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- Herausgeber: John Wiley & Sons
- Kategorie: Geisteswissenschaft
- Sprache: Englisch
When the Treasury lost control of interest rates to the Bank of England in 1997, its status looked under threat. However, it quickly reasserted its power by dominating policymaking across Whitehall and diminishing other ministries in the process. It also successfully fought off attempts by Prime Ministers, from Blair to Johnson, to cut it down to size. In this fascinating insider account, based on in-depth interviews with the Chancellors and key senior officials, Howard Davies shows how the past twenty-five years have nonetheless been a roller-coaster ride for the Treasury. Heavily criticized for its response to the global financial crisis, and for the rigours of the austerity programme, it also ran into political controversy through its role in the Scottish referendum and the Brexit debate. The Treasury's dire predictions of the impact of Brexit have not been borne out. Redemption of a kind, though a costly one, came from its muscular response to the COVID crisis. Anyone with an interest in economic policymaking, in the UK and elsewhere, will find this a valuable and entertaining account.
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CONTENTS
Cover
Title Page
Copyright
Abbreviations
Introduction
Notes
1 Economic Performance
1997–2010: The Brown years
2010–16: The austerity years
2016–20: The EU Referendum and after
Beyond Covid
Notes
2 Macroeconomic Policy
Notes
3 Public Expenditure
Brown One: Married to Prudence
Brown Two: Prudence jilted?
Darling and the financial crisis
Osborne: The austerity Chancellor
The Hammond years
Javid’s short-lived rules
Sunak: Covid-19
Notes
4 Tax Policy
Labour and tax: 1997–2010
Coalition and Conservatives: 2010–21
The Mirrlees Review
Why is tax reform so difficult?
Notes
5 Scotland: Saving the Union
Notes
6 Europe: The Ins and Outs
The euro: failing the tests
Semi-detachment
The EU referendum: Project Fear
Brexit and after
Notes
7 Financial Regulation and the City of London
The Financial Services Authority
The New Bank of England
The gathering storm
All hands to the pump
Financial regulation after the crisis
Brexit and the City
Notes
8 Climate Change: The Road to Net Zero
Notes
9 The Treasury’s Changing Shape
Setting the Bank free
John Birt’s teddy bear
Structural changes
Feeble threats
Does size matter?
Cheap but cheerful?
Call a spad a spad
Culture
Notes
10 Leadership
Gordon Brown
Alistair Darling
George Osborne
Philip Hammond
Sajid Javid
Rishi Sunak
Other ministers
Permanent Secretaries
Notes
11 Trouble Ahead
1. The Treasury View
2. Monetary and fiscal policy
3. Public finance post-Covid
4. Tax policy
5. Levelling up
6. Climate change
7. Productivity
Notes
Index
End User License Agreement
Guide
Cover
Table of Contents
Title Page
Copyright
Abbreviations
Introduction
Begin Reading
Index
End User License Agreement
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The Chancellors
Steering the British Economy in Crisis Times
Howard Davies
polity
Copyright © Howard Davies 2022
The right of Howard Davies to be identified as Author of this Work has been asserted in accordance with the UK Copyright, Designs and Patents Act 1988.
First published in 2022 by Polity Press
Polity Press65 Bridge StreetCambridge CB2 1UR, UK
Polity Press101 Station LandingSuite 300Medford, MA 02155, USA
All rights reserved. Except for the quotation of short passages for the purpose of criticism and review, no part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher.
ISBN-13: 978-1-5095-4955-9
A catalogue record for this book is available from the British Library.
Library of Congress Control Number: 2021948546
The publisher has used its best endeavours to ensure that the URLs for external websites referred to in this book are correct and active at the time of going to press. However, the publisher has no responsibility for the websites and can make no guarantee that a site will remain live or that the content is or will remain appropriate.
Every effort has been made to trace all copyright holders, but if any have been overlooked the publisher will be pleased to include any necessary credits in any subsequent reprint or edition.
For further information on Polity, visit our website:politybooks.com
Abbreviations
AIFMD
Alternative Investment Fund Management Directive
B-DEM
Bespoke Dynamic Equivalence Mechanism
BEIS
Department for Business, Energy and Industrial Strategy
CBI
Confederation of British Industry
CCC
Committee on Climate Change
COP
Conference of the Parties
CPI
Consumer Prices Index
CST
Chief Secretary to the Treasury
DMO
Debt Management Office
DTI
Department of Trade and Industry
ECB
European Central Bank
ECJ
European Court of Justice
EEA
European Economic Area
EMU
Economic and Monetary Union
ERM
Exchange Rate Mechanism
ESRC
Economic and Social Research Council
EST
Economic Secretary to the Treasury
FCA
Financial Conduct Authority
FCDO
Foreign, Commonwealth and Development Office
FSA
Financial Services Authority
FSR
Financial Stability Review
FST
Financial Secretary to the Treasury
GDP
gross domestic product
GFC
global financial crisis
GVA
gross value added
HAM
High Alignment Model
HMRC
Her Majesty’s Revenue and Customs
ICT
information and communication technologies
IFS
Institute for Fiscal Studies
IMF
International Monetary Fund
MOU
Memorandum of Understanding
MPC
Monetary Policy Committee
OBR
Office for Budget Responsibility
PFI
private finance initiative
PRA
Prudential Regulation Authority
PSAs
public service agreements
PSL
private sector liquidity
QE
quantitative easing
R&D
Research and Development
RBS
Royal Bank of Scotland
RPI
Retail Prices Index
SEC
Securities and Exchange Commission
SIB
Securities and Investments Board
SME
small and medium-sized enterprise
SNP
Scottish National Party
TSC
Treasury Select Committee
WTO
World Trade Organisation
Introduction
In 2006, I edited and introduced The Chancellors’ Tales.1 It included lectures given at the London School of Economics by the five former Chancellors of the Exchequer then alive: Denis Healey, Geoffrey Howe, Nigel Lawson, Norman Lamont and Kenneth Clarke (I excluded John Major who had served for a short period). Their brief was to reflect on the challenges of running the Treasury.
The period covered ran from 1974 to 1997. Aside from the personal availability, there was a certain policy logic in that it began with Healey’s attempt to establish budget discipline and control inflation, after the International Monetary Fund (IMF) visitation in 1976. Healey introduced the monetary framework which Howe made the centre of his policy. The period ended with the 1997 election, immediately after which Brown handed control of interest rates to an independent Bank of England.
Since 1997, five more Chancellors have passed through the Treasury, with a sixth (as I write) now in office. So it seemed timely to assemble their reflections on the role. But, partly because the Covid pandemic ruled out another series of lectures, I have adopted a different technique. Gordon Brown, Alistair Darling, George Osborne and Philip Hammond, who cover the period from 1997 to 2019, were kind enough to agree to be interviewed. I am very grateful to them, and to the senior officials, special advisers and ministers who also agreed to answer my questions. Where they were happy to be quoted, they are identified in the text and the notes. I have taken the story up to late 2021, though without the benefit of oral evidence from Sajid Javid or Rishi Sunak.
Three pieces of conventional wisdom are often recycled by the Treasury’s critics. First, that by international standards it is far more powerful than its counterparts: in most other major developed countries there is typically an economic ministry alongside the finance ministry, and there is often a stronger central policy function around the President or Prime Minister. Second, that the Treasury’s ‘dead hand’, masquerading as public expenditure control, constrains government policy unreasonably and damages investment and innovation. Third, that after a series of missteps, the Treasury’s authority is not what it was, and it is riding for a fall.
There may be some truth in the first argument, though a little less since Bank of England independence and the creation of the Office for Budget Responsibility (OBR). But it is not obvious that a single ministry of finance and economy delivers worse policy outcomes. There were several attempts during this period to cut the Treasury down to size, usually driven by the Prime Minister’s staff. In a political system where a Prime Minister with a large majority in Parliament has a remarkable degree of power, the existence of a strong alternative centre is a valuable check on ‘elective dictatorship’.
The second, the ‘dead hand’ argument, includes two subvariants, one micro, one macro. The micro case is that the Treasury is ‘the bank that likes to say no’, always sceptical about new ideas unless they are generated by its own people, and especially suspicious of local initiatives. As one former Permanent Secretary acknowledged, officials are far readier to explain why new initiatives may not work than to generate new thoughts of their own. The Treasury defence is that if it does not train a sceptical eye on wizard ideas for spending other people’s money, no one else will, and that, in the long-running Whitehall drama, it is inevitably cast in the role of Scrooge. To mix Dickensian metaphors, Scrooge may not be popular, but where all the other characters are Oliver Twists with their bowls out asking for more, some with bowls already quite full, his spirit is required.
The macro critique is more serious and has gained force during the period under review. In a world where there is a chronic surplus of saving over investment, the Treasury has maintained a version of Mrs Thatcher’s household economics, urging successive Chancellors (though Osborne needed little urging) to work towards balancing the books, even when the economy was operating below capacity and real interest rates were very low or negative. So the charge is that UK recovery from the 2008/9 financial crisis was slower than it need have been, and that a similar mistake is in the course of being made as we exit from the pandemic. I review those arguments in Chapters 2 and 3, and again at the end.
The third argument is that, partly because the Treasury has been on the wrong side of history on the second critique, its authority has declined within government and it is a shadow of its former self. Lionel Barber, former Financial Times editor, summarized the case in an article in Prospect magazine titled ‘The Treasury Today: A Devalued Currency?’.2
That view, as I hope to show, is misconceived. The Treasury has successfully fought off attempts to diminish its status over the past two decades, continues to attract high-quality staff (if perhaps too few of them) and is as powerful as ever. Successive Prime Ministers have found that fighting the Treasury in the end makes them weaker, and they come to rely on its support. Boris Johnson has followed exactly that trajectory. In macroeconomic policy, the Treasury must now share centre stage with the Bank of England, but that has in some ways strengthened its hand: ‘We would love to help with your spending plans, but the bank manager will not allow it.’
This is, nonetheless, a story of downs and ups for the Treasury as an institution. It took a knock in 1997 when the Bank was set free, but rolled with that punch. It was floored briefly by the financial crisis, but not counted out, performed well at the most difficult time, and reasserted its authority in the recovery phase. It triumphed in the 2014 Scottish wars, but suffered another heavy blow in the 2016 EU referendum, and was then side-lined in the Brexit negotiations. For a time, that looked fatal, and its enemies marshalled their resources for a final assault, but Covid, paradoxically, came to the rescue. It was no time to begin reshuffling the economic deckchairs, and Treasury ministers and officials showed resilience and imagination in devising rescue schemes to keep the productive economy afloat in the storm. So reports of its death proved greatly exaggerated.
In what follows, my aim has been to allow ministers and officials to tell the story themselves, as far as possible, though I am sure they, and readers, will consider that I have at times led the witnesses. Others will consider that, as an intermittent insider, I have delivered a conventional reading, too favourable to the ‘Treasury view’. As the saying goes: ‘You can take the man out of the Treasury, but you can’t take the Treasury out of the man.’
Chapter 1 sets the scene, with a brief review of the UK’s economic performance during the period.
Chapter 2 discusses macroeconomic policy, which was defined rather differently in a period when interest rates were set by the central bank.
In Chapter 3, I review the approach taken by successive governments to the control of public expenditure and in Chapter 4, I assess the performance of the Treasury in setting tax policy.
Chapter 5 changes gear and considers the Treasury’s unusually public role in the 2014 referendum campaign on Scottish independence, where its intervention was arguably decisive in determining the outcome. Chapter 6 examines the department’s far less successful interventions in the EU referendum campaign – dubbed Project Fear – and explores the Treasury’s changing attitude to the European Union, and specifically to Economic and Monetary Union (EMU), through the period. I review the economic implications of Brexit and the Treasury’s role in the negotiations leading to the Trade and Cooperation Agreement.
Chapter 7 explores the Treasury’s responsibilities for financial regulation and the City of London generally. Those responsibilities were broadened in 1997 after the creation of the Financial Services Authority (FSA). The way the department responded to the 2008/9 Global Financial Crisis (GFC) is evaluated, as is the subsequent second reform of the regulatory bodies carried out under Osborne. The specific issues raised by Brexit for the UK financial sector and its access to EU markets are considered.
Chapter 8 reviews the Treasury’s attitude to climate change and its economic implications, from initial scepticism, through the Stern Review to the embrace of a net zero target in 2021.
In Chapter 9, I describe the way the responsibilities of the Treasury have evolved through the period and Chapter 10 includes an account of the key individuals, both ministers and officials, who have led and shaped the department over the last quarter of a century.
Chapter 11 concludes with some reflections on the period as a whole, and the challenges the Treasury now faces. My thesis is that the troubles ahead will be more menacing to the institution, and more challenging to its traditional philosophy and ways of working than were the crises of the recent past. The whole basis of the ‘Treasury view’ needs to be rethought and, if it is to navigate the twin challenges of Covid recovery and climate change, it will need different skills and more people.
Notes
1.
The Chancellors’ Tales
, ed. Howard Davies. Polity, 2006.
2.
Lionel Barber, The Treasury today: A devalued currency?
Prospect
, January/February 2021.
https://www.prospectmagazine.co.uk/magazine/the-treasury-today-a-devalued-currency-lionel-barber-rishi-sunak
.
1Economic Performance
Gus O’Donnell, Permanent Secretary to the Treasury from 2002 to 2005, has declared that ‘the era of GDP being the unique measure is now over’. He quotes Robert F. Kennedy, who said: ‘GDP measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything, in short, except that which makes life worthwhile.’1 And he points out more prosaically that gross domestic product (GDP) as conventionally defined is not well suited for modern service-based economies with larger government sectors. That describes the UK quite well, indeed increasingly so. But even O’Donnell acknowledges that GDP measures ‘have a long history and are very useful for making comparisons over time and between countries’.
Using that imperfect methodology, how well did the British economy perform under the five Chancellors whose periods of stewardship we are considering, both in absolute and relative terms? And what can we confidently say about the influence of the government’s economic policy on that performance?
The period, like Gaul, divides into three parts. The Labour government was in office from 1997 to 2010, which is a long enough interval to use for comparisons forward and back. The figures are distorted somewhat by including the years of the financial crisis and its immediate aftermath, but if we allow Labour the pre-crisis boom, it is not unreasonable that they should also accept the bust. Brown famously declared that he had put an end to boom and bust, so it would be hard for him to complain. The second period runs from 2010 to 2016. That encompasses the full term of the Coalition government, and the first year of a majority Conservative administration. Osborne was Chancellor throughout. The third period begins with the EU referendum, which marked the beginning of a significant change of trend. The end of that third period is dominated, and distorted, by the Covid crisis, but the four-year stretch from the launch of the referendum campaign to the first Covid lockdown is long enough to have its own distinct characteristics.
1997–2010: The Brown years
The early 1990s had been a turbulent period in economic policy terms, with the chaotic withdrawal from the European Exchange Rate Mechanism (ERM) in 1992. However, underlying economic performance during the long Conservative hegemony, from 1979 to 1997, was relatively good. GDP per capita had fallen relative to the US, Germany and France from 1870 to 1979, if we ignore the war periods, but the trend began to reverse at the end of the 1970s. UK GDP per head was about 23% above the US in 1870. By 1979 the US was 43% ahead of the UK. In 2007 the UK was still behind, but the gap had narrowed to 33%: still a significant discount, but reflecting a steady improvement in productivity throughout the period.
The extent to which this change in trend can be attributed to the policies of the Thatcher and Major governments remains in dispute, and is outside the scope of this book, though most economists would acknowledge that the labour market reforms, privatization (at least in its early stages), a tougher approach to failing firms, and lower marginal tax rates all contributed. The period was also the first in which we began to see the implications of membership of the European Community, as it then was. Nicholas Crafts shows that larger trade volumes have had a positive impact on productivity. He argues: ‘In the case of the United Kingdom the gain from joining the EU was probably around 10 per cent of GDP … [arising from] a significant increase in competition as protectionism was abandoned.’2
There was no sign that the relative productivity improvement was running out of steam in 1997, so in that sense Labour’s inheritance was a good one. The economy was expanding, and for some time had been the fastest growing in the G7.
That record was sustained over the whole period from 1997 to 2010. Even though there was a sharp recession precipitated by the financial crisis, as Dan Corry et al. conclude, ‘relative to other major industrialised countries, the UK’s performance was good after 1997’.3 Growth in GDP per head averaged what might by historical standards appear a fairly modest 1.42% a year over the thirteen-year period. But that was faster than in any of the other comparable large economies. Germany grew by 1.26% a year, the US by 1.22%, France by 1.04%, Japan by 0.52% and Italy by a remarkably weak 0.22%.
With the exception of Italy and Japan, the differentials are not great, but sustained over more than a decade they become significant. There was certainly an element of catch-up at work. Poor economic governance leading to high inflation, an underperforming education sector, weak industrial management and bad industrial relations resulted in the UK slipping back against comparable countries during the 1950s, 1960s and 1970s. The German Wirtschaftswunder and the Trente Glorieuses in France passed us by. So once the shackles of poor labour relations and weak competitive dynamics were thrown off, some convergence was to be expected. But Corry et al. reject the argument that growth in the Brown and Darling years was driven mainly by the momentum created by their predecessors.
Some maintain that much of this outperformance was in a sense illusory, and that the productivity improvement was driven by unsustainable bubbles in the financial and property sectors in particular. But the financial sector contributed only 0.4% of the 2.8% annual growth in the market economy and productivity improvements were primarily driven by business services and distribution, through the utilization of new skills and technologies. Financial intermediation accounted for around 6% of gross value added (GVA) throughout the period from 1979 to 2010, only slightly higher than the French figure (5%). Property activity did grow, but from 5 to 8% of GVA. The biggest improvements in productivity are traceable to changes in the composition of the labour force, in other words a higher proportion of workers with higher-level skills, and greater use of information and communication technologies (ICT), which was an important differentiating factor for both the UK and the US vis-à-vis the large European economies. The UK was also more successful than others in attracting inward investment, and foreign-owned firms have long shown higher productivity than their domestic counterparts.
How much credit can the Blair and Brown governments take for this outperformance?
A neutral to negative interpretation might be that they did not reverse the earlier Conservative labour market reforms, and did not revert to a policy of nationalization and support for ailing industries. But there are also positive points. Labour support for ‘neoclassical endogenous growth theory’, which earned Brown ridicule when he included it in a political speech (in Michael Heseltine’s words ‘it wasn’t Brown, it was Balls’), did carry through into government. They overhauled competition policy through the 1998 Competition Act and the Enterprise Act of 2002, which gave the Competition Commission stronger powers. International comparisons of competition enforcement now typically score the UK highly.
Labour also prioritized expansion of university education. The proportion of the workforce with a university degree rose more sharply in the UK than elsewhere, from less than a quarter in 1997 to more than a third by 2010. There is room for doubt about whether holding a degree in media studies is a robust proxy for higher workplace skills, and vocational and further education have remained weak areas, but the additional investment in higher education has overall been positive.
It is also likely that tax credits introduced in 2001 and 2003 helped to arrest the decline in Research and Development (R&D) expenditure, which had been a feature of the UK economy since the late 1970s, and there is a strong case for saying that the regulatory changes introduced under Labour, especially in telecommunications, had a positive impact.
There were, however, three negative features, which have become persistent and worrying. The first is that British management scores poorly in international comparisons, well below the US, Japan and Germany.4 There was a modest improvement in the later years but not enough to change the overall picture. Second, regional differences in GVA and productivity are greater than elsewhere. In Europe the UK is second only to Ireland in the degree of regional inequality. London is far more productive and wealthier than other cities, partly because of the City’s remarkable success in establishing and maintaining its position as the largest financial centre in Europe, even outside the Eurozone. London as a global city has grown apart from its hinterland in terms of growth, productivity and social and political attitudes. That growing inequality seems to have been a factor in the Brexit vote, and also in the 2019 election. Third, the performance of the public sector was weak. Measuring output and productivity in the public services is not straightforward, but Corry et al. conclude as follows: ‘UK output growth in the non-market sectors was greater in the Labour period than under the Conservatives, but labour productivity growth fell from 0.6% to zero … this is consistent with the story that the large increase in public services expenditures led to a fall in productivity in these sectors.’
Nonetheless, the record of the first decade of Labour, with Brown as Chancellor, was quite strong. The economy was the fastest growing in the G7, with rising productivity, high inward investment (though investment was not high overall) and relatively low unemployment by international standards. Also, while the UK share of exports of goods continued to decline, its share of world services exports rose and remained second only to the US.
The UK economy had grown consistently since the spring of 1992: there were 64 consecutive quarters of growth until the second quarter of 2009. That relentless expansion contributed to the psychology of optimism which lay behind the financial market excesses. The global financial crisis (GFC), which began in the summer of 2007, but hit the real economy hardest in 2009, brought this steady progress to a crashing halt.
As we shall see in Chapter 7, Osborne mounted an argument, in opposition and then in government, to the effect that Labour was responsible for the crisis because of the change in regulatory structure introduced in 1997–8, and because of its encouragement of light-touch regulation. Given the global nature of the problems revealed, that does not seem plausible.
But there is a separate point: the crisis may have hit the UK economy harder, and led to more persistent weakness, because of the large increase in public spending after 2000. We discuss the public spending and taxation profile through the period in more detail in Chapters 3 and 4. The particular argument here is that the government’s fiscal position was out of balance when the crisis hit. As Corry et al. put it: ‘In retrospect, it is clear that public debt levels were too high for the stage of the cycle in 2008 … [and] the debt position exacerbated the pain of recession.’ Nicholas Sowels argues that the pre-crisis deficits broke the government’s own fiscal rules, which ‘in turn prepared the way for a substantial deterioration in public finances when the crisis broke, a deterioration which may take years, if not decades, to set right’.5 By contrast, Jonathan Portes points out that the structural deficit was only around 1% of GDP.6 That jumped to 5% over the next two years, but the ‘poor state of the public finances was a consequence of the recession, not a cause of it’.
Unsurprisingly, Gordon Brown and Ed Balls, then Chief Economic Adviser in the Treasury, reject the idea that they had left the UK in a vulnerable position. In his memoirs Brown asserts the contrary: ‘We entered the crisis with debt and deficits low by historical standards. There was no profligate pre-crisis spending spree.’7 But he acknowledges that there were different views in the official Treasury. Nick MacPherson, then Permanent Secretary to the Treasury, ‘considered everyone too soft on the deficit and debt’. From the perspective of 2021, the figures look almost insignificant, but their influence on policy was important, as we can see from the spending policies of the Coalition government.
It is reasonable to conclude that, while all Western governments, central banks and regulators should shoulder a share of the responsibility for the imbalances and financial excesses that led to the GFC, the particular role of the spending and regulatory policies of the Labour government does not feature prominently in considered analyses of its causes.8 So the thirteen years of Labour governments from 1997 to 2010 were a relatively successful period for the British economy, during which its long catch-up phase, closing the GDP gap with comparators, continued at roughly the same pace as in the previous two decades.
The crisis was, however, extremely severe. The economy shrank by more than 6% between the first quarter of 2008 and the second quarter of 2009, and took five years to recover fully. Unemployment, always a lagging indicator, rose from 5% to 8.4% by the end of 2011. The government’s deficit reached 7% of GDP in 2009 and was still 5% in 2010. Real incomes fell sharply in 2009 and did not begin to rise sustainably until 2015. With household, business and financial debt at 420% of GDP, the UK was the most highly indebted developed country in the world.
2010–16: The austerity years
That was the difficult background against which the Coalition government was formed in May 2010. George Osborne, who had been Shadow Chancellor since David Cameron became leader of the Conservative Party in 2005, was the inevitable choice for 11 Downing Street. The complex negotiations over the leading positions in government led to the appointment of Liberal Democrat MP David Laws as Chief Secretary to the Treasury (CST), soon replaced by Danny Alexander, making him an unusually powerful holder of that post, as one of the ‘Quad’ of key decision-makers in the government.
The economy had, in fact, begun to recover in the first quarter of 2010, though that was barely perceptible to the electorate while unemployment continued to rise, as it did for another year or more. Although the recovery was steady, without a second recession, triggered in other parts of Europe by the Eurozone crisis, there was no post-recession boom as had typically been seen after earlier downturns. The economy returned to growth, but on a lower trajectory than before. The Institute for Fiscal Studies (IFS) estimated that in the summer of 2018 GDP was 11% higher than it had been at the pre-crisis peak in 2007–08, so the economy was 16% smaller and GDP per head was £6,000 lower than they would have been had growth remained on its pre-crisis trend.9
Surprisingly, employment growth remained strong, and there were 2.7 million more people in work in 2018 than a decade before. So average household incomes were higher than in 2008, and household income inequality had fallen a little. But the worst news was that productivity per hour grew by a mere 0.3% a year compared to a long-term trend of 2% a year. Output per hour worked was 18% below the average for the G7, and the current account deficit in 2015 was at a record high of 5.2%. The IFS summary stated:
The UK economy has broken record after record, and not generally in a good way: record low earnings growth, record public borrowing followed by record cuts in public spending. On the upside employment levels are remarkably high and, in spite of how it may feel, the gap between rich and poor has actually narrowed somewhat, but the gap between old and young has grown and grown.10
That may seem to be a definitively negative verdict on the Coalition government’s performance. But through an international lens the position looks rather different. The immediate recession hit to the UK economy was large by international standards, reflecting the high relative size of the financial sector. In 2011, growth in UK GDP remained below the average for the other advanced economies. But by the end of 2012 the UK was expanding a little more rapidly than the average, and that remained true until the middle of 2016, except for a brief period in 2015.11 That average was, however, reduced by the impact of the Eurozone crisis of 2010–12.
Economic opinion was divided on the extent to which Osborne could claim any credit for the recovery. Simon Wren-Lewis has argued that the government’s austerity programme unnecessarily cut 1% from the growth rate in 2011 and 2012, while Nicholas Crafts considered that the deficit reduction programme made little difference to the speed of the recovery.12
The underlying problem, however, which preoccupied economists and policymakers alike, was stagnant productivity. Productivity has flat-lined since 2010, a performance unprecedented since 1860.13 As Paul Krugman of Princeton observed: ‘Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living … depends almost entirely on its ability to raise its output per worker.’14 After 2010, productivity growth slowed almost everywhere in the developed world, but it fell more sharply in the UK than elsewhere in the G7, except Italy. In the last decade of the twentieth century German and British productivity growth rates, measured as the change in output per hour worked, were similar, at about 2.5% a year. In the second decade of the twenty-first century German productivity growth was around 1% a year. The UK rate had fallen to just below 0.4%.
Unpicking the causes of this differential is not straightforward, but two other measures are relevant. The UK has invested a lower share of GDP than Germany. Since 2007, UK investment as a share of GDP has consistently been the lowest in the G7. In the EU, only Greece invested less. UK fixed capital formation was a little over 16%, while German investment was over 20%. And the comparisons on R&D expenditure are even less favourable. The UK typically spends about 1.7% of GDP on R&D, compared to 2.8% in Germany.15
So the second of the three periods, from 2010 to 2016, shows a mixed picture: a slow start, a catch-up to roughly the average growth rate of comparator countries, but underlying weakness in investment and productivity, which suggested continuing sluggish growth, unless performance in those areas picked up.
2016–20: The EU Referendum and after
The third period needs some disaggregation. The Covid-related lockdowns beginning at the end of the first quarter of 2020 confuse the picture. It is too early to say how the economy will recover from a highly unusual health-related government intervention. Also, at the end of 2020 the post-Brexit era began, initially with a very large impact on trade volumes with the EU. Exports to the EU fell by 40% in the first two months of 2021, then stabilized somewhat as firms became more accustomed to the new arrangements.
These immediate post-Brexit trade figures are volatile and may be misleading. But we can assess the period from 2016, when the referendum campaign was announced, to the beginning of the Covid recession. The data strongly suggest that there was a significant change of trend. Up to the referendum, UK GDP growth remained above the average of the other advanced economies, except for a brief period around the end of 2011. Since the referendum, UK growth has been lower than the average. The IFS has constructed a ‘doppelgänger’ of the UK economy, based on a weighted average of the OECD economies that performed most similarly to it up to the end of 2015. The doppelgänger tracks the UK closely, apart from a period during the financial crisis when the UK underperformed. That was not surprising given the UK’s, and especially London’s, exposure to trends in global finance. But, as the IFS says, ‘since 2016 a sustained divergence has opened up between realised GDP and the level implied by the synthetic model’.16 By the end of 2019 the economy was 2.5% smaller than expected had the predicted pre-referendum growth trend continued. The differential is closer to 3% if one takes account of the unexpected increases in global growth since 2016. The doppelgänger grew more rapidly than before. The IFS acknowledges that ‘the estimates from this model cannot provide a perfect indication of what would have happened had the Brexit referendum gone the other way’, but they are strongly suggestive. What can we learn about why this change of trend occurred?
The clearest immediate impact of Brexit was a sharp fall in sterling. Between May and September 2016 sterling dropped from €1.31 to €1.11. That suggested a market view that the UK’s growth prospects had deteriorated. But contrary to the Treasury’s 2016 forecasts, the domestic economy continued to grow, fuelled by an increase in consumer spending financed in part by a dramatic fall in the saving rate, from 10% in the second half of 2015 to around 4% by the end of 2016, and in part by rising nominal wages, which returned to the pre-crisis average of 4% a year. Between 2015 and 2019, unit labour costs in UK manufacturing rose by almost 10 percentage points more than in Germany, negating most of the competitive impact of sterling’s devaluation.
The most depressing observation is that productivity remained flat, and business investment was remarkably weak. The UK appears to have lost out in many of the new, high innovation, high productivity sectors.17 Investment took a long time to recover from the 2008 recession, but it grew by some 10% from 2012 to 2015. Since the referendum, it has dropped to the bottom of the G7 range and by 2019 it was 20% below what it would have been had the post-2008 trend line continued. That change in trend appears to be linked to a rise in economic uncertainty which, in turn, is linked to the referendum result and the consequential concerns about the terms of Britain’s future trading relationships with the EU and other countries.18 It is probable that, as business adjusts to a new set of trading relationships, that uncertainty will diminish, but the future course of investment remains highly uncertain.
The OBR, in its budget report in March 2021, assumes that long-run UK productivity and growth will be 4% lower as a result of Brexit, and that ‘around two-fifths of the 4 per cent impact has effectively already occurred as a result of uncertainty since the referendum weighing on investment and capital deepening’.19 By 2019, UK GDP per head was 88% of the German figure; in 2007 it had been 94%.
So in economic terms, the period ends on a downbeat note. The UK’s Covid-induced recession was deeper than average for developed countries, and the immediate recovery a little stronger. But setting that aside, the economy seemed set for a period of sub-par growth, underperforming even a not very challenging set of comparators in Europe. The Treasury can hardly be blamed for that, or for Brexit. All the Chancellors before Sunak were firmly against leaving the EU, as were most if not all the senior officials, however emotionally disengaged from the European project they might have been. It is highly unusual for a sophisticated developed economy to have its economic and trading policy upended on non-economic grounds. The verdict on the Brexit experiment will take years, if not decades, to be handed down.
Beyond Covid
The deep Covid-induced downturn was followed by a strong short-term recovery. GDP fell by a record 9.9 per cent in 2020. The recovery was expected to bring aggregate GDP back to the level at the end of 2019 by the summer of 2022. Will growth thereafter be stronger than before, allowing the two lost years of growth to be recovered? In the summer of 2021 the Bank of England, while optimistic in the short term, saw no reason to believe the trend growth rate would revert to a figure higher than had been achieved since 2009, in other words 1.7–1.8% a year. That would be a disappointing outcome.
In May 2021 the Resolution Foundation, an independent think-tank, and others launched an inquiry into the UK economy in 2030.20 The premise was: ‘The UK’s recent past has been marked by stagnant living standards, weak productivity, low investment and high inequality. This makes a new economic approach desirable.’ They present a balanced picture of the strengths and weaknesses of the UK as it emerges from recession.
On the asset side of the balance sheet, they identify a fast-growing services sector, especially insurance and other financial and business services, internationally competitive higher education, and a relatively advanced position in the necessary transition to a net zero economy. The existence of a strong political consensus on the latter point is also potentially a trump card. On the liability side, in addition to the poor investment and productivity record already discussed, they list a high degree of inequality, and an unfavourable demographic position, with the population ageing rapidly in the next decade, and Brexit likely to reduce high-skilled immigration from neighbouring countries.
Some of these factors are not susceptible to Treasury intervention. But the report identifies policy weaknesses which are potentially under Treasury control. In particular, they see ‘long-run issues with parts of our tax system, such as the relative taxation of capital and labour’, and the absence of a coherent approach to carbon taxation. (I discuss the tax system in Chapter 4.) And they conclude: ‘The UK also lacks any long-term institutional structure to govern industrial strategy. The ability of sub-national government to manage change has also been weakened, with local authority spending power in England falling by 18 per cent since 2010.’ That is important given the evidence across Europe that attempts to ‘level up’ economic development ‘are driven by regions with high human capital and high-quality local government’.21 The Treasury’s centralizing instincts, and suspicion of local government, could be serious disadvantages in pursuing a levelling-up agenda. Critics see ‘no sign the government is embracing the co-ordination needed for the moves to have a significant impact – nor any hint of further devolution of policy powers away from the centre’.22
The stakes are high. Torsten Bell et al. conclude: ‘If the pace of UK underperformance … were to continue at the same pace in the 2020s as in the 12 years to 2019, then the country will end this decisive decade with GDP per capita much closer to that of Italy than Germany: 17 per cent lower than Germany and just 6 per cent higher than Italy.’23 My first job on leaving university in 1973 was as desk officer for Italy in the Foreign and Commonwealth Office, as it then was. At the time, the Italians liked to talk of il sorpasso (the overtaking), the moment when their economy would overtake the UK’s. That did in fact happen in 1987, but by 2020 we were almost 30% richer per capita, after dismal performance in Italy since joining the euro. For us to fall back to the Italian level would be dramatic. Fortunately, in the summer of 2021 external forecasters expected the UK economy to grow less rapidly than France and Germany in the recovery phase, but still ahead of Italy.24 That is not, however, a high bar.
Notes
1.
Gus O’Donnell, Angus Deaton, Martine Durand, David Halpern and Richard Layard,
Wellbeing and Policy
. Legatum Institute, 2014.
https://li.com/wp-content/uploads/2019/03/commission-on-wellbeing-and-policy-report-march-2014-pdf.pdf
. The Kennedy speech can be found at
https://en.wikipedia.org/wiki/Robert_F._Kennedy%27s_remarks_at_the_University_of_Kansas
.
2.
Nicholas Crafts, The impact of EU membership on UK economic performance.
The Political Quarterly
, 18 May 2016.
https://doi.org/10.1111/1467-923X.12261
.
3.
Dan Corry, Anna Valero and John Van Reenen, UK economic performance since 1997: Growth, productivity and jobs. Centre for Economic Performance, LSE. December 2011.
http://eprints.lse.ac.uk/47521/1/CEPSP24.pdf
.
4.
Nicholas Bloom and John Van Reenen, Why do management practices differ across firms and countries?
Journal of Economic Perspectives
24/1, 2010, pp. 203–224.
5.
Nicholas Sowels, From prudence to profligacy: How Gordon Brown undermined Britain’s public finances.
Observatoire de la société britannique
, 2011, pp. 77–93.
https://doi.org/10.4000/osb.1136
.
6.
Jonathan Portes, The Coalition’s confidence trick.
The New Statesman
, 2011.
7.
Gordon Brown,
My Life, Our Times
. Bodley Head, 2017, p. 350.
8.
Howard Davies,
The Financial Crisis: Who’s to Blame?
Polity, 2010.
9.
Jonathan Cribb and Paul Johnson, 10 years on: Have we recovered from the financial crisis? Institute for Fiscal Studies, 12 September 2018.
https://ifs.org.uk/publications/13302
.
10.
Ibid.
11.
Benjamin Nabarro and Christian Schulz, Recent trends to the UK economy. IFS Green Budget, October 2019.
https://ifs.org.uk/uploads/GB2019-Chapter-2-Recent-trends-to-the-UK-economy.pdf
.
12.
Jonathan Portes, ed., The economic record of the Coalition government.
National Institute Economic Review
231, February 2015.
https://www.cambridge.org/core/journals/national-institute-economic-review/article/abs/economic-record-of-the-coalition-government-introduction/8015174E2D750BB262797CB54D544413
.
13.
Jennifer Castle, David Hendry and Andrew Martinez, The paradox of stagnant real wages yet rising ‘living standards’ in the UK. VoxEU, 21 January 2020.
https://voxeu.org/article/paradox-stagnant-real-wages-yet-rising-living-standards-uk
.
14.
Paul Krugman,
The Age of Diminished Expectations: US Economic Policy in the 1990s
, 3rd edn. MIT Press, 1997, p. 11.
15.
Martin Wolf, Why once successful countries like the UK get left behind.
Financial Times
, 21 February 2021.
16.
Nabarro and Schulz, Recent trends to the UK economy, p. 66.
17.
David Sainsbury,
Windows of Opportunity: How Nations Create Wealth
. Profile Books, 2021.
18.
Abigail Haddow, Chris Hare, John Hooley and Tamarah Shakir, Macroeconomic uncertainty: What is it, how can we measure it and why does it matter? Bank of England Quarterly Bulletin, 2013 Q2.
https://www.bankofengland.co.uk/quarterly-bulletin/2013/q2/macroeconomic-uncertainty-what-is-it-how-can-we-measure-it-and-why-does-it-matter
.
19.
Impact of the Brexit trade agreement on our economy forecast. Office for Budget Responsibility, 3 March 2021.
20.
Torsten Bell et al., The UK’s decisive decade. The launch report of ‘The Economy 2030 Inquiry’. Resolution Foundation. May 2021.
https://economy2030.resolutionfoundation.org/reports/the-uks-decisive-decade/
.
21.
Sascha Becker, Peter Egger and Maximilian von Ehrlich, Absorptive capacity and the growth and investment effects of regional transfers: A regression discontinuity design with heterogeneous treatment effects.
American Economic Journal: Economic Policy
5/4, November 2013, pp. 29–77.
22.
Diane Coyle, Sam Warner, Dave Richards and Martin Smith, Budget ditches industrial strategy for centralised levelling up. Bennett Institute for Public Policy, 10 March 2021.
https://www.bennettinstitute.cam.ac.uk/blog/budget-ditches-industrial-strategy-centralised-lev/
.
23.
Bell et al., The UK’s Decisive Decade.
24.
Gregory Claeys, Zsolt Darvas, Maria Demertzis and Guntram Wolff, The great COVID-19 divergence: Managing a sustainable recovery in the European Union.
Policy Contribution
11 2021, Bruegel.
https://www.bruegel.org/wp-content/uploads/2021/05/PC-2021-11-ecofin-210521-1.pdf
.
2Macroeconomic Policy
Bank of England independence in May 1997 changed the role of both the Treasury and the Chancellor in macroeconomic policy. In the dying days of the long Conservative regime which began in 1979, a hybrid monetary policy-making model had been constructed, in which the Bank of England gave its interest rate advice to the Chancellor, and could publish it, but the Chancellor made the ultimate decision. The so-called Ken and Eddie show (Chancellor Ken Clarke and Governor Eddie George) ran monthly from June 1993 to May 1997. No other country has operated such a hybrid model. For two years, I chaired the internal Bank committee which prepared the draft advice, and attended the meetings. They were civilized encounters but sometimes with an element of Whitehall farce. On occasions, faced with a carefully crafted letter, representing thousands of hours of work by the Bank’s economists leading to a considered recommendation of a quarter point rise (sometimes accompanied by internal Treasury advice saying the same thing), Ken Clarke would open the meeting by saying cheerily: ‘Well there’s obviously no chance of a rise this month.’ He then asked for our views, but only on how long we needed to stay before the Bank team drove out of the Treasury courtyard. Too short a stay, and the waiting press would say our advice had been dismissed without discussion. Too long a stay, and the story would be that there had been a row between the two teams.
