The biggest lie in politics

The political realm is luxuriant with lies. And the biggest lie which, over the last decade, has dominated public discourse more than any other is the lie that the last Labour government mismanaged the economy and caused a recession.

Contrary to what many politicians may tell you, Labour’s fiscal policy decisions did not cause the economic crisis. There was no reckless spending or profligacy. It’s worrying to see how this lie has become accepted as conventional wisdom, for two reasons. First, it gives a false explanation as to how the crisis came to be. And, second, as a result of this false explanation, it has enabled the Tories’ to justify their unnecessary austerity programme, which has resulted in real-word damaging consequences. That is why it is important to expose this myth.

The notion that Labour mismanaged the public finances is false, for six reasons that I can think of.

First, the idea that Labour overspent is wrong – in the macroeconomic sense anyway. Most individuals tend to define overspending as an excess of spending over current income. While this may be true for a household, it is almost certainly not true for a government. The symptoms of overspending, or fiscal excess, for a national economy are: unsustainable levels of inflation and sufficiently high long-term real interest rates. Under New Labour, there was no evidence of this. Inflation was stable and long-term real interest rates (measured by the 10 year gilt yield) declined. There was no ‘overspending’ under Labour.

Second, the argument that Labour were somehow profligate is objectively untrue. If Labour were truly fiscally irresponsible then we would have witnessed an excessively high, and rapidly increasing, debt-to-GDP ratio. But this wasn’t the case. As Simon Wren-Lewis observes, the ratio of public debt to GDP “before the recession (37 percent in 2008) was below the level Labour inherited (42 percent in 1997), and below its fiscal rule figure of 40 percent”. The simple truth is that Labour kept to their fiscal rules for well over a decade, and it took the gravest economic crisis since World War Two to knock them off course.

Third, prior to the 2007 financial crisis, the structural budget deficit (the budget deficit adjusted for the economic cycle) stood at 2.3 percent of GDP (OBR, p. 104, 2010) – not insignificant, but not pivotal either. Furthermore, in the same fiscal year, the (structural) current budget deficit – which excludes state capital investment – was an inconsequential 0.4 percent of GDP

Fourth, between 1997 and 2010, public spending accounted for 37 percent of Gross Domestic Product (GDP). During Major’s term it was approximately 38 percent of GDP, and under Thatcher public spending accounted for 40 percent of GDP. The truth of the matter is that the last Labour government were one of the most prudent in the post-war era.

Fifth, following the financial crisis, the majority of the increase in public sector borrowing (and, thus, the public debt) was due to the collapse in tax revenues and increase in transfer payments, which in turn was a result of the financial crisis, and the global recession. It was not the result of fiscal profligacy. Chart 1 illustrates this very well. The blue segment of the chart illustrates clearly that the rise in public debt was primarily driven by “revenue losses associated with output losses from the financial crisis” (IMF, p. 3, 2011). Essentially, tax revenues fell because there were less people in work meaning less people earning income, hence lower income tax receipts; consumers were, collectively, spending less, so VAT receipts were lower, and businesses were making less profit, thus corporation tax receipts declined. Meanwhile, the higher unemployment rate induced greater ‘automatic’ increases in government transfer payments (i.e unemployment benefits). The simple fact is that the large budget deficit – and the associated increase in the national debt – was largely a consequence of the financial crisis and the global recession, rather than the result of budgetary mismanagement and fiscal imprudence.

Chart 1: Drivers of Public Debt Increase, 2007-2011 (IMF, p. 3, 2011).

Sixth, if Labour’s overspending had caused the crisis, or played any part whatsoever, then we would have observed a significant increases in long-term government bond yields since investors would have demanded higher interest rates to compensate for the increased risk of government default, from increasing public debt. But that did not occur. We did not experience a fiscal crisis. Instead, as Chart 2 demonstrates, demand for sovereign debt continued to increase throughout the recession; markets were not only fine with Labour’s borrowing levels, they were fine with them borrowing even more, and at declining rates of interest. There was no crisis in the public finances, as Labour’s critics repeatedly claim. Public sector borrowing, under both Blair and Brown, was sustainable, and did not play any role in causing the global crisis.

uk-10-year-bond-yields-iudmnpy-chartbuilder-57edad0b75c7e
Chart 2: UK 10 year Gilt yields (Source: Bank of England).

We have established that the crisis was not the result of Labour’s fiscal decisions, but another question regarding the management of the public finances still remains: did running persistent budget deficits during an economic expansion phase reduce the state’s capacity to deal with the crisis?

To answer the question: no, not significantly anyway, and for two key reasons. Firstly, While it is true that if Labour had not run deficits in the years preceding the crisis, the public debt might have been a little lower, but the difference would have been insignificant. Most of the sharp increase in the public debt was due to the impact of the recession (see chart 1) – it was not the result of a public spending splurge, but a collapse in tax receipts (as explained, above, in paragraph 8).

Secondly, long term real interest rates were in decline suggesting there was no market panic, and no fiscal crisis. In fact, contrary to what some politicians and mainstream media pundits claim, there was significant room for the government to borrow more (see chart 2) since markets allowed it precisely because of the structural financial surpluses in the private and foreign sectors.

Labour’s fiscal decisions played no role in causing the crisis. To suggest otherwise is intellectually dishonest. I cannot change, or influence, the mainstream media’s misleading narrative on this issue, nor can I prevent politicians weaponizing this lie for further political gain, but I can, however, educate my fellow elector on the folly of this widely-accepted, prevalent myth.

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