Extracts from the Chancellor's lecture on economic policy
Extracts from the Chancellor's lecture on economic policy at the Royal Economic Society.
Today (14 January 2015) I’d like to set out an ambitious agenda for economic policy in the next Parliament and beyond.
Given how this Parliament began – a budget deficit of 10% of GDP, unemployment at 8%, and a sovereign debt crisis brewing on our doorstep – it’s no surprise that it has been dominated by debates about economic policy.
We’ve made significant progress; but we must not be complacent, or think the job is done.
Some huge economic challenges remain.
The deficit has been cut by half, to 5% of GDP; but that is still far too high.
Debt is set to fall in 2016-17 but at 81% of GDP it leaves us exposed.
GDP has grown by 8.3%, and in 2014 we were the fastest growing G7 economy.
Our labour market has performed even more strongly than people expected – there are more people in work now than ever before and unemployment has fallen to 6% - but we should be aiming for full employment
And beneath the surface remain many of the long standing structural weaknesses in our economy which were obscured by the excesses of the boom and the urgent need to recover from the ensuing bust.
Increases in the state pension age will save half a trillion pounds, but the long term fiscal challenges of an ageing population remain.
Investment has grown by 23% since the depths of the recession but the UK still invests less than our competitors.
The value of our exports to the faster growing emerging economies have grown by 31% since 2010 but we are still far too dependent on slow-growing European export markets.
And even though standards in our schools are rising, Britain still suffers from an endemic problem of low skills. That is one of the causes of our persistently weak productivity.
So as you can see, I am very far from being a Chancellor who looks at Britain’s economic performance and – because it’s better than most – says job done.
I am a Chancellor who says: there’s a lot more to do.
The government has pursued a consistent economic plan built around the three elements that I set out in my Mais lecture very nearly five years ago.
Monetary activism to support demand in the economy and repair our financial sector.
Fiscal responsibility to underpin economic stability.
And supply side reform to deliver sustainable increases in our standard of living.
They remain, five years on, the cornerstones of my economic approach.
Today, I want to set three ambitious goals for the next two decades of British economic policy.
First, while we must never be deluded into thinking you can abolish the economic cycle, we do have it within our power now to curb Britain’s age-old vulnerability to banking and housing booms.
Second, having regained fiscal credibility, let’s resolve never to lose it again – the only way to keep our economy secure is with a credible plan to reduce our debts.
And third, we can become the most prosperous of any major economy by the 2030s, with that prosperity widely shared – an aim I believe is firmly within our grasp.
These three goals present a formidable agenda for economic policy over the years ahead.
Let me take each element of our economic plan in turn and explain how these goals are achievable.
– First, resilience in our housing market and banking sector – the cause of so many of Britain’s economic problems in recent decades. This is about coherent monetary policy and financial stability.
In response to the financial crisis and the clear failures of the previous “tripartite” regulatory system the government has made sweeping reforms.
Our rationale was that monetary policy, the prudential supervision of our banking system and the lender of last resort facility are all intimately linked, and separating them between the Financial Services Authority (FSA) and the Bank of England was a mistake.
So we broke up the FSA and moved prudential supervision back to the Bank of England under the auspices of the new Prudential Regulation Authority, while markets and conduct regulation were moved to the new Financial Conduct Authority.
At the time, I was criticised by many for going against a global move away from placing prudential regulation in the hands of central banks.
But since 2010 this decision has been mirrored in many other jurisdictions, with both the Federal Reserve and the ECB being given important roles in banking supervision.
And our new system has performed well through testing times.
In the face of chronic problems in the Eurozone the Bank of England, the Monetary Policy Committee (MPC) and the Prudential Regulation Authority (PRA) have worked together to prevent weaknesses in our banking system from undermining the role of monetary policy in supporting the economy.
The Funding for Lending Scheme, launched jointly with the Treasury, was a huge innovation.
It supported our economy at a crucial moment and successfully ensured that the monetary transmission mechanism did not break down.
And we have strengthened the capital position of our banks, with tough stress tests that helped restore confidence.
Another lesson of the crisis was the importance of macro-prudential regulation to monitor and manage emerging financial stability risks at an economy wide level – something that was missing entirely in the run up to the crisis.
So we created the Financial Policy Committee within the Bank of England – one of the most sophisticated systems for macro prudential regulation of any country in the world. It is one of our most striking policy innovations.
It has already passed its first test by acting in a timely and proportionate way last year to limit risks in our housing market – an Achilles heel for the UK economy so many times in the past.
Their moves to restrict loan to income ratios, and increase mortgage underwriting standards deflated what could have been the next housing bubble.
And the new Financial Conduct Authority has led the world in responding rapidly and decisively when the manipulation of benchmarks in LIBOR and foreign exchange markets were exposed – and our Parliamentary Commission has raised banking standards.
The crisis also revealed vital flaws in the structure of our banking system, so we set up the Vickers Commission to make recommendations about how to better protect UK taxpayers in future from bank failures.
Together with international reforms to capital rules, bail in and bank resolution, championed so ably by Mark Carney in his role as Chair of the Financial Stability Board, we have now gone a long way towards ending ‘too big to fail’.
Thankfully, the new system has not yet been tested, but I am confident that future Chancellors of the Exchequer will have more options than Alistair Darling had that dreadful weekend when things go wrong – as no doubt they will one day.
So we have made a lot of progress in giving ourselves the tools to tame the excesses of the housing cycle and prevent catastrophic financial failure.
But only the naïve would think the problem has been solved altogether.
The real challenge now comes in operating the system as a coherent whole.
This is why I support the Governor’s interesting proposals to further strengthen governance and accountability within the Bank. The changes I’ve instigated rested on the concept of ‘One Bank’ bringing together monetary policy, macro-prudential policy and micro prudential regulation under one shared vision and culture.
Mark Carney has put forward new proposals to strengthen the Bank’s internal coherence and increase its transparency.
Many of the Governor’s proposals will require primary legislation. I commit to introducing a new Bank of England Bill early in the next Parliament to ensure that oversight of our financial system remains at the forefront of international best practice.
We need to complete the implementation of the Vickers ring fence.
Some banks have thought strategically about this and got on with it; other banks are still reluctant to face up to the inevitable. Ring fencing retail banks from investment banks is a job that must be completed in the next Parliament.
The other remaining challenge is to complete the state’s exit from ownership of our banking system in order to boost competition and get back the money taxpayers were forced to put in.
We have sold Northern Rock to a new challenger and reduced our share in Lloyds to below 25%.
When it comes to RBS, we have made huge progress in de-risking and restructuring the bank, bringing us close to the point at which we can start getting taxpayers’ money back.
Early in the next Parliament we will have to make a decision on the timing of any exit programme from RBS.
It is not good for taxpayer value or for the competitiveness of our banking system to have such a large and complex bank in state hands for too long.
– Yesterday’s inflation number – the lowest in modern times – presents the latest challenge for our new system.
The low inflation we see here in the UK – driven as it is almost entirely by external factors such as the oil price – is much more welcome than in the Eurozone where inflation has been very low for some time and is now negative.
There the debate has understandably turned to the dangers of deflation – the risk of a self re-inforcing spiral where economic activity falters, consumers defer purchases as prices fall and nominal debt burdens become ever harder to manage.
A core economic principle of mine is that political systems should give their central banks the space and the independence to do their job.
So I fully support Mario Draghi’s efforts to ensure that the European Central Bank (ECB) does whatever it takes to meet its inflation mandate.
And I also agree with those on the continent arguing that the Eurozone needs to do more to strengthen its institutions, and deliver on commitments to structural reform.
It may be that the time has come to revisit the ECB’s inflation target, which is to keep inflation below but close to 2%, and replace it with a symmetric target as in the UK, the US and many other countries.
Symmetric targets have helped to ensure that inflation expectations remain anchored and that monetary policy can play its role fully.
In the UK, our system is well equipped to deal with negative inflation shocks just as the MPC were able to look through the surge in commodity prices in 2010 and 2011.
A few months of very low or even negative inflation, driven mainly by external factors, does not in and of itself mean that we run the risk of deflation.
Core inflation, which strips out those factors, remains relatively stable and indeed rose slightly in yesterday’s data.
Even more importantly, expectations about future inflation remain well anchored and the latest data show that earnings growth is accelerating not slowing down.
Of course we will always remain vigilant to ensure that inflation is low for the right reasons.
But we should not confuse this welcome news for Britain’s households as a result of falling oil prices with the threat of damaging deflation that we see in the Eurozone.
Rising real incomes, a recovery spreading to all parts of our economy, and family budgets that can stretch that little bit further – let’s celebrate these effects of low inflation, not fear them.
Today I am publishing the MPC’s remit for the coming year.
It confirms that the inflation target remains at 2% as measured by CPI inflation.
It also confirms that this is a symmetric target.
And I have agreed with the Governor that we will change the timing of open letters so that in inflation report months the letters will be published alongside the inflation report, in order to further improve the transparency and consistency of communications.
This will apply for the first time to the open letters that the Governor and I will write, responding to the latest inflation number, alongside the Inflation Report on 11th February.
Monetary policy that provides economic stability; new arrangements to curb the excesses of Britain’s financial and housing markets. These are how we will achieve our first goal.
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My second goal is simple.
Having regained fiscal credibility, let’s resolve never to lose it again – the only way to keep our economy secure is with a credible plan to reduce our debts.
Fiscal responsibility has been a key element of the Government’s economic strategy.
In May 2010 we were faced with a record 10.2% budget deficit, a Parliament where no party had a majority, a banking system four times as large as our GDP, and none of the advantages that the role of the dollar as the world’s reserve currency provides for the US.
What’s more, across the Channel and the Irish Sea some of our nearest neighbours were teetering on the brink of a sovereign debt crisis.
In these circumstances fiscal credibility was vital for economic stability, let alone economic recovery.
So we moved quickly to set out a multi-year deficit reduction plan and legislated for it.
The pace of our fiscal consolidation over the last four years has been steady, with an average annual reduction in the cyclically adjusted primary balance of around 1.6% of GDP according to the IMF - the largest and most sustained of any major advanced economy.
In response to the acute crisis in the Eurozone we made no significant changes to tax policy or spending plans – indeed annual government spending has continued to come in slightly below the plans we set out in 2010.
So the underlying stance of fiscal policy remained unchanged.
But the fiscal credibility we had earned meant we could safely allow the automatic stabilisers to operate through lower than forecast tax receipts.
That wasn’t an accident – or something forced upon us. That was a deliberate and conscious decision that I took.
The net result is that since 2010 fiscal consolidation has been accompanied by the third fastest GDP growth in the G7 and the fastest employment growth of any major advanced economy in the world.
In the early years of this Parliament a lot of focus was placed on whether fiscal consolidation was compatible with recovery; it is now clear that credible fiscal policy is a precondition for recovery, underpinning confidence and an activist monetary policy.
The argument about the past is settled, but disagreements remain about the future.
Yesterday, Parliament voted on a new Charter for Budget Responsibility.
It commits us to the fixed timetable of getting debt falling as a share of GDP by 2016-17, and to get the cyclically adjusted current budget into balance by 2017-18.
And according to official Treasury estimates, it requires around £30 billion of further consolidation over the first two full years of the next Parliament – equivalent to continuing the rate of spending reductions over this Parliament for another two years.
Explaining how that £30 billion will be delivered is now an obligation for all political parties as we approach the general election.
Some are already claiming that this £30 billion of consolidation won’t be required if we can raise the economy’s trend growth rate
That mistake has been made many times before in the UK – most recently in 2002 and 2006.
Politicians are always tempted to make overoptimistic assumptions about trend growth and borrow against them.
The fiscal consequences are always disastrous.
But balancing the structural current budget cannot be the end point of Britain’s journey to restore fiscal credibility.
The argument for a surplus has two parts: first, high levels of national debt are risky and damaging for an economy like the UK; and second, the only reliable way to reduce debt levels when inflation is low is to run an absolute surplus.
High levels of debt are risky and damaging for several reasons.
High debt leaves you vulnerable to shocks – and if recent years have taught us anything it is that there will be other shocks.
Imagine if we had entered this crisis with debt at 80% of GDP; by now it would be approaching 125% – similar to Italy.
With debt that high it’s very possible that our ability to support our financial system and allow the automatic stabilisers to operate would have been severely constrained, with damaging consequences for jobs and prosperity.
High debt means higher debt interest which squeezes out future spending and disadvantages future generations.
And the conclusion of the academic literature is that high debt is undoubtedly correlated with lower growth.
Even the possibility should give us cause for concern given the huge impact that small growth differentials can have over time.
Having established a strong economic policy case for reducing our debt levels, some argue that we can afford to run deficits indefinitely and allow the ratio of debt to GDP to drift down over time.
The problem is that it’s difficult to find examples of countries that have successfully achieved a significant reduction in this way without the help of high inflation, financial repression or both – solutions that we cannot and should not seek today.
It also complacently assumes that economic conditions will remain benign for several decades, without further shocks that would increase our debt along the way.
But again, experience has taught us never again to believe the idea that we have abolished boom and bust.
Indeed, the Treasury analysis we’ve published has found that, if you allow for regular shocks consistent with those experienced in the UK over the last 6 decades, running a balanced current budget alone would only reduce debt as a share of GDP by 5% over the next 20 years.
In 2035 our debt would still be 76% of GDP.
Instead, countries like Canada and Sweden have demonstrated that the only reliable way to reduce debt levels in a low inflation world is to operate some kind of balanced budget or surplus rule.
Canada and Sweden also serve as examples where political parties of the centre left put in place balanced budget or surplus rules after recovery from a financial and fiscal crisis: the Liberals in Canada in 1998 and the Social Democrats in Sweden in 2000.
In both cases the motivation was simple: never again.
And in both cases the results speak for themselves – Sweden and Canada have had amongst the strongest public finances of any developed economy during the last eight years, and neither has had to make large cuts to public spending as a result of the crisis.
So let me be clear.
My decision to target a surplus is not a judgement based on ideological or party political grounds; it is based on the evidence and a realistic assessment of what is prudent for the UK.
In short if we in the UK, with a high level of national debt, are not going to start significantly reducing that debt after 7 or 8 years of economic growth, people will rightly ask “if not now, then when?”
The evidence also suggests that a balanced budget or surplus rule should be simple if it is to have an impact over an extended period of time.
For a country in the situation that Britain found itself in in 2010 there is clearly a role for fiscal rules based on cyclical adjustment and specified time horizons. But the academic literature on fiscal rules has long recognised a trade-off between simplicity and flexibility.
And this audience knows that cyclical adjustment is as much an art as a science.
So let me sum up what I’m proposing today.
We need a plan to keep Britain secure.
So in the good times we stay in surplus – raising more money than we spend and using that to pay down our debts.
And when the bad times come, the government will have to set out a clear plan to get back to health.
All over-seen by an independent body.
Fixing the roof while the sun is shining and a plan for repair when the storm hits.
Good housekeeping for Britain – that’s the only way to keep everyone living here secure.
So our second goal for our economic policy is that having restored fiscal credibility we maintain it by bringing debt down.
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My third goal is for Britain to become the most prosperous of any major economy by the 2030s, with that prosperity widely shared across our country.
It is within the power of my generation to achieve this – if we have the discipline and the ambition.
The ingredients are all here:
We now have the most competitive tax rates of any in the G20.
We’ve sharpened work incentives with tax cuts for the low paid, welfare reforms and a higher minimum wage – and we have a plan to continue with all of them.
4 of the top 6 universities in the world in the most recent assessment are in Britain.
Thanks to our investment in science we’ve now overtaken the US to rank 1st by field weighted citation impact, an indicator of research quality.
We’ve secured the number one place in the world index for investing in infrastructure.
We’re attracting more Chinese inward investment than Germany, France and Italy put together.
By 2030 we’re set to have the largest economy in Europe.
Yet we will not become the most prosperous major economy without some big and serious decisions to make ourselves more productive.
And we have to start with education.
Low skills and poor standards in many schools have been a persistent problem for our country.
The government has embarked on a wide ranging programme of school reform to give parents more choice, raise standards, ensure rigour in teaching and give schools more freedom from local bureaucracy.
All of these changes have been resisted, but we have persisted in making them and already we can see the benefits as more and more children get an education in an outstanding school.
In the next Parliament we will keep up the pressure – so that there are more academies, more free schools, more outstanding schools, more children studying science and maths.
And we should be aiming to abolish illiteracy and innumeracy altogether.
That is perfectly possible if we put the effort in.
We need to raise the standards of our vocational education, with more of the excellent new University Technical Colleges – and 3 million more apprentices.
One of the most controversial and contested things we’ve done is the changes to student finance that have put our universities on a sustainable financial footing.
Far from deterring applications from those from disadvantaged backgrounds, we have instead seen them reach a record high.
I have now abolished the artificial cap imposed by the Treasury on the number of students but I believe that the number going to university in Britain is still too low.
I have no time at all for those who say we’ve reached the limit, or that many of our young people are simply not cut out for university.
If you look around the world at the economies leading the pack on skills and productivity, like South Korea and the USA, they are sending far more of their young people to university.
Having abolished the cap on aspiration we now need to lift the aspirations of our young people and encourage even more to get the necessary qualifications and apply to university.
It would be a disaster if we now reversed the student finance reforms and undermined the funding of our universities. This would lead to fewer people going to university, less social mobility and a weaker economy.
If we are to become the most prosperous of any major economy then we also need to unlock more capital investment in our economic infrastructure, including housing.
Part of this solution is through prioritising that investment within government spending.
Even within a reducing overall budget we have shown what can be achieved. Britain is seeing the biggest road improvement programme since the 1970s and the largest programme of rail investment since Victorian times.
But that level of ambition needs to be sustained.
Some now argue that government borrowing for infrastructure investment is a ‘free lunch’.
I don’t think I need to explain to a room full of economists why there is no such thing.
It is just an excuse for spending and borrowing more public money.
Even the IMF analysis often cited to support this conclusion finds that it is not the case in a growing economy with its own monetary policy.
And we do not have to choose between our goal of reducing our national debt and improving our infrastructure.
Government capital investment should be paid for with savings in other less productive parts of the government budget.
That is why, alongside a surplus rule, I have said that in the next Parliament we will always grow capital investment at least in line with GDP.
But so many of our problems when it comes to infrastructure are not about taxpayers’ money – they are about planning, consistency and delivering stable and predictable frameworks for private sector investment.
The debate about High Speed 2 is over. The budget is agreed. The paving legislation has passed through Parliament and the alliance of a Chancellor and civic leaders in the north has seen off all comers.
Let’s now get it built.
And let’s use the Howard Davies Commission on airports to agree the location for a new runway in the South East and get that agreed later this year and under construction soon after.
We’ve already made major changes to our planning system. Planning permissions for house building are up as a result; but we can go further.
By 2020 I want to see 90% of brownfield sites suitable for housing turned into land that is zoned for development – a revolution in our current plan-led system.
We should change our outdated compulsory purchase regime. Both the London School of Economics (LSE) Growth Commission and Chambers of Commerce have had the bright idea that, in some cases, if you pay people a little more you’d get planning a little quicker and the whole process could cost you less. That’s something we’ll consult on at the Budget.
Some parts of our country are already amongst the most prosperous regions in the world, but we can make the whole country more prosperous.
Not so long ago, people thought that the internet might make physical location less important.
But it seems in the modern, knowledge-based economy businesses and entrepreneurial types want to flock together more than ever in big cities. To form clusters where they can learn from and spark off each other.
And of course, as a great global city, London benefits from those important agglomeration effects, helping the capital to suck in money and talented people from all over world.
That is a relatively recent phenomenon. London’s population, for example, declined for decades and it’s still less now than it was at the end of the 1930s.
The cities of the north, like Manchester, Leeds and Liverpool are all individually too small to have a big role on the global stage. But together they have a combined population of 10 million people.
And the distances between them are not huge – the central line that runs underneath us here in London is longer that the distance from Manchester to Leeds.
But if you bring our northern cities closer together – with high speed transport;
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if you back their universities and teaching hospitals with world beating science investments;
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if you improve the quality of life with better housing and schooling and vibrant culure;
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if you give them strong voices with elected mayors as we’re now doing in Greater Manchester – then the whole of the north can be made much greater than the parts.
That’s the idea behind the northern powerhouse that I have put forward; it has caught people’s imagination, it has won local cross party support – and it is resulting in real changes.
Today, the part of our country that is seeing the fastest economic growth, and the most rapid job creation, is the north of England.
We have to sustain that, and we can.
None of these reforms to education or planning or elected mayors have been easy.
Many have been bitterly opposed by entrenched and vested interests.
All of them will need to be defended constantly over the next Parliament and beyond.
But I’ve learned one thing, above all, doing this job – it is always the economically essential that are the politically difficult.
So these are the three goals I set for economic policy over the decades ahead.
Taming the cycles in housing and banking that have bedevilled the UK economy for so long, so we have stability.
Running a surplus in normal times so that we reduce our debt and make our economy resilient.
And becoming the most prosperous of all the major economies.
They are not easy to achieve but I believe we should set our expectations high.
Pessimism has been fashionable in recent years, whether it’s predictions of secular stagnation or claims that the proceeds of growth would only go to the richest.
The problem for the pessimists is that the evidence and experience of the last few years increasingly don’t support their claims.
Instead the case for optimism is strengthening.
If we are willing to take on the vested interests and pursue the right policies with consistency and discipline then there are no limits to what Britain can achieve.
There is no reason why Britain cannot be the richest major economy in the world.