Original URL: http://www.theregister.co.uk/2010/11/16/gov_spending_cuts_analysis/

Those govt cuts - slasher horror or history-changing brilliance?

Computers, menus and ideologies: take your pick

By Tim Worstall

Posted in Government, 16th November 2010 13:10 GMT

Opinion So, these Tories and Lib Dems, eh? Baby-eating bastards or careful correctors of a drunken sailor's spending spree? The most painful cuts since Abraham's circumcision or a mild trimming of the fiscal sails? You can read it all either way and depending upon your pre-existent political prejudices you probably have done.

coalition budget cuts

The cuts are ideologically driven, whatever platitudes the Boy Dave gives us.

This is the largest long-running reduction in planned government expenditure since the 1920s. It's also milder in each year than Dennis Healey's one year of serious cuts in 1976/7. Back then he cut near 4 per cent of GDP out of the budget in only one year while the aim here is to take 6 or 7 per cent out over the lifetime of the Parliament. Again, you can differ over whether it's all about too much spending in the past or the way the banks falling over has destroyed tax revenues. Revenues certainly have fallen – it's been a deep recession – but then public sector spending was rising swiftly just when a classic Keynesian stance would have said that it should have been falling. The other side of this “spend in recessions” is indeed "save in the booms": the amount of fiscal expansion you do should be balanced by the fiscal contractions over the entire business cycle.

But then macroeconomics – the study of the way the whole economy moves about – is that part of economics where we're really not sure that we know all that much. We've an awful lot of variables out there and we've really only got 10 or so business cycles to study (information pre the 1930s, pre the invention of the very concept of measuring GDP, isn't all that useful) and only two really big recessions/depressions, now and the Great one. The evidence we've got from those is also highly contradictory. If you concentrated on the US you'd probably buy the Labour story today: don't cut spending until the recovery is properly underway (the US 1937/8 recession within the Depression being the poster child for that) and thus just keep running up the debt until then. If you looked only at the UK experience, you'd probably buy the Coalition's story.

Cuts in British history

The big cuts here were in the early 1920s, and since we'd just finished fighting a world war, cutting the 50 per cent of GDP we were spending on the military sounds like a damn good idea: whatever it does to GDP or unemployment. In the Depression itself we didn't have the bank runs that the US had, didn't have great cuts or booms in spending: what we did do was come off the gold standard in 1931 and we'd started growing again by 1932 ... back to higher than ever GDP by 1934. (This is a great little site to explore all these sorts of numbers). We've just had a 25 per cent depreciation of the £ in the past couple of years, equal to that of coming off the gold standard. It's also true that exchange rates are much more important to us than they are to the US (twice as much of our economy is traded as it is in the US), meaning that as imports get more expensive there's more incentive to produce domestically, and as our exports get cheaper to others there's more incentive for others to buy them.

You can, just about, if you squint, see what has already been done as sufficient to get us out of all of this: as it did last time (early '90s, European Monetary System and Black Wednesday stuff) and the time before (1931 gold standard).

But, if we're to be honest, it's a bit of a gamble, as is letting the deficit rip until everything's been kissed better. My own opinion is that economists, with the macro side of things, are like generals: always fighting the last war/recession.

For example, the new big thing in macro is the New Keynesian synthesis: sorting out what went wrong with base Keynesianism in the 70s. At the heart of this "New K" is the idea of sticky prices, or menu costs. The idea comes from, well, menus! If prices are changing (up or down) how often will a restaurant reprint the menu? Purely an analogy for the costs of changing prices everywhere of course. Great, fine, lovely, sure it was true and is partially true today. Equally sure that these costs, as a result of computerisation (who actually has a printed price list these days? Who doesn't change prices daily, weekly?) are a lot lower than they used to be, meaning that we've got a little closer to where the assumptions of the New Classicals hold. Alternatively, we might look at the Keynesian assumption that labour is homogenous, and point to this year's Nobel prize in Economics, which went to the people who pointed out the search-and-matching costs of the fact that it isn't homogenous at all ... and that's probably enough macroeconomics for one day.

Don't pretend it's not about ideology

What's much more fun is screaming at these ideologically driven cuts. And yes, they are ideologically driven, whatever platitudes the Boy Dave gives us – but perhaps not by quite the ideology that everyone seems to think. You know, this slash-the-state and overturn the post-war consensus thing: even after all the cuts, at the end of this Parliament, the State will still be 40% of GDP (if everything goes to plan, which it won't) which is above that post war average. The ideology is, rather, that said State, the haphazard expansions of it, had got rather out of hand. Take, for example, the housing benefit changes.

Housing Benefit will be reformed so we do not subsidise people to live in private sector accomodation on rents working families couldn't afford.

That's a quote from the Labour Party Manifesto by the way, the one written by Ed Miliband. And I do think the Coalition's played a political blinder on this one. Whatever you think of the policy, the presentation has been an object lesson in how to do it. The first limitation was the £400 top whack on the largest houses.

Cue every lefty in the land screaming blue bloody murder, then the reminder that this is per week, not per month. It will still be possible for a family to get the median wage (post tax) just to pay for housing even after these cuts and limitations. Once this sunk in the comments sections were full of “You what? You mean I pay tax on my £25k a year so that...but, but, hang them!”

After that, the revelations of the much more important (and possibly much more damaging) reductions from 50 per cent of area median rents to 30 per cent have simply not made that much public impact. The Great British Public has heard one story about bloodcurdling cuts, found them not believable, and isn't going to pay much more attention.

Opportunity knocks at DWP's door

The change that's probably going to make the most difference over time though is the one about raising social rents from 50 per cent of market rents to 80 per cent. It's true that social housing largely pays its costs from the rents paid for it, yes, but economists insist upon something called opportunity costs. Rent foregone is a subsidy just as much as lashing out cash in housing benefit is.

If social rents rise then there will be more requiring HB in subsidy, so we'll be nowhere different at all you might say. Except for two things. This first one is the entirely insane way that we allocate housing subsidies.

If you at some point qualify for social housing: you're broke, homeless, just divorced with small kiddies, whatever, then you get that subsidy of below market rent for your whole life. It's as if having been unemployed for a few months you get dole forever: sick pay continues when you've recovered and you're playing first team rugby again. Increasing the rents (ie, lowering the subsidies) means that we'll only be paying out HB to those who need subsidy, rather than those who did need subsidy at one point in the past.

For the life of me, I cannot grasp why Lee Jasper should have had a council house at £150 a week when he was earning £100,000 a year from Ken Livingstone's administration. Nor why Baroness Uddin had social housing (from, erm, the social housing organisation her family ran) while owning a flat in Maidstone and building a villa in Bangladesh. Oh, while making speeches about the short supply of “affordable housing” when she was bedblocking a unit of that very affordable housing.

How much will it cost, eh?

The second is the cost of all of this. Taking rent foregone as just as much a subsidy as cash paid out, my back-of-the-fag-packet numbers are that housing subsidies cost £40 to £60bn a year (£20-£40bn in lost rents, a wide range as no one actually publishes the figure that I can find, plus £20bn HB). That's enough to raise the personal income tax allowance by £10,000 to £15,000 a head, to take income tax back to what it was, something paid only by those on median incomes or above.

If we move a large chunk of this from that opportunity cost, which we can't see, to a line item of expenditure, then the pressure to really deal with the structural problems of the housing market will grow. For example, it would help if we freed up the planning process (at least 50 per cent of the cost of a house in the south of England is the planning permission to build the thing), and perhaps realise that while the Green Belt is a lovely and wondrous idea, here's the cost: income tax kicks in £10k lower than it has to.

A man can dream can't he?

One more example of ideology: the introduction of markets into schools and hospitals. It's entirely possible to read this as the bastards carving out profits for their buddies from our tax money and thus hold the Red Flag high and march on Downing Street. We could also read a little Polly Toynbee.

Throughout its history the NHS has had an average 4 per cent increase above ordinary inflation, because medical and pharmaceutical costs rise faster.

Ah, now, we know what that is, that's Baumol's Cost Disease. Average wages are determined by the average productivity in an economy. It's a lot more difficult to increase productivity in labour-intensive services than it is in manufacturing: therefore we expect services to rise in price relative to manufactures over time. The NHS will have a higher inflation rate than the rest of the economy. Do note what happens eventually - we get to Douglas Adams' the Shoe Event: the NHS has swallowed the rest of the economy and we all make our living by taking in each others' hernias.

Marxist markets?

We therefore rather need to do something to try to increase this productivity. Specifically, we want to improve total factor productivity (TFP – the jargon way of saying we want to get more out for the same resources put in). We've only really found one consistent way of doing this: markets.

Serious economists suggest that the Soviet Union, in its entire history, did not manage to improve total factor productivity at all. The same point turns up in Mikhail Gorbachev's memoirs and other serious economists suggest it was the same for all of the planned, non-market economies.

It may even be true that the short-term result will be profits for buddies but as Bob Solow (yet another, serious, Nobel-winning economist) has pointed out, 80 per cent of the increase in production in the 20th century, in those market economies, came from increases in TFP.

The use of markets rather than planning might only crank out a 1 or 2 per cent per year increase in productivity, but think of what compounding over the decades does to that.

It's not necessary to have the “you're poor so you die” sort of markets either: Germany, France, innumerable countries, have the “the government will pay for most or all of it” markets, with different suppliers, charitable, non-profit, for-profit, all scrambling to get a slice of that cash. It's the scrambling that seems to do the trick after all.

So yes, this last bit is ideological, but that's because the British left has a very strange, Marxist almost, attitude towards markets. They're not just, as Brad DeLong points out, methods for the extraction of that surplus which rightfully belongs to the labourers: they are also information, incentive and asset-allocation devices.

But of course, what everyone really wants to know is, well, Tim, will the cuts work? Are we about to be ushered into the sunlit uplands of permanent economic growth, falling debt levels and a miraculous escape from a second Great Depression? Sorry to disappoint, but I haven't a clue: and nor, contrary to public statements, has anyone else, economist or not. While there's a lot of public spluttering going on, everyone recognises that it might work, also that it might not. The odds and probabilities change depending on who is talking, there cannot be an absolute insistence one way or the other.

Those Nobel Laureates will let us know, just like the politicians and us journalists, oooh, sometime in 2015. ®