt to fall as a share of GDP in the 2016-17 financial year. This target is currently expected to be met a year early (consistent with a previous objective) but only because the government now plans to sell shares in Lloyds Banking Group this year. While this reduces public-sector net debt under national accounting practices, remember that it comes at the expense of more borrowing farther down the line to make up for the profits those assets would otherwise have generated. It's for voters to judge whether the risks associated with a quick sale outweigh the benefits of debt falling slightly in one year rather than another.

The government's second fiscal objective is for the public finances, excluding investment and adjusted for the effects of the economic cycle, to be in balance in three years — currently by the 2017-18 fiscal year. Again, the government is forecast to meet this objective, but only because it has penciled in an implausible path for public spending. Those plans would see spending on public services in real terms fall by 5.4 percent in 2016-17, almost twice as fast as the biggest annual cut recorded in the last parliament. After the target is achieved, spending is then set to rise in 2019-20 by 4 percent.

The Public Spending Rollercoaster

Since pay is a big chunk of public sector spending, the implication is that departments would make big layoffs only to rehire a year or so later. Of course, no ministers in their right minds would actually implement a policy like this. And by the time spending plans are set out, the year that budget balance needs to be achieved will have moved on from 2017-18 to 2018-19, changing the policy incentives. This is a prime example of what could be termed the time inconsistency of fiscal policy — there is an incentive for the government to say it will do one thing, in order to meet its rules, but then do another shortly afterward.

A more reasonable baseline policy assumption might be to assume that the government will smooth the cuts over four years. That would leave the government with the same surplus at the end of the forecast period while eliminating the public spending rollercoaster. However, it would probably mean the government borrows more along the way — perhaps 10 billion pounds next year and 20 billion pounds in each of 2017-18 and 2018-19. There will still be a bigger squeeze on spending in the next parliament than has occurred in the last, but it will probably be achieved more slowly than is currently planned.

An Alternative Path for Borrowing 

That view seems to be vindicated by financial market participants. Such a significant and uneven fiscal squeeze would probably require significant monetary policy activism in order to stabilize demand. The smoothness of the yield curve gives no indication that this is what's expected.

This post is courtesy of Bloomberg Intelligence Economics.

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