The power of political theatre explains Budget’s enduring mystique
Some unravel, some prove historic, but all point to a promised land years away
by: Nick Macpherson
When the chancellor announced last November that he would move from two fiscal events a year to one, the Treasury will have breathed a collective sigh of relief.
True to the Augustinian tendencies of his office, which encourages its holders to ignore their own stringencies, Philip Hammond qualified his announcement by making clear he planned to make three Budget statements in 12 months. And who can blame him?
The Budget is one of those great British events, like the Grand National or Trooping the Colour: the subject of TV specials and newspaper supplements.
The media needs its story. And there are always a multitude of sources ready to provide it, some authorised and some not. As permanent secretary I initiated many a leak inquiry. I never caught a single culprit.
But the more interesting thing about Budgets is why they maintain their mystique. It is not as if we live any longer in a world of capital controls, fixed exchange rates and endemic balance of payments crises. And with chancellors regularly appearing on the political chat shows the preceding Sunday, the days of Budget purdah have all but gone.
But just as the media needs an event, so does the chancellor. The Budget is an opportunity to set out the government’s stall for the year ahead. The political theatre this entails has made the office of chancellor of the exchequer the second most important in the government.
And it is why it has taken an austere and principled chancellor like Mr Hammond to move to a single fiscal statement. He may be being astute.
The fact is Budgets are remarkably similar. All of the 34 Budgets I worked on as an official had productivity and growth as a central theme. Yet for all the interventions designed to make Britain more productive, the underlying growth rate has remained stubbornly unchanged at about 2.25 per cent.
And whenever a chancellor has assumed higher trend growth, such as Nigel Lawson in the late 1980s or Gordon Brown in the 2000s, they have usually had cause to regret it. Fortunately, the creation of the Office for Budget Responsibility in 2010 has put paid to such optimism: not because it is intrinsically better at forecasting, which is a mug’s game, but because it is unbiased.
In the old days, much of the debate both within the Treasury and with Number 10 was about the forecast. Now the Treasury can focus on getting policy right.
Too often in the past the Treasury obsessed about the level of demand and steering the economy. Very occasionally this has mattered — as in Alistair Darling’s 2008 autumn Budget. But the bias in favour of deficit financing is big enough as it is. In all but four of the past 40 years the government has run a deficit. And a reminder of the difficulty of delivering fiscal retrenchment is that it has taken until the eighth year of governments committed to consolidation to achieve the much less demanding target of reducing public debt as a share of national income.
Of course, such is the Treasury’s fear of losing control that it tends to become mesmerised by its own targets and rules. I have seen a number of them come and go. From time to time, they have even had a brief impact. But all too often they encourage the Treasury to develop ever more elaborate fiddles and fixes just to keep on the right side of the rule in question. What matters is the substance: get that right, and rules become irrelevant.
Budgets should be about the noble aim of delivering a better tax system. And once in a generation a chancellor surprises us by effecting a tax reform that lasts — think of Nigel Lawson in 1988.
All too often they have the prosaic aim of securing the revenue base. There have been extraordinary changes to tax over the past 30 years. The top rate of income tax has been cut from 60 per cent to 40 per cent and then raised before coming to rest at 45 per cent. VAT has been raised from 15 per cent to 20 per cent. National insurance rates have been raised substantially and corporate tax rates halved.
New taxes have been created, others abolished. Yet the tax take has remained completely static.
Taxes were 33.9 per cent of national income in 1984-85, the year I started work at the Treasury. This year they are projected to be 33.7 per cent.
As Mr Hammond contemplates reaffirming his plans for the highest tax take since 1982, he should bear in mind that such a yield eluded his seven immediate predecessors.
Of course, whatever goes wrong with a Budget is never quite what you expect. Generally, chancellors are pretty good at getting big measures through: such as, say, 2.5 per cent on the rate of VAT. It is the smaller measures which create the difficulties — think of the “pasty tax” on hot takeaway food, part of the “omnishambles” Budget of 2012.
And when the Conservative party is having one of its existential crises over Europe, you have to be very careful indeed.
Having been in a room in the House of Commons with Ken Clarke and John Major the night the so-called Maastricht rebels had the whip withdrawn, I should perhaps have spotted last year that Iain Duncan Smith would resign as work and pensions secretary over disability benefits. It is still a little puzzling that someone should resign over a policy he himself announced. Then again, having seen Mr Duncan Smith’s description of the Treasury as the “worst thing in Britain”, I should really not have been surprised.
But in the end there is only one certainty about Budgets. The promised land is always four years away.
The writer was permanent secretary to the Treasury and is now visiting professor at King’s College London
IF THERE is one aspect of the current era sure to obsess the financial historians of tomorrow, it is the unprecedentedly low level of interest rates. Never before have deposit rates or bond yields been so depressed in nominal terms, with some governments even able to borrow at negative rates. It is taking a long time for investors to adjust their assumptions accordingly.
Real interest rates (ie, allowing for inflation) are also low. As measured by inflation-linked bonds, they are around -1% in big rich economies. In their latest annual report for Credit Suisse on global investment returns, Elroy Dimson of Cambridge University and Paul Marsh and Mike Staunton of the London Business School look at the relationship between real interest rates and future investment returns. Very low real rates have in the past been associated with poor future equity returns (see chart).
That may come as a nasty shock for state and local-government pension funds in America.
They have to assume a future rate of return on their investments when calculating how much they need to contribute to their plans each year. Most opt for 7-8%, a level that has prevailed for years. That return looks highly implausible at a time when ten-year Treasury bonds yield just 2.4%.
There is a strong incentive not to change these assumptions. CalPERS, a Californian state pension fund, has cut its assumed return from 7.5% to 7%. But even that small shift will cost the state $2bn a year in extra contributions.
Why should low real rates and low returns be linked? One reason is that very low real rates are associated with times of economic difficulty, and thus periods when corporate profits are under threat. But a low real interest rate also means a low cost of capital for companies, which ought to be good news. Indeed, central banks ease monetary policy to try to drive down interest rates, and thus encourage business investment.
There has been some recovery in business investment since the last recession. But that recovery has not been as robust as might have been expected, given the low cost of capital. In a recent speech, Sir Jon Cunliffe, deputy governor of the Bank of England, noted that “in the 40 years to 2007, business-investment growth averaged 3% a year. In the eight years since the crisis it has averaged 1.5% annually.”
A number of possibilities could explain this decline, including a lack of access to finance. Banks have been boosting their capital ratios in recent years and have been more reluctant to lend.
But another factor relates to the “hurdle rate” companies use before they decide whether to invest. A survey by the Bank of England indicates that firms are still using a hurdle rate of 12%, around the average of the rate of return on investment they have achieved in the past.
In other words, despite the big fall in the cost of borrowing since the crisis, the hurdle rate has not come down. Since the risk-free rate is in effect zero, the bank says British firms are now looking for a 12-percentage-point margin compared with one of seven points before the crisis.
This could be a version of “money illusion”, when people fail to adjust their expectations for nominal returns as inflation declines (in this case, both real and nominal expectations ought to have fallen).
There is an alternative explanation for the failure of expectations to shift. Both businesses and investors, realising that the economic outlook is uncertain, may be demanding a higher risk premium for starting new projects or buying shares. That explanation is a little hard to square, however, with the repeated new record highs being scaled by stockmarkets or with the high valuations afforded to American equities.
Since the market low in March 2009, dividends have risen by 48% in real terms and real share prices have risen by 167%, according to Robert Shiller of Yale University. The cyclically-adjusted price-earnings ratio (or CAPE), which averages profits over ten years, is 28.7, its highest level since April 2002. In the past, very high CAPEs have been associated with low future returns.
Indeed, having analysed the data, Messrs Dimson, Marsh and Staunton reckon global investors are expecting a risk premium of 3-3.5% relative to Treasury bills—a level that is lower, not higher, than the historic average. So something does not add up. American pension funds are optimistic.
Businesses are cautious. Shares are trading on very high valuations. Not all these assumptions can be proved right.
Real interest rates (ie, allowing for inflation) are also low. As measured by inflation-linked bonds, they are around -1% in big rich economies. In their latest annual report for Credit Suisse on global investment returns, Elroy Dimson of Cambridge University and Paul Marsh and Mike Staunton of the London Business School look at the relationship between real interest rates and future investment returns. Very low real rates have in the past been associated with poor future equity returns (see chart).
They have to assume a future rate of return on their investments when calculating how much they need to contribute to their plans each year. Most opt for 7-8%, a level that has prevailed for years. That return looks highly implausible at a time when ten-year Treasury bonds yield just 2.4%.
There is a strong incentive not to change these assumptions. CalPERS, a Californian state pension fund, has cut its assumed return from 7.5% to 7%. But even that small shift will cost the state $2bn a year in extra contributions.
Why should low real rates and low returns be linked? One reason is that very low real rates are associated with times of economic difficulty, and thus periods when corporate profits are under threat. But a low real interest rate also means a low cost of capital for companies, which ought to be good news. Indeed, central banks ease monetary policy to try to drive down interest rates, and thus encourage business investment.
There has been some recovery in business investment since the last recession. But that recovery has not been as robust as might have been expected, given the low cost of capital. In a recent speech, Sir Jon Cunliffe, deputy governor of the Bank of England, noted that “in the 40 years to 2007, business-investment growth averaged 3% a year. In the eight years since the crisis it has averaged 1.5% annually.”
But another factor relates to the “hurdle rate” companies use before they decide whether to invest. A survey by the Bank of England indicates that firms are still using a hurdle rate of 12%, around the average of the rate of return on investment they have achieved in the past.
In other words, despite the big fall in the cost of borrowing since the crisis, the hurdle rate has not come down. Since the risk-free rate is in effect zero, the bank says British firms are now looking for a 12-percentage-point margin compared with one of seven points before the crisis.
This could be a version of “money illusion”, when people fail to adjust their expectations for nominal returns as inflation declines (in this case, both real and nominal expectations ought to have fallen).
There is an alternative explanation for the failure of expectations to shift. Both businesses and investors, realising that the economic outlook is uncertain, may be demanding a higher risk premium for starting new projects or buying shares. That explanation is a little hard to square, however, with the repeated new record highs being scaled by stockmarkets or with the high valuations afforded to American equities.
Since the market low in March 2009, dividends have risen by 48% in real terms and real share prices have risen by 167%, according to Robert Shiller of Yale University. The cyclically-adjusted price-earnings ratio (or CAPE), which averages profits over ten years, is 28.7, its highest level since April 2002. In the past, very high CAPEs have been associated with low future returns.
Indeed, having analysed the data, Messrs Dimson, Marsh and Staunton reckon global investors are expecting a risk premium of 3-3.5% relative to Treasury bills—a level that is lower, not higher, than the historic average. So something does not add up. American pension funds are optimistic.
Businesses are cautious. Shares are trading on very high valuations. Not all these assumptions can be proved right.
