Will Brexit make austerity worse?

There seems to be some confusion among some on the left about the impact of Brexit. Statements like ‘Brexit will make austerity worse’ by Remainers are imprecise, so let me spell this out. Because of the controversy this generates I’m afraid this is going to be a rather dry, analytical post. But if you think government spending can somehow reverse the negative economic impacts of Brexit, this post is for you.

Brexit will reduce UK trade relative to what it would be if we stayed in the EU. How much will depend on the type of Brexit. As I outlined here, it will not be possible to come near to replacing that trade through new trade deals. So less trade is a given.

Less trade reduces GDP mainly because it reduces productivity. Trade allows specialisation. Instead of Honda cars being produced in each EU country they can be made in just one, which allows (in part because of what economists call economies of scale) the cars to be produced more efficiently. Trade also increases competition (you can buy many makes of car in the UK) which improves efficiency. Therefore if you restrict trade, you reduce productivity. Less productivity means less GDP. I discussed how much GDP could fall under May’s preferred trade arrangement here.

A reduction in productivity is a supply side decline in GDP. It is very different from a demand deficient recession of the kind we had after the GFC. In a demand deficit recession fiscal policy (more government spending or lower taxes) can be used to restore demand and therefore GDP, and must be used if interest rates are stuck at their lower bound. The tragedy of austerity from 2010 is that the opposite was done. The decline in GDP brought about by lower productivity following less trade cannot be tackled in that way.

When GDP falls, taxes fall. To keep the deficit constant, that requires a reduction in government spending. Brexit will reduce government spending compared to what it would be if we stayed in the EU. To that extent Brexit makes austerity worse. To say that those who point this out are advocating a continuation of the policy of 2010 austerity are wrong.

It is important to note that what I am doing here is comparing two states of the economy, and saying what the differences would be between those two states. This type of comparison confuses many people. I am not saying government spending is going to be lower than it is now - it almost certainly will not be. People say cannot we do something to mitigate the impact on GDP of Brexit? There are many things that can be done to improve GDP, like more public investment, but they could also be done if we stayed in the EU. If you think there is still spare capacity in the economy then GDP can be raised by fiscal or monetary policy, but that is equally true in or out of the EU.

Does government spending have to lower out of the EU compared to inside the EU? The answer is no, which is why statements like Brexit will make austerity worse are incomplete. You could keep government spending at the same level in and outside the EU. But that would raise the deficit, which requires higher taxes. So in that case Brexit would increase taxes. So a correct statement would be that Brexit either reduces government spending or raises taxes or some combination of the two.

At this point you get MMTers up in arms. The deficit does not matter for a country with its own currency and so on. Or even worse, that government spending determines taxes and not the other way around. This is a very good illustration of how misleading MMT rhetoric can be. To see why, go back to the case where government spending falls in proportion to GDP under Brexit, which means the deficit is unaffected by Brexit. Now suppose you increased government spending to the level it would have been without Brexit. That is an expansionary fiscal policy, which stimulates demand which raises inflation. The obvious way to reduce demand and inflation is to raise taxes so the deficit is back to its original level. It does not matter whether you need to keep the deficit unchanged because you have a fiscal rule, or you have fiscal policy stabilising the economy as MMT advocates, you get the same result.

Some MMT followers never admit they are wrong, so I got a lot of stuff about how you can use other measures to reduce inflation like credit controls. But you could use them if we stayed in the EU as well to allow higher government spending or less taxes. There is no obvious reason why leaving the EU makes such measure more effective.

The correct statement about the impact of Brexit on the public finances is that it means government spending will be lower or taxes higher or some combination of the two. Furthermore the overwhelming majority of economists think GDP will fall as a result of Brexit, and I have not come across an academic whose field is trade economics who thinks otherwise. If you think, as I do, that this government has reduced public spending way beyond the level that people want, and therefore you want to raise that spending, Brexit makes that more difficult. .

Health spending over time

There has been some comment on the fact that, with recent increases in spending on the NHS, the health budget is taking a growing proportion of UK state spending. I am missing Flip Chart Fairy Tales, so here is a chart heavy post to make one or two obvious points that regrettably are often missing from political reporting.

The first is that health has been taking up a growing slice of our total expenditure (i.e.GDP: expenditure on everything including investment) for a very long time. Here is a chart from a recent IFS publication which is a good source for more in depth analysis.

Note that real spending numbers can be misleading: although real spending has increased since 2010, as a share of GDP it has not, which is a reversal of previous trends. That alone does not inevitably explain recent problems in the NHS, but it certainly could do.

So why is it only recently that the growing share of public spending has been so obvious? Again the IFS have a handy chart that goes a long way to providing the answer.

In 1955/6, defence spending was over 20% of total spending, while by 2015/6 it had fallen to just 5%. This peace dividend (actually two: first a retreat from empire and then the end of the cold war) masked a steady rise in heath, which was only 7.5% of total spending in 1955/6 but was approaching 20% by 2015/6.

Many economists would simply describe this as reflecting that health was a luxury good, which means that spending as a share of income rises when income rises. Not all the evidence confirms this, e.g. the spending patterns of lottery winners. In reality I think there are various things going on. One may be that medical science has got better at prolonging life faster than it has held back the aging process. Another is that medical innovation is increasing the scope of what medicine can do. For example cancer is now increasingly survivable, but only with expensive care. While there is productivity growth in the NHS, it is below the national average and therefore fails to match increases in wages. In the document all the figures so far come from, the IFS expect these factors will require real health spending to increase by 3.3% each year over the next fifteen years.

Politicians, particularly those adverse to taxation, love to think that some kind of reorganisation will somehow change the inevitability of an increasing share of government spending and GDP. But this chart, taken from this source, suggests these trends are not some peculiarity of the way we organise things in the UK

In 1970 health spending was between 4-6% of GDP in these 5 countries, but by 2016 it was between 9-16% of GDP. (There is a definitional break in the UK series in 2013: there was no leap of spending in 2013 as earlier graphs show.) If there is any organisational lesson here, it is not to run a health service in the way they do in the US. It is indicative of the mess the world is currently in that politicians are busy trying to dismantle the positive recent reforms in the US and key politicians in the UK have once talked about making the UK health system more US like.

If the IFS is right, this inevitably means that taxes of some kind will have to rise significantly. Yet the Conservatives have repeatedly pledged not to raise any of the headline taxes, and Labour have felt compelled to match these pledges at least in part. That the budget included increases in the tax thresholds, and Labour’s internal spat over whether to vote for them, illustrates nothing has changed in this respect. This year this tax/spend dilemma was avoided by a tax windfall no one had forecast. But at some point in the near future something will have to give, and I really hope it is not once again the quality of our health services.

A referendum on taxes

Suppose we had a referendum on taxes. A simple question: should taxes be reduced or not? Polling evidence suggests that the resounding answer would be yes. But polling evidence also suggests that most voters would also say yes to more money for schools and the NHS. They might also say yes to reducing the deficit. Referenda do not need to respect constraints, which in this case is a simple budget constraint.

You might say that polls are a bad guide to what might happen in a real referendum on lower taxes. Those in the No campaign would point out that you cannot have over the longer term both lower taxes and higher public spending. But those arguing yes would say that lower taxes could be 'paid for' through greater efficiency in public spending. They might even say that lower taxes pay for themselves because the incentives they provide would lead to more growth and therefore more tax receipts. Most economists would say that this was highly unlikely, but we know economists will be ignored.

There was a similar constraint in the EU referendum. Reject free movement of labour and you cannot be part of the single market, and if you are not in the single market growth will suffer. Some might say that the success of the Leave campaign lay in making the EU referendum into a referendum on immigration, but as I argued before the campaign started this was always likely to happen. While the equation relating free movement to EU membership was straightforward and uncontested, the constraint relating free movement to the single market and growth was contested.

The real failure of Cameron and Osborne was not to forsee this would happen when they agreed to a referendum in the first place. They should have known, because they had managed to shut out economic expertise in the 'debate' over austerity. Their mistake, and perhaps arrogance and conceit, was not to realise that their opponents would do the same to them over Brexit.