Wednesday, May 06, 2015

The evil of two lessers

Britain faces some major challenges. The recovery is unbalanced, and productivity growth has been weak. Poor infrastructure, patchy skills and constrained housing supply are holding back the economy. The Union itself is in danger, with the rise of the Scottish National Party. And relations with the EU and the US are at a low point. Yet neither the Conservative party nor Labour has a compelling strategy for tackling Britain’s problems.

There are only two possible governments after Britain’s general election on Thursday: a minority government led by the Conservatives or one led by Labour. Neither main party will command a majority at Westminster, even in coalition with the Liberal Democrats. Both have ruled out going into coalition with the Scottish National Party (SNP), which will be the third largest parliamentary force following the election.

The UK faces major challenges. While its economy has grown swiftly since 2012, so has its current account deficit. Productivity growth has been weak, and there are serious supply-side problems, especially in infrastructure and housing. Britain’s influence with both the EU and the US has diminished as the country has withdrawn to the margins, and the future of the UK itself is in danger. Which of the two possible governments is more likely to tackle the political and economic uncertainties facing the country?

Assuming (as the polls suggest) that the Conservatives emerge as the largest party, they will have first crack at forming a coalition. One involving the Conservatives, the Liberal Democrats and Northern Ireland’s Democratic Unionists might get close to the 323 seats needed. But although the Liberal Democrat leader, Nick Clegg, has indicated that he would back another coalition with the Conservatives, he could struggle to bring his party with him, opening the way for a Labour-led coalition.

A coalition between Labour and the Liberal Democrats is unlikely to command much more than 300 seats, and so would fall even further short of a majority. However, the SNP is likely to secure nearly 50 seats. Ed Miliband has ruled out a formal coalition with the SNP, but one can imagine an informal arrangement, whereby a Labour-Liberal Democrat coalition governs with the tacit support of the SNP.

The UK’s economic performance compares well with the eurozone since the trough of the downturn. However, this partly reflects the fact that the British government has (sensibly) eschewed the draconian fiscal austerity seen across much of the eurozone. As a result, the UK’s fiscal deficit in 2014 was the second-highest in the EU after Spain. Furthermore, Britain’s current account deficit has widened sharply, to 5 per cent of GDP in 2014, in the process ending the coalition’s hopes of rebalancing the economy away from consumption in favour of investment and exports (see Chart 1).

Chart 1. Government, current account and private sector balances
Source: Office of National Statistics, Haver Analytics. Private sector and government are calculated as four-quarter rolling averages.

To a significant extent, the British government is powerless to do anything about the external imbalance. The UK’s exports to non-EU markets have grown strongly in recent years, but exports to the EU have fallen, since demand in the eurozone has been weak (see Chart 2). Indeed, the UK’s trade with non-EU markets is broadly in balance, with the deficit mainly accounted for by the EU, suggesting that the origins of the deficit lie as much in weak demand in export markets as supply-side constraints at home. Stronger eurozone growth should start to rebalance trade with the EU, although the current strength of sterling against the euro suggests that progress will be slow.

Chart 2. UK exports to the EU and the rest of the world
Source: UK trade info

However, policy differences between the Conservatives and the Labour Party could influence the outlook for the UK economy. While the UK faces several more years of fiscal consolidation regardless of the outcome of the election, the Conservatives are also likely to cut spending on education and infrastructure – two of the UK’s key weaknesses – by more than the Labour party. While Labour has announced that it will balance the current budget (that is, the budget excluding investment spending) by 2020, the Conservatives are committed to balancing the overall budget (including investment spending) by then, implying much tighter policy than under Labour.

The Conservatives’ ‘reform and referendum’ EU strategy is economically risky. It proposes minor changes – some of which might help the economy (such as deepening the single market, and striking more trade agreements with non-European countries) and some of which might not (making it easier for national parliaments to block legislation to deepen the single market). But the loss of foreign direct investment deterred by a referendum campaign would far outweigh any benefits from such tinkering. And if ‘Brexit’ does happen, it could result in considerable damage to Britain’s manufacturing base, and to the City of London, since it would raise barriers to competition between firms in Britain and the rest of Europe, rather than reducing them. It would also hit the poorest regions of the UK hardest.

Britain has a productivity problem. Output per hour remains lower than it was in 2007. The pick-up in economic growth since 2012 has been founded on a growing labour force rather than productivity growth. Neither of Britain’s biggest parties has a coherent set of policies for dealing with the supply-side problems responsible for this trend, and some of their proposals might worsen it.

Both Labour and the Conservatives promise to intervene in prices – for domestic energy, rail travel and housing – in a clumsy attempt to tackle the ‘cost of living crisis’ brought on, in part, by a failure to address the underlying supply-side constraints. Labour has proposed a price freeze on household energy prices and controls on rents. The Conservatives have promised to cap rail fares and provide subsidised finance for homebuyers. These policies would discourage investment in energy and rail capacity, reduce the number of homes to rent, and inflate house prices.

Despite Conservative claims that Ed Miliband is suspicious of markets, it is Labour that promises more forceful attempts to promote competition. It wants to compel the big six energy companies to build a Chinese wall between their generation and supply businesses, and to make companies buy and sell energy on exchanges. It promises two new challenger banks ‘on the high street’ (although it has not specified how it will create them) and is more likely to take concrete steps to alleviate the UK’s chronic housing crisis.

The Conservatives will do very little to address Britain’s biggest supply-side problem – the constrained supply of housing. The party plans 200,000 new ‘starter homes’ for young people over the next parliament, although its dire performance in this regard since 2010 strongly suggest this target will not be met (see Chart 3). But it will ensure ‘local people have more control over planning’ and promises to protect the green belt (the areas of largely agricultural land that surround Britain’s largest cities and which may not be built upon). It will pump up house prices by extending the ‘help to buy’ scheme, which offers subsidised finance for first time buyers. And it will reduce the availability of affordable rental housing by forcing housing associations (private charities that provide Britain’s cheaper rented accommodation) to sell to tenants, with the government subsidising their purchases. This set of policies would make the situation worse, not better.

By contrast, Labour promises 200,000 new homes a year. Although it is short on the specific policies to deliver them, its track record on housing is far stronger than the Conservatives: two-thirds as many houses were built in 2014 as in 2007. However, Labour has not said how it would tackle the issue of excessive business rents, which are as important a supply constraint as private housing. And while it promises a so-called ‘mansions tax’, which will hit the owners of expensive homes, Labour has no plans to reform Britain’s low and regressive property tax rates.

Chart 3. Housebuilding
Source: Department of Communities and Local Government

What impact will the election result have on the outlook for constitutional reform? The rise of the SNP in Scotland after the country voted to stay in the UK at last September’s referendum is, at first sight, perplexing. But the Scots were promised more devolution in the referendum campaign, only for David Cameron to announce the morning after the vote that more devolution would only happen if Scottish MPs were stopped from voting on English matters in Westminster. Since then, the Conservatives have portrayed any Labour government reliant on SNP support as a betrayal of the English, and Ed Miliband has felt compelled to say that Labour will not deal with the SNP if Labour forms a government. If the Scots return 45 to 50 SNP MPs to Westminster, and both major British parties shun them in an attempt to court English votes, Scottish voters will be disenfranchised and the Union will be further weakened.

There is one way out of this: reforming the voting system to make it more proportional, and devolving more powers to Scotland, Wales, Northern Ireland – and to the English regions. Proportional representation (PR) would ensure that parliamentary representation was more closely aligned with voter preferences, and would mean that more voters’ views were represented in parliament and government, since coalitions would be more likely. And crucially, it would prevent Scotland from becoming a permanent SNP fiefdom. The SNP has taken over from Labour as the beneficiary of first-past-the-post in Scotland. With PR, there would be far more Labour, Liberal Democrat, Green and Conservative MPs in Scotland, slowing or stopping the drift towards independence.

In many ways, Conservatives’ attitudes towards the EU are the mirror of Scottish Nationalists’ attitudes towards the UK. Both want sovereignty returned to ancient parliaments, and both consider themselves to have bad deals in their respective unions. Labour is the best hope for constitutional change. Having lost most of the Scottish MPs, it will no longer be a beneficiary of the current first-past-the-post voting system, and could hope to be the dominant political force in most the UK’s devolved regions.

Finally, could the election reverse Britain’s increasing international marginalisation? The current coalition has presided over a dramatic worsening of Britain’s relations with the EU. This has partly been the result of David Cameron’s decision to concede a referendum on membership of a ‘reformed’ EU. As there is no appetite on the part of the rest of the EU for a treaty change to accommodate major concessions to the UK, the relatively minor reforms Cameron is likely to achieve will not be enough to assuage the eurosceptics in his party. Even if Britain votes to stay in the EU, a referendum campaign will ensure that British politics is inward looking until the vote is held, further weakening Britain’s already diminished status in the Union.

A Labour-led government would be better placed to improve relations with the EU. Crucially, it is highly unlikely there would be a referendum. Nor would Labour seek to renegotiate the terms of the UK’s EU membership. Britain’s relations with a number of EU governments could improve significantly: the Conservative-led coalition has focused on relations with Germany almost to the exclusion of relations with other countries because it believes that Germany is key to a successful attempt to renegotiate membership. A Labour-led government is also more likely to reboot Franco-British military co-ordination, which has been badly neglected by the current government since Fran├žois Hollande became the French president. However, even under Labour, it is far from clear that Britain would revert to a more assertive role in the EU, given the need to manage what promises to be a tricky domestic situation.

Not only has the current British government damaged relations with the EU, but it has undermined relations with the US. The UK’s waning influence in the EU combined with big cuts in defence spending, and a growing reluctance to participate in international military operations, has made the UK a less important partner for the US. However, this is unlikely to change much regardless of the outcome of the election. A Labour-led government would at least remove the spectre of a referendum and with it the biggest threat to British influence in the EU. But neither party is likely to try to meet the NATO target of spending 2 per cent of GDP on defence, although both would renew the Trident nuclear deterrent. Similarly, as minority governments, neither would risk participating in international military action in the face of strong domestic opposition.

The general election campaign has shown some of the uglier features of British politics. It has been marked by short-termism: the Conservatives have been willing to risk both Britain’s membership of the EU and the UK itself in order to court English votes. For its part, Labour has focused on populist responses to the UK’s poorly performing markets (such as price and rent controls) as much as on policies to make those markets work better. The campaign has focussed on side issues: how each party plans to cut the budget deficit has featured far more prominently than what they will do about weak productivity growth, or how to make Britain’s government more legitimate in the eyes of its people. And British politics is becoming insular: while the Middle East and Eastern Europe are torn by conflicts and a rising China squares up to the US, the next parliament will ignore those challenges in favour of arguments over ‘Scoxit’ and ‘Brexit’.

John Springford is a senior research fellow and Simon Tilford is deputy director at the Centre for European Reform.

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