Would things have been different if Clegg had allowed himself to be seduced by a red petticoat rather than a blue stocking?

April 2015

I’m not sure if its because we live in the county forever blighted by Coward’s throwaway observation – very flat, Norfolk – but one of the increasingly few things Mrs R and myself seem to agree on is that tramping in the hills is the perfect tonic for restoring body and soul. Which is how we found ourselves in the Peak District in the lead-up to Easter.

The good news is that this time having taken the route up William Clough to the Kinder Plateau and on to Kinder Scout we managed to find the right track down and finished back where we started six hours later. There wasn’t a lot of running but certainly a fair bit of scrambling and by the time we returned to the car it felt like we’d put in quite a lot of effort to get back to where we’d started.

I felt much the same when George Osborne proudly announced during his budget speech that after five years of his stewardship the economy was performing so well that living standards were now a smidgen higher than when he took office. Regular readers of these ramblings will have gathered that I have not been overly impressed with young George’s efforts.

It seems to me the justification of the whole austerity experiment rests on the assertion that Gordon Brown was a profligate over-spender which in turn created an imperative to reduce, and ultimately eliminate, the deficit by cutting expenditure.

At this stage it may be helpful to explain the difference between deficit and debt as both terms are routinely bandied around as if they are interchangeable – apologies if you find this bit patronising. The Deficit (or, very occasionally, the Surplus) is the difference between receipts (principally from taxation) and government expenditure during a fiscal period (i.e. a tax year). The Government directs its Fiscal Policy towards striking a balance between income and expenditure and sets this out annually in the Budget. The Structural Deficit is the budget deficit adjusted for the economic cycle and tries to capture the underlying position. The Debt is the total amount the country owes and is (broadly) the sum of historic deficits. The Debt is primarily funded through the sale of Gilts – typically fixed term, fixed interest securities.  Under the Coalition the deficit has fallen slightly but the debt has continued to rise.

Chart 1 shows that in the period leading up to the financial crisis the Brown Government was running a deficit, but importantly at under 3% of GDP it was arguably affordable and certainly not excessive.

The data encourage some surprising observations on the perceived fiscal responsibility of Tory governments over Labour. The average deficit during the Blair/Brown Governments was 2.35% of GDP (including the spike to 10.2% in the wake of the global financial crisis) compared with an average of just under 3¼% for the Thatcher/Major periods in office. (see chart 2). Even 2.3% of GDP is still a very large number and adds to an ever-increasing debt burden but at least Labour did so at a significantly slower rate than their Tory predecessors.

Of course, both sets of administrations were burdened by MacMillan’s ‘events, dear boy, events’ and it would be silly to draw any firm conclusion other than, perhaps, that there is little basis for the belief that the Tories are any better at managing the deficit than Labour.

It is interesting, too, to see how increasing VAT coincided with a reversal of the trend of deficit reduction Osborne inherited, a trend that took a further 18 months to become re-established.

It is important to appreciate the causes of the increased deficit. We entered the financial crisis spending a shade over 2% more than we were ‘earning’. By the time the deficit peaked our spending exceeded our income by more than 10%. Some of this was down to increased welfare expenditure – unemployment ticked upwards – but the biggest influence was not on the expenditure side of the equation but the income side.

Prior to the crisis the country had become overly reliant on the financial sector – in 2007 it provided 13.9% of all tax revenues, regularly vying for top place with North Sea Oil. In the period 2007-2010 tax revenues from Financial Services fell by 45.1% (source PWC/City of London Corporation).

Understanding the root cause of the deficit explosion is of more than academic interest. It suggests that while cutting expenditure may have been a sensible measure it would be unlikely alone to close the deficit –what was needed was a stimulus to restore tax revenues. We can now see clearly that those Governments that favoured a more interventionist, Keynsian route (the US and Canada) have seen their economies fair considerably better than the ‘Austerity’ nations – i.e. our own and those of Europe. (see chart 3)

Would things have been different if Clegg had allowed himself to be seduced by a red petticoat rather than a blue stocking? (Brown in a red petticoat and Cameron in blue stockings are images that now formed are proving hard to shake…). Probably not – for all his bluster Osborne has in the main followed the reductions in capital expenditure set out by Darling before the last election and unsurprisingly came to the same result Darling anticipated – the deficit has about halved. This tends to support the view that however strong the political motivation there is a natural pace of change an economy will accept and it develops checks and balances to maintain this equilibrium. So, if the result is likely to be much the same whichever route we take to a balanced budget, the devil is in the detail. To my mind it seems better to focus on growth – to view the country as having a future worth investing in rather than as simply a cost to be cut.

We can see this tendency to self regulate playing out globally at the moment in what are likely to be the two main themes in investment markets this year. The US and Canadian economies have drawn far ahead of their G7 competitors. Both economies have not only grown more quickly but, as importantly, have maintained their productivity – the element that gives them a real competitive edge. The US economy has recovered strongly from the crisis but this relative strength has had the effect of increasing the value of the dollar. This is making imports cheaper and US exports more expensive, dampening demand for domestic goods and potentially aiding the recovery of non-dollar denominated trading partners. However, for the many emerging and frontier markets that are also tied to the dollar this creates a real risk. Their economies are poorly placed to weather the increased competition a strong dollar presents and this suggests an already high risk investment area has risen a few rungs higher up the risk ladder. The second theme is commodity prices. Canada, like Australia, is heavily dependent on its plentiful commodities. As with the strong dollar, lower commodity prices create winners and losers. Canada has been a winner as commodity prices boomed in the recovery but now it looks in danger of seeing this reverse. It will be interesting to see how Mark Carney’s protégés at the Bank of Canada react.

The collapse in oil prices in particular also has mixed implications here in the UK. The North Sea remains one of the largest sources of tax revenue and the UK offshore industry employs many people in high tech knowledge industries around the world. Against that, the fall in oil prices has been seen as the main factor in removing inflation. This is unhelpful because it makes it less easy to disentangle the (good) deflationary effects of an oil price fall and the (bad) deflationary effect of weakening demand. I suspect the latter is having a greater influence on falling prices than we are being told. This view tends to be supported by figures from JP Morgan cited in the Economist back in October that an oil price fall from $115 to $85 knocked around 0.4% off global inflation. Today Brent Crude is trading at $58 a barrel so, if we’re generous, we can say the fall in oil prices may account for around 1% of the fall in inflation which means a good chunk of the fall is down to ‘bad’ deflation which does not bode well for the post-election future.

In a world of checks, balances and unintended consequences following any route can lead to unanticipated costs. The previous time we were on Kinder Scout was during a blizzard with poor visibility. Disorientated we stumbled across what we thought was the track down from the plateau. It wasn’t – it took us down the wrong side of the mountain and after an 18 mile trek we had to take a train back through the mountain and a twenty pound taxi ride from the station back to our car. So, while we did end up where we’d started it was by no means straightforward!

Richard Ross

April 2015

 


This newsletter is intended for information only and does not represent personalised financial advice. If you require advice in respect of your financial planning, you should contact us. Past performance is not a guide to future performance. The information in this newsletter was correct as at Apr 16, 2015 but may not apply at the time of reading.

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