Deficit reduction through growth

This blog post seeks to answer the question: what economic growth rate does the UK need to sustain in order to reduce the deficit to zero?

This seems like a relevant question at the moment, and I’ve not seen a straightforward calculation of the answer – so I thought I’d give it a go myself. The idea being that even if the end result is not particularly informative the thinking behind getting the end result is useful.

The key parameter of interest here is the gross domestic product (GDP): the amount of goods and services produced in a year in the UK; it’s a measure of how wealthy we are as a nation, how it increases with time is a measure of economic growth. Also important are the deficit (how much the government’s annual spending exceeds its income) and debt (how much the government is borrowing).

Inflation means that the GDP can appear to grow each year with no increase in real economic activity, therefore I decided to use “inflation adjusted” GDP figures. I also preferred to use annual GDP figures rather than quarterly ones.

To model this I took a starting point of a known GDP, debt, deficit and government spend which I then propagated forwards in time: I made the GDP grow by a fixed percentage each year, and assumed that government spending would be flat (I’m using GDP adjusted for inflation so I think this is reasonable). Assuming that the total tax take is a fixed proportion of GDP I can calculate the deficit and hence increasing debt in each year, I add the debt servicing cost to the government spending in each. Since I’m doing everything else in the absence of inflation I’ve used a debt servicing rate of 2% rather than the 5% implied by a £43bn debt interest cost in 2010 – this makes my numbers a bit inconsistent.

I’ve put the calculation in a spreadsheet here.

Given this model my estimate is that the UK would need to sustain GDP growth of 4.8% per year until 2020 in order to reduce the deficit to 0%. This 4.8% GDP growth brings in approximately an additional £30bn in taxes for each year for which the growth is 4.8%. During this time the debt would rise to nearly 80% of GDP and so the cost of servicing the debt will double. These numbers seem plausible and fit with other numbers I’ve heard knocking around.

To get a feel for how GDP has varied in the past, this is the data for inflation adjusted annual GDP growth in the UK since 1950:

The red line shows the “target” 4.8% GDP growth, and the blue bars the actual growth in the economic, adjusted for inflation. The data comes from here. What’s notable is that GDP growth has rarely hit our target and what’s worse, over the last 40 years there have been four recessions (where GDP growth is negative), so the likelihood must be that another recession before or around 2020 is to be expected.

In real-life we are actually using a combination of GDP, government spending cuts and tax increases to bring down the deficit. These calculations indicate 0.5% GDP growth is approximately £7bn per year which is equivalent to a couple of pence on basic rate (see here) or about 1% of government spending (see here).

Doing this calculation is revealing because it highlights why there is an emphasis on cuts in government spending as a means of reducing the deficit. This had been a bit of a mystery to me with the figure of 80:20 cuts to taxes ratio being widely quoted as some sort of optimum, although there is some indication of other countries working with a ratio closer to 50:50. The thing is that when you cut your spending, you are in control. You can set a target for reduction and have a fair degree of confidence you can hit that target and show you have hit that target relatively quickly and easily. On the contrary relying on growth in GDP, or taxes, is a rather more unpredictable exercise: taxes because the amount of tax raised depends on the GDP.

The Office for Budget Responsibility (OBR) published uncertainty bounds for it’s future predictions of GDP in their pre-budget report last year (see p10 and Annex A in this report), their central forecast is for growth of 2.5% but by 2014 (i.e. in only 4 years) they estimated only a 30% chance that it lay between 1.5% and 3.5% actually they only claim a 40% chance of being in that range for this year (2011).

At the risk of being nearly topical, GDP is reported to have shrunk by 0.5% in the last quarter of last year, 2010. This is largely irrelevant to this post, although forecasts for GDP were growth of ~0.5% which supports the idea that GDP is not readily predictable. It’s worth noting that the ONS will revise this figure at monthly intervals until they get all the data in – the current estimate is based on 40% of the data being available.

Given this abysmal ability to predict GDP I suspect that there is little governments can do to influence the growth in GDP. It would be interesting to estimate the influence government policy has relative to prevailing global economic conditions, and what timelags there might be between policy changes and growth.

I think these calculations are illustrative rather than definitive, and what I’d really like is for someone to point to some better calculations!

Which country is the UK like economically?

This blog post attempts to answer the economic question: What country is the United Kingdom like economically?

The question arises from discussions of deficit (how much the government’s annual spending exceeds its income) and debt (how much the government is borrowing). To use a digging analogy: debt is a hole, deficit is how fast you are deepening the hole. We can get a feel for how countries compare in this sense by plotting them as a function of their deficits and debts on a graph. I’ve done this for the countries of the OECD (data here). The horizontal axis tells you  the deficit, whilst the vertical axis is the debt. These values are plotted as a percentage of the gross domestic product (GDP) so we can compare big countries and small countries, rich countries and poor countries on an equal footing.

As we go to the top left area of this graph we find countries which are in the deepest hole, digging fastest. Out of the extreme left we find the UK – it is digging its hole fastest at the moment, but it is not in the biggest hole – that honour currently goes to Japan. On this graph our nearest neighbours are Ireland, the United States and Iceland, with Greece and Japan having higher debt but lower deficit. France and Spain have similar debts but rather lower deficits.

Norway is actually bringing in more money than it spends and building a surplus, they have large oil revenues and are saving against the day when it runs out. Korea is doing this too but to a far smaller extent.

Economically it is often said that the PIGS or PIIGS countries are in most trouble in Europe, these are Portugal, Ireland, (Italy), Greece and Spain.

But is it true to say we are like Ireland, the US and Iceland? Ireland and Greece have much higher levels of unemployment than us, whilst the US has slightly higher levels and Iceland’s levels are comparable. Iceland has very high inflation (12%) whilst most other countries have moderate inflation including the UK, with a few countries having moderate deflation including the US and Ireland. We have moderate levels of unemployment, with Ireland, Greece, the US having much higher levels. It’s also worth pointing out that the UK has a population of 60,000,000 whilst Ireland only has 4,000,000 and Iceland a mere 300,000.

So whilst in deficit/debt terms we may resemble other countries in other, economically relevant ways, we are quite different.

From a mathematical point of view there are methods for measuring the closeness of things based on large numbers of variables, called clustering algorithms. These algorithms amount to our eyeballing of the debt/deficit data – they are a measure of distance. However, in economic problems things aren’t so simple. The economy is described by many variables and I don’t know their relative importance in determining economic similarity. The problem that the numbers involved may vary tremendously in size is trivially solved. My suspicion is that economists have probably spent a great deal of time arguing about economic similarity and haven’t come to a definitive answer.

So in answer to the question: What country is the United Kingdom like economically? Although the UK may be most like Ireland, the US and Iceland in debt/deficit terms. In terms of many other economic factors such as inflation, unemployment and so forth it is quite different. I suspect the real answer to this question is that the UK is most like France, Germany and Italy economically: these countries are of similar size, have similar unemployment rates, have inflation of the same sign, usually run public sector/ private sector ratios of similar size furthermore given their common membership of the EU their economic behaviour is probably similar. Of this group of countries Italy has the largest debt and we have a largest deficit.

Book Review: The Third Man by Peter Mandelson

A little bit of politics for this book review: “The Third Man: Life at the heart of New Labour” by Peter Mandelson. It’s been a while since I’ve read much politics; I did go through a spell of reading various diaries and biographies (Alan Clark, Tony Benn, John Major, Churchill) a number of years ago but gave up largely because the diarists and autobiographies seemed unwilling to accept they were wrong on anything, and I had a nasty experience with the biography of Gladstone.

I’m sort of fond of Peter Mandelson, I never really bought the Prince of the Dark Arts thing and he seems to be one of the more coalition minded senior Labour figures.

The book covers briefly Mandelson’s early life but the main focus of the book is the personal relationship between Tony Blair, Peter Mandelson and Gordon Brown from the late eighties all the way through to the 2010 election. Peripherally it is also the story of New Labour: firstly, a switch to a more professional presentational style, followed by the scrapping of Clause IV then it seems to go a bit vague in terms of a guiding policy theme. Mandelson states the central vision of New Labour being of fairness and social justice: but these are ideals I’m sure the Liberal Democrats would cleave to and the Tories would claim the same. Ultimately ideology is not helpful in discriminating between parties rather implementation of policy and no-one is really grasping the nettle of going for excellent implementation.

I’d always assumed that poor press for Labour ministers was as a result of biased media and some mysterious influence from the Tories that I hadn’t entirely thought through. Mandelson makes it pretty clear that the worst press for Labour came from Labour ministers and their hangers-on briefing against each other!

The central theme of the book was how awful the relationship between Brown and Blair was, lasting for many years and seriously hampering a New Labour programme for reform. The origin of this poor relationship is in the leadership struggle which took place following the death of John Smith in 1994. Communication between the Prime Minister and the Chancellor was poor, and they often seemed to be working largely to block each other. This makes hard reading, it’s like the story of a couple trapped in a loveless marriage “for the sake of the kids”. In some ways I find this disturbing: New Labour effectively provided it’s own opposition whilst in government in the sense that it limited their ability to make policy and enforce change on public services. What happens when the Prime Minister and the Chancellor are working to the same agenda?

Clearly as a Liberal Democrat I’m interested in what he has to say about us, the truth is: not much. There seems to be a degree to which Mandelson and Blair held key early members such as Roy Jenkins in high regard, seeing them as something of a lost tribe who had left the Labour party in the early eighties believing it to be un-reformable. He also describes the talk toward involving the Liberal Democrats in government following the 1997 election, eventually floundering because ultimately there was no need to give anything to the Liberal Democrats. It does seem that there was some quiet local arrangements where Labour or Liberal Democrats agreed not to fight too hard against each other at general elections. I suspect things have changed in both parties now, Liberal Democrats and Labour members of my generation and younger joined well after the split so for us the “progressive alliance” is something of an old man’s tale.

What also comes through for me is how grateful Labour should be for our electoral system, in the 1983 election when Labour polled 27.6% and the SDP-Alliance polled 25.4% they still gained 209 seats as opposed to the meagre 23 that the SDP-Alliance achieved. Similarly at the 2010 election, the Conservatives lead Labour by 7.1% in votes but only 48 seats whilst in 2005 Labour led Tory by just 2.8% but gained a 157 seat lead over the Conservatives giving them a firm majority.

Mandelson’s description of the Coalition negotiations following the May 2010 General Election are consistent with the Laws and Wilson books which I reviewed previously. Labour had not made any pre-election plans for coalition, which I still find odd since Peter Mandelson clearly saw the possibility of a hung parliament; the Labour party was split on whether they should make the attempt and ultimately there was a recognition that the parliamentary arithmetic did not add up.

It’s clear that the current theme of “no cuts” from Labour is a continuation of the Brown policy pre-election, Alastair Darling appears to have made considerable efforts to reach a budget which made at least some effort to start addressing the deficit in the final days of the previous government, in the teeth of enormous opposition from Gordon Brown whilst other members of the team such as Ed Balls were keen to make further spending commitments. Brown’s great fear seemed to have been being labelled a “tax-and-spend” Chancellor, who seems to have ended up a “spend” Chancellor and in the long term that does not add up.

Is this a good book to read? It is if you want to know about the personal relationship at the core of the book, and if want to know more about Peter Mandelson. I’m tempted to read Andrew Rawnsley’s “The End of the Party” for a more detached view.

An electoral thought experiment

This morning I asked the good people of twitter:

Anybody else playing #fantasyAV? What would you vote under AV in the by-election in Oldham East & Saddleworth on Thursday?#yes2av

You can follow the responses to this question here. AV in this context is the “Alternative Vote” system, voters rank the candidates on the ballot paper using as many or as few numbers (1,2,3…) as they wish. My response to this question is:

1. Liberal Democrat
2. Tory
3. Green

If you’re interested in my rationale then, as a committed, LibDem 1. is unsurprising! As a supporter of the Coalition then 2. also makes sense. 3. Is because I sort of like the Greens, although Caroline Lucas occasionally slips into “ConDem” mode she has at least made some attempt at providing policy alternatives.

The aim of such experiments is to reveal an underlying truth or at least think clearly about such truths. In this instance applying this to a concrete example helps make the proposal to move to the AV system real, it obliges you to think about what you’d actually do. For me the nice thing about AV is that my vote reflects my preferences for the outcome of the election, I’d like the LibDem candidate to win, I’d be happy if the Tory won and although I may not always agree with them I’m happy to show some support for the Green candidate. I can do all of this under AV without attempting to second guess what other people are going to vote in order to get my most preferred outcome given their votes, which is what I’m stuck with when the first-past-the-post system is used. In this particular by-election I imagine this issue is most acute for Tory voters, some fraction of them would prefer the LibDem candidate if their own candidate does not win. Under AV the answer is simple vote 1. Tory and 2. LibDem, under FPTP the answer to your voting dilemma is not clear.

Put another way AV is about getting more data from the voter. Under first-past-the-post I put one X in one box – very little data is transmitted from me, the voter. Under AV I get to put numbers, not just a single pre-literate mark, into more boxes, therefore more data is transmitted. There is a technical field of “Information Theory” which would tell you precisely how much more information is being transmitted. To use an example from my job, if we are trialling new products we will often ask consumer panels to rank variants rather than simply select their favourite because ranking gives us more information.

I won’t attempt to analyse the results of the responses I received in electoral terms. The “No to AV” campaigners steadfastly refused to accept they had anything other than a single preference. Others placed less mainstream choices such as the Pirate Party and the Greens before other parties. As someone pointed out: “Its already showing the liberating effect AV would have”. As a result of their rankings I learnt more about what they wanted the outcome of the election to be.

Personally I’d like to see a fully proportional system where the number of seats a party gains in parliament reflects the number of votes cast for that party. However, that system is not on offer. AV at least allows us to be honest in our voting, you give the highest rank to your favourite candidate.

What would you vote under AV in the by-election in Oldham East & Saddleworth on Thursday?

No Merger!

Once again, rattling around the wires is the idea that the Conservative and Liberal Democrat parties should merge. The origins of these mutterings are largely Conservative, for example, Fraser Nelson in the Telegraph, or René Kinzett on ThinkPolitics. I’d like to put a Liberal Democrat view as to why this is utterly implausible.

A key motivating factor for this talk is the low performance of the LibDems in opinion polls at the moment. However, there are two issues here:

Firstly, members of both Labour and Conservative parties see polls in a different light to LibDems. In part because the other parties are programmed to believe in a steady pendulum swing which sees power passing to and fro between them with a period of years. Therefore for them regaining power is largely a matter of waiting for the pendulum to swing. The LibDems do not lie on the pendulum swing, they do not have this expectation. Aside from the national coalition during the Second World War, the Liberal forbearers to the current party have not been in office since 1918. You can see this in action in my immediate post-election blog post, which is characterised by gloomy resignation at another disappointing general election. Broadly the reaction of a long term LibDem to a general election is crashing disappointment. So facing so-called “electoral annihilation” at a future general election the LibDem response is “no change there then”.

Secondly, as my previous post alludes: the opinion polls are not a great predictor of electoral success for the LibDems. Just to give an example: in the 1983 election the SDP-Liberal Alliance got 25.4% of the vote and 23 seats, in the 2010 election the LibDems got 23% of the vote and got 57 seats. This is only a very small rise in the % of the vote since the 2005 election (just 1%) and a drop in the number of parliamentary seats (5 seats). If you want to see some more numbers, go have a look at the wikipedia list of UK elections.

At the heart of this believe that there should be a merger seems to be a problem with counting, one alluded to in the title of this blog; it seems to be in the UK that there is a serious problem with counting parties beyond two. It’s seems to go “Labour, Conservative,……… nope can’t cope!”. This is in no doubt partly driven by the first-past-the-past electoral system which encourages the merger of parties into two blocks (know as Duverger’s Law).

It’s also a mistake to see a major schism forming between a party leadership in government and the rank-and-file membership. A naive view is that the leadership have “gone Tory” at the head of what is essentially a left-leaning organisation. However, I understand this more in terms of the way I see the large company I work in operating. At some level within the company there are discussions about the way forward for the company should be, and at points in time a decision is made as to what the way forward actually will be. At this point everybody gets on and does it, at higher levels the company appears unified – the message from senior management is consistent, at my level I have the opportunity to gripe about stuff but ultimately I have to get on and help execute the plan. What we see in government is, I argue the same, LibDem ministers have argued for their beliefs in coming to a plan: where they have prevailed they support the agreed plan but where they don’t agree they still work to enact the agreed plan – sulking, griping and refusing to support where you did not prevail is not an option.

The other thing to consider is how the LibDem party works: even in the event of a proposed merger by the leadership of the party the likely response of the membership would be a resounding “no” and in the LibDems that means something. And just to be clear on my own position: if there was a successful proposal to merge with either the Labour or Tory parties I’d be off to form the Continuity Liberal Democrats – and I wouldn’t be alone! As Simon Cooke (Tory) accurately points out, any LibDem is free to leave the party and join either the Conservatives or Labour, or the Greens (or no party at all). In the deeply untribal view of this Liberal Democrat they should feel free to do so (and positively encouraged if that’s what they want). But don’t expect to see this happen in any great numbers, at the very least Nick Clegg and David Laws have had serious offers from the Tories to join them in the pre-2010 election past but chose to stay in the electoral unsuccessful LibDems. I’ve no doubt that similar applies to offers from Labour during the 1997-2010 governments.

Finally there is a question of political positioning, ideology if you like. It seems to me that the LibDems are precisely where they should be: on the centre ground and they shouldn’t be thinking of moving from there. Labour and Conservatives have come to power when they have decided to be more like us. You can still find our manifesto on the Liberal Democrat website, largely these are the things I still believe in and these are the things I will fight for, of the Labour manifesto I find no sign on their website.

Viva the Continuity Liberal Democrats!