Economics

UK: clowns to the left of me, jokers to the right

● Thirteen weeks until the general election and none of the options look appetising to an economist: For the economy, both main parties bring with them big, but different, problems. The choices are 1970s left-wing statism or ludicrous public spending cuts and a Brexit vote. Talking of political uncertainty misses the point. The result of those options is that UK politics is almost certain to undermine the UK’s growth potential somewhat.

● The best result may be one that prevents either major party from implementing its preferred policies: Neither is likely to gain an electoral mandate strong enough to enact radical policies. That would be good news. The UK is not Italy or Greece. Britain does not need radical surgery just to grow at all. If coalition politics mean modest austerity and no other changes, the UK will be fine.

● Parties closer than they care to admit: Most agree that significant austerity is needed. The Conservatives will not be able to cut spending by as much as they plan, while Labour just plan to make fewer cuts in the first place. Labour would meddle with the economy but the Conservatives would hold a Brexit vote. That Labour would not hold such a vote could remove one of the biggest political risks if the party formed a government.

● The Scottish Nationalist Party (SNP) risk: Political gridlock need not hold back growth much. But a Labour/SNP coalition, whose chances are gaining, would cause problems for markets. It could threaten to split the country apart. Labour may want to avoid this coalition, given the possible English backlash.

● Labour poll readings falling: But the smaller, rather than larger, parties are benefiting, making a hung parliament likely. Major parties would need to garner much more support than they have now to gain a parliamentary majority. Even 36% of the vote at the 2010 election gave the Conservatives only 306 of 650 seats.

● We assume the Conservatives will gain the most seats: There are more United Kingdom Independence Party (UKIP) voters who could switch to the Conservatives than there are Greens who could shift to Labour. The Conservatives are the most trusted on the economy, which is improving. Could we see a repeat of the late Conservative gains in 1992?

● But could they find partners?: The Liberal Democrats may baulk at another coalition, given their haemorrhaging support since 2010. UKIP would be a ruinous partner. We see a 60% chance of a Conservative-led government.

● More potential partners for Labour: The Liberal Democrats could join Labour, as could the SNP and the Greens. We see a 35% chance of a Labour-led government. We put the potentially problematic scenario of Labour/SNP at 20%.

Chart 1: Main parties neck-and-neck in the polls

Moving average of last 10 polls, excluding the two most extreme. Source: YouGov, Opinium, Populus,

Ashcroft, IPSOS-Mori, TNS, ComRes.

Key Macro Views reportsKey Macro Views reportsKey Macro Views reportsKey Macro Views reports

Understanding Germany Understanding Germany Understanding Germany Understanding Germany –––– a last golden decade a last golden decade a last golden decade a last golden decade aheadaheadaheadahead 13 October 2010

Euro crisis: The role of Euro crisis: The role of Euro crisis: The role of Euro crisis: The role of the ECBthe ECBthe ECBthe ECB 29 July 2011

Tough love: the true Tough love: the true Tough love: the true Tough love: the true nature of the euro crisisnature of the euro crisisnature of the euro crisisnature of the euro crisis 20 August 2012

Mind the court: the top Mind the court: the top Mind the court: the top Mind the court: the top event risk in Europeevent risk in Europeevent risk in Europeevent risk in Europe 31 May 2013

Europe 2020: Reaping Europe 2020: Reaping Europe 2020: Reaping Europe 2020: Reaping the rewards of reformthe rewards of reformthe rewards of reformthe rewards of reform 26 November 2013

Banking union: help for Banking union: help for Banking union: help for Banking union: help for tomorrow, not todaytomorrow, not todaytomorrow, not todaytomorrow, not today 19 December 2013

Eurozone: Debunking Eurozone: Debunking Eurozone: Debunking Eurozone: Debunking the deflation scarethe deflation scarethe deflation scarethe deflation scare 13 January 2014

ECB: ECB: ECB: ECB: the unthinkable the unthinkable the unthinkable the unthinkable edging closeredging closeredging closeredging closer 9 April 2014

Credibility questions: Credibility questions: Credibility questions: Credibility questions: Mark Carney’s first yearMark Carney’s first yearMark Carney’s first yearMark Carney’s first year 1 July 2014

Euro Plus Monitor 2014: Euro Plus Monitor 2014: Euro Plus Monitor 2014: Euro Plus Monitor 2014: leaders and laggards leaders and laggards leaders and laggards leaders and laggards 18 December 2014

UK outlook 2015: strong UK outlook 2015: strong UK outlook 2015: strong UK outlook 2015: strong economy, weak politicseconomy, weak politicseconomy, weak politicseconomy, weak politics 19 December 2014

Global outlook 2015: Oil, Global outlook 2015: Oil, Global outlook 2015: Oil, Global outlook 2015: Oil, Putin and Greece Putin and Greece Putin and Greece Putin and Greece 6 January 2014

How big might the Greek How big might the Greek How big might the Greek How big might the Greek fallout to the UK be fallout to the UK be fallout to the UK be fallout to the UK be 26 January 2014

6 February 2015

Rob Wood

Chief UK Economist

+44 20 3207 7822

robert.wood@berenberg.com

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Almost certain that UK politics will undermine the

UK’s growth potential over the coming years

An utterly unpredictable general election faces the UK on 7 May. Rising support for smaller parties makes a hung parliament the most likely outcome, with days of coalition-building possibly following the election. Will the SNP prop up a left-wing Labour government? Will Prime Minister David Cameron ramp up his anti-European rhetoric too far, winning the election battle but setting himself up to lose the campaign to keep the UK in the EU? Markets will worry.

By far the most likely result from May’s vote is a coalition with a thin majority. Indeed, voters seeing the populist-party-inspired chaos in Greece may be more inclined to go for the safe option in the UK, meaning the major parties could lead coalitions with workable majorities. A coalition with a thin majority need not fall quickly and the pressure may even improve policymaking. None of the parties will be able to implement their most extreme ideas. Instead they will have to focus on building consensus. Remember, the UK is not Italy or Greece and 2015 is not 1974. Growth will be just fine without radical surgery, so a period of political inaction need not be costly. The US has coped well, for instance, despite coming within a day of defaulting on its debt and also closing down the government for two weeks.

The Conservatives and Labour will, together, take the vast majority of seats. A bias in the electoral system means that the Conservatives would need to lead by at least two points, and maybe more, to gain more seats than Labour. But surging support for the SNP is offsetting that in-built imbalance (Chart 2). It is hard to exaggerate how important that shift in Scotland is for the UK election. If the polls remain where they are now, the SNP could take almost all of Labour’s 41 Scottish seats, as well as all of the Liberal Democrats’ 11. In any case, neither main party would win an outright majority of seats unless it gains a lot more support than it has now. Even 36% of the popular vote in 2010 gave the Conservatives just 306 of Parliament’s 650 seats. A one-party majority government is not impossible but it remains an outside bet.

Neither UKIP nor the Green Party is likely to hold the balance of power. UKIP leader Nigel Farage may not even win in the east coast Thanet South seat he is contesting, while he may do well to get half a dozen colleagues into Westminster. If they are lucky, the Greens may secure two parliamentarians. Those parties do, however, complicate the electoral maths in the UK’s 650 constituency first-past-the-post system. How many – if any – of the smaller parties’ supporters switch back to the main two by the election could determine who wins. We see a 60% chance of a Conservative-led government, and a 35% chance of a Labour-led one.

For the economy, both main parties bring with them big, but different, problems

Uncertainty about the result is not the same thing as uncertainty about the subsequent policies. Indeed, talking of political uncertainty now is almost trite. Many people may actually mean the opposite but are afraid to say it: it is almost certain that UK politics will undermine the UK’s growth potential over the coming years. That is because the business environment would deteriorate under either main party. Labour’s 1970s statism would undermine UK competitiveness, but the Conservatives would play chicken with Britain’s future in the EU and probably clamp down much more on immigration. Indeed, the UK’s position with the EU is probably just as, if not more, important for business than whether the Liberal Democrats form a coalition with Labour or the Conservatives.

The parties are much closer than they care to admit on fiscal policy. All main parties agree on the need for sizeable further austerity. Labour plans to cut public spending by less than the Conservatives do, but the Conservatives’ planned cuts are so large as to be unachievable. In other words, in practice the parties’ spending will probably be closer than their plans imply, though trying to implement those large cuts could cause real damage. The tax side of Labour’s plans is a mess, but at least it is a mess of small changes. Few wealthy people would like a mansion tax or higher marginal tax rates. Such is life. Those income tax rates are not going anywhere near the levels seen during the bad old days of the 1970s. In any case, the Conservatives would probably have to raise taxes anyway.

Coalition partners could blunt some of the sillier policies. The government will have to focus on areas of agreement, or risk achieving nothing. Austerity, modest tax rises, raising housebuilding, renewing Trident, trying to kneecap the SNP – those could all be areas where even a fractured parliament could make progress.

Economics

3

Another way of viewing this election could be through the lens of 2010. A coalition government came as a surprise. The UK had not had an inconclusive election result for 36 years. The government has not always enacted what was planned – messing about with energy policy, cutting corporation tax further than expected, scrapping fuel duty rises. Yet the UK economy has grown by 8.9% since Q1 2010, only 1.8ppt less than the US despite the raging euro-crisis over that period. Or, to put it another way, John Major won the 1992 general election but presided over a chaotic parliament riven with arguments about Europe. Yet the UK recovered very strongly from the early 1990s recession.

Two big risks

The near-term impact in most scenarios would be relatively modest. But there are cases in which that may not be true. One obvious one is if the vote conspires to prevent any plausible coalition from being able to form a majority. Another election would follow quickly. There are two other serious risks.

1. A Conservative-majority government would hold a Brexit referendum by end-2017

We expect the UK to choose to remain in the EU if a Brexit vote were held. Polls have shifted in favour of membership over the past year (Chart 3), and show very wide support if Prime Minister David Cameron endorsed the results of a renegotiation of Britain’s relationship with the EU. But the uncertainty about Brexit could weigh on growth through 2016 and 2017. If the Conservatives ruled alone but with a slim majority, Eurosceptics in the party would have more power. They could bounce Mr Cameron into an earlier referendum, which would be more likely to go against continued EU membership and prompt a much earlier negative reaction in markets and the economy. A Conservative-majority government, then, may be a bad outcome for business.

2. Labour-SNP tie up, for which we see a circa 20% chance

Despite losing the Scottish independence referendum, the SNP has made enormous gains from Labour in Scottish polls (Chart 2). It could conceivably become the third-largest party in the UK parliament. The SNP has governed as a minority party in Scotland before, but would inflame English-Scottish tensions if it starts voting on English issues in the Westminster parliament after the election – after further devolution, there are more policy areas that Scottish MPs can vote on in Westminster without it affecting policy in Scotland. Indeed, a Labour government propped up by the SNP could mean the second and third most-popular parties, which together captured less than half of the popular vote, rule the UK. Unlike other countries, not having the strongest party leading the government would be highly unusual for the UK.

The Labour Party may try to avoid such a coalition, which limits the risks. If, by forming a government with the SNP, Labour demonstrated that the Nationalists could wield power in Westminster, then Labour could lock itself out of Scotland for many years, making a future Labour majority government for the UK unlikely – voting SNP would no longer be a wasted vote in Westminster elections. Furthermore, a coalition with the SNP would inflame English resentment and could erode Labour’s remaining strongholds south of the border. The best long-term result for Labour in May could well be to lose the election, which would show that voting SNP actually puts the hated Conservatives in power. Losing could, therefore, build up Labour’s Scottish strongholds again. That being said, if Labour teamed up with the SNP and delivered further autonomy to Scotland, Mr Miliband could perhaps capitalise on the goodwill to boost Labour’s chances north of the border.

Chart 2: Surging SNP support in Scotland Chart 3: UK voters support EU membership

Source: Wikipedia Source: YouGov

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Electoral calculus

Britain’s electoral system favours Labour. That is worth at least 2ppt of the popular vote to the party. Constituency boundaries that have not been redrawn since the 2010 election are the cause. The Conservative Party scuppered an agreement with its coalition partners, the Liberal Democrats, to change the boundaries because it could not stomach the other side of the deal. To persuade the Liberal Democrats to change the boundaries, the Conservatives would have had to agree to reform the House of Lords, the upper chamber of Parliament.

However, surging support for the SNP eats into Labour’s advantage. Currently, Labour holds 41 of the 59 seats in Scotland, after winning 42% of the Scottish vote in the 2010 general election. The latest polls, however, give the SNP around 50% of the Scottish vote and Labour around 25%. The SNP has seemingly won the war, despite losing the Scottish referendum battle. That swing in support is probably the single most-important electoral event over the past six months. As we argued back in September, the no vote in the Scottish referendum was unlikely to be the end of the issue (see UK: never the same again, published 18 September 2014). The SNP could take almost all of Labour’s Scottish seats, potentially more than offsetting the bias in the electoral system. However, as the SNP would never form a coalition with the Conservatives but would with Labour, that might matter less when it comes to the Conservatives’ chances of forming the next government.

Chart 4 provides a rough way of visualising the importance of those factors. It shows how many seats the two big parties would have under different assumptions about the popular vote and how well the SNP does. As with any forecast for an electoral system as complicated as the UK’s, the numbers can be only very approximate and subject to large errors. The base level of support for both main parties matters, as does the difference between the two. The chart, however, gives us a rough idea.

Electoral Calculus, a forecaster, estimates that the SNP would win three quarters (29) of Labour’s (42) Scottish seats if the polls do not change between now and May. The base case is constructed from that assumption and recent poll readings which show Labour and the Conservatives with about 33% of the vote each, the Liberal Democrats on 8% and UKIP on 16%. We then vary the Conservative and Labour vote share, assuming that they take support proportionally from the other parties. On that basis, Labour would be the largest party in parliament as long as it is less than two points behind the Conservatives in the popular vote. If the SNP does better than the base case, then Labour’s advantage would narrow. As an example, Labour would need to gain about 0.75% in the popular vote to offset the impact of the SNP gaining 10 seats more in Scotland than we have assumed.

On the basis of current polls, Labour could end up with about 20 more seats than the Conservatives, but around 30 seats short of a parliamentary majority. The Conservatives would need to be at least seven points ahead in the popular vote to gain an outright majority. Labour and the SNP combined could have a parliamentary majority if Labour is less than two points behind the Conservatives in the popular vote.

Chart 4: Election scenarios

Base forecast from ElectoralCalculus.co.uk, assuming Labour one point ahead of Conservatives.

Gains for Conservatives relative to that base are assumed to come from Labour, Liberal Democrats

and UKIP in proportion to their current poll ratings, and vice versa for Labour gains relative to the

base. Current polls put Labour and Conservatives on 33% each. Source: Electoral Calculus.

Berenberg calculations.

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Economics

5

The key question is how support will shift between now and May

Those scenarios above were based on one forecaster. But there are several competing predictors out there. Table 1 compares the 2010 election results with four forecasts for 2015. Though they vary, we can draw some conclusions that are similar to those we have highlighted above. First, the SNP’s gains matter a lot for whether Labour could emerge as the largest party. Second, how the polls move between now and May is obviously key. Electoral Calculus takes the current polls as they are. Elections Etc forecasts how the polls themselves will move, based on how they have done so before past elections. That is why the latter expects the Conservatives to win more seats. Third, UKIP is unlikely to hold the balance of power. Fourth, the Liberal Democrats are a wildcard, just like the SNP. Their huge loss of support suggests they could lose most of their 57 seats. But Liberal Democrat voters tend to be very concentrated in particular constituencies, meaning the degree of national support the party has lost will probably not be reflected proportionately in seats. Three of the four forecasters expect the Liberal Democrats to hold on to around 25 seats.

Table 1: Hung parliament likely

2010 vote

share

Seats in

2010

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Current

polls

Forecasts ----> May2015 Electoral

Calculus

Elections

etc.

Election

Forecast

Conservatives 36.1% 306 33.1% 272 274 282 280

Labour 29.0% 258 33.1% 270 302 280 285

Lib-Dems 23.0% 57 6.9% 25 14 24 25

UKIP 3.1% 0 15.0% 4 0 3 2

SNP 1.7% 6 4.3% 56 38 40 36

Current polls column shows the average of the last 10 polls, excluding the two most extreme. Forecasts taken on 4/2/2015. Source: Wikipedia,

May2015.com.

Opposition parties tend to lose support in the run-up to elections (Chart 5), which is why we have presented our scenarios above in terms of the Conservatives’ lead over Labour. Though the two are neck-and-neck, Labour is more likely to shed support by May than the Conservatives are. The question is how much and where that support goes. If the 2010 election result were repeated, and the Liberal Democrats’ vote share remained as low as it is now, then the Conservatives could just about win a majority.

That does not seem likely. Labour’s declining support over the past six months has mainly benefited UKIP and the Greens (Chart 1). Chart 5 shows that the third party normally benefits from that loss of opposition support. But the traditional UK third party, the Liberal Democrats, is part of the government and has bled voters, net, to the populists (Chart 6).

The big issue, then, is how many of those UKIP and Green voters will switch back to the main parties in May. Precedent cannot help here, as the UK has never been in this position before. YouGov’s latest poll, however, records that 17% of Conservative voters in 2010 now support UKIP, compared to 8% of Labour voters and 10% of Liberal Democrats. Extra Green support has come almost entirely from the Liberal Democrats. Of those voting Liberal Democrat in 2010, 14% now support Conservatives, 28 % Labour, 10% UKIP, 16% Greens and 4% SNP. So the Conservatives have more potential upside than Labour does from current populist supporters switching back to the main parties once they realise the smaller parties are unlikely to win many seats, meaning a vote for them would be wasted.

Chart 5: Opposition loses support in the election run-in Chart 6: Smaller parties make electoral maths messy

Vote shares in UK general elections. 2015 shows the average of the

latest 10 polls, excluding the two most extreme. Source: Wikipedia.

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UKIP voters are very exercised about immigration and Europe. 89% of UKIP supporters believe immigration is the most important issue facing the UK, compared to 49% for the whole population. 43% of UKIP voters say Europe is the most important issue, compared to 17% for the population as a whole. In that sense, UKIP voters are much more like the Conservatives’ supporters than Labour’s. And, of course, the Conservatives are the only plausible party of government offering a referendum on EU membership.

Lord Ashcroft conducts some of the most detailed constituency-level polling available. He finds that only half of people say they have decided how they will vote, and Conservative supporters who now state they support UKIP “overwhelmingly prefer Cameron to Miliband and [say] that a Conservative government is their preferred election outcome.” (Lord Ashcroft Polls, 22 December 2014). He also reports that “six in ten swing voters, and a third of those who currently say they will vote Labour, worry that Labour have not learned the right lessons from their time in government and that they might spend and borrow more than the country can afford”.

Lord Ashcroft’s poll of marginal constituencies also shows that some UKIP voters switch back to the main parties when voting in their constituency, rather than when expressing a preference over a general party. In other words, some UKIP supporters choose to vote for a major party instead of potentially wasting their vote.

Where does this leave us? Chances are that the opposition Labour Party will lose support over the next 12 weeks, while the Conservatives could gain from current UKIP supporters. So the polls should shift in the Conservatives’ favour.

In the past, pollsters have struggled with the problem of “shy Conservatives”; those who voted Conservative but would not say so to a pollster before the election because they were embarrassed. Now pollsters may be struggling with “rash UKIPpers”: those who support UKIP now but will change their mind when it comes to the serious business of voting. The Scottish referendum may provide a parallel. It is one thing to support a major change when talking to a pollster, but quite another in the polling booth when it really matters. Despite polls showing a close Scottish referendum race, the “No” campaign won by 10 points (55-45). A similar effect was evidence in Quebec’s earlier independence referendum, for what it is worth.

Consumers’ spending power is also turning up at just the right moment for the Conservatives’ campaign, while Ed Miliband has poor approval ratings. Events in Greece could prove a boon to the main two parties in the UK too, especially if uncertainty about Greece turns into chaos and front page news (to be clear, that is not our central expectation, but it is possible). That bad fallout from populists wielding power could kill the romantic notion for some of the underdog UKIP or Green supporters gaining significant influence and leading the UK to some sort of promised land. Voting for a large party may then look much more attractive. That argument does not cut all one way though. UKIP may be able to bolster its arguments by pointing to mounting problems in the Eurozone if the Syriza-Eurozone stand-off continues, or ends badly.

How much might the Conservatives gain? There is no reliable way of solving the problem. It is not totally implausible that the Conservatives will win a majority, although it would be an outside bet. For instance, the last 10 polls ahead of the 1992 general election gave Labour 39.5% of the vote on average and the Conservatives 37.6%. The final result was 34.4% for Labour and 41.9% for the Conservatives. Polling companies have put a lot of effort into fixing that shy Tory factor since then, but maybe UKIP has introduced a new problem. That seems more plausible than assuming one in six of voters will support a party that might win only half a dozen seats. The more likely result, though, is that the Conservatives win the popular vote and the most seats, but end up short of a majority in parliament.

Economics

7

Labour are from Mars, the Conservatives are from

Venus (or something like that)

Ideologically, the two main parties are far apart. As leader of the opposition Labour Party, Mr Miliband has jumped to the left and back in time by about 40 years with a 1970s statist agenda. The Conservatives, by contrast, seem to be aping the US Tea Party’s approach to government spending: it is all bad except for one or two sacred cows. For defence in the US, swap pensioner benefits and the National Health Service in the UK. Despite a broadly pro-enterprise approach, the Conservatives still retain a streak for self-harm. Mr Cameron was forced to commit to an “in-out” referendum on EU membership, which is a hell of a risk even though we expect the UK to vote to remain in. For the economy, both main parties bring with them big, but different, problems. For that reason, the best result may be one that prevents either party from implementing its preferred policies.

Fiscal policy

All of the parties plan significant future austerity, and the differences between their plans are more make-believe than real. The Conservatives’ spending plans are so severe that they look unachievable. For that reason, a Conservative government could well end up doing more-or-less what Labour and the Liberal Democrats plan anyway.

The Conservatives, Labour and the Liberal Democrats have all signed up to a “fiscal mandate” that requires them to achieve a cyclically adjusted current budget surplus in 2017/18 (that borrowing measure excludes government investment spending). But the parties differ on how to get there and what to do afterwards.

The government’s independent forecaster, the Office for Budget Responsibility (OBR), estimates that Whitehall’s current spending plans would deliver a cyclically adjusted surplus of 0.7% of GDP, or £13.7bn, by fiscal year 2017/18. That means all the parties could spend £13.7bn more, or tax that amount less, in fiscal year 2017/18 than Chancellor George Osborne has said he plans to and still, just, hit the fiscal target. That sounds a bit odd, so let us put it another way. Mr Osborne has pencilled into his budget larger spending cuts than his new fiscal rule requires. Presumably that is to allow him to unveil big future tax cuts ahead of the election while still meeting his borrowing rule. The Conservatives seem to be trying to almost precisely mimic the 1992 election campaign (Norman, now Lord, Lamont, then Chancellor, unveiled tax cuts ahead of that election), bribing voters with their own money – tax cuts funded by implausible, and potentially damaging, government spending cuts are unlikely to durably increase the size of the economy.

What about the parties’ own fiscal rules? The Conservatives have pledged to achieve an overall budget surplus in the next parliament as long as the recovery is sustained. Labour has pledged to achieve a surplus on the current budget in the next parliament. The Liberal Democrats plan to meet the fiscal mandate. Both Labour and the Liberal Democrats also have supplementary debt goals (because their deficit targets do not cover all of government spending they could, in principle, recklessly increase spending enormously if they had no debt target). Both plan to have debt falling once they reach their deficit goal.

Chart 7: Three parties, three targets

Percent of GDP, OBR stands for Office for Budget Responsibility. Forecasts are from the OBR,

assuming policy follows the current government’s plans. Source: OBR.

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The Conservatives plan to run a surplus even once investment is taken into account. These rules, therefore, mean that Conservative fiscal policy would be tighter than the other parties by about 1.5% of GDP, or £27bn a year, by fiscal year 2019/20. Beyond fiscal year 2017/18, all of the parties have wiggle room in their plans for more spending or lower taxes. By fiscal year 2019/20, all target measures of the deficit are forecast to be comfortably in surplus. The sums in question are large: £23.1bn for the overall fiscal surplus, £50bn for the current budget surplus, and £50.6bn for the cyclically adjusted surplus.

Usefully, the Institute of Fiscal Studies (IFS) in its recent Green Budget boiled all this down into a nice neat table (Table 2). While the Chancellor put £51.4bn of real spending cuts over the next parliament in his Autumn Statement, all parties could, or plan to, do less than that. For reference, £50bn is a similar figure to the education budget.

Table 2: Potential spending under parties’ proposals

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2014 Autumn Statement plans -14.1 -51.4 -22.2 -89.5

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stated plans

Conservatives -6.7 -24.9 -15.5 -53.1

Labour -1.4 -5.2 -10.8 -43.3

Lib Dems -2.1 -7.5 -11.3 -45.7

Source: IFS Green Budget 2015, Table 7.7

Plausibility

So it looks like the Conservatives offer a very different alternative to Labour and the Liberal Democrats: a slimmed down, less wasteful government, allowing lower taxation. Would this yield a big supply-side reform that would help growth and calm markets? To judge that, we need to consider the plausibility of these plans. Chart 8 shows that Mr Osborne’s spending plans, detailed in the Autumn Statement, imply implausibly large cuts in the day-to-day running costs of the government. Table 3 highlights that more starkly by splitting out the implications for departments “protected” from real cuts, and those that are not. For instance, the Autumn Statement plans imply an eye-watering 46% cut in real-terms spending by the Home Office over the next parliament. The courts would also see funding cut by 45%. The reasons for those enormous falls, despite relatively sedate overall consolidation plans (Chart 7), are that the current government plans to use spending to achieve all the consolidation and it will ring-fence large areas of expenditure, meaning the knife has to cut deeper elsewhere. Pensioner benefits will continue to rise, for instance. And cutting back working age benefits is hard.

Chart 8: Implausible spending plans Chart 9: Real departmental spending plans

Autumn Statement 2014 spending plans/forecast. Source: OBR. Potential departmental spending assuming all parties’ stick to the Autumn

Statement 2014 plans for investment, that they borrow the maximum

amount their fiscal rules allow and that they implement their specific tax

and benefit reforms and stated intentions as of December 2014. Source:

Figure 7.5 from IFS Green Budget 2015

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Mr Osborne’s planned cuts are simply implausible in our view. As the IFS has said: “Real public service spending per capita has not been cut for more than two consecutive years at any point since the series began in 1964-65, whereas current plans imply 10 consecutive years of cuts.” It continues: “If the protection afforded to health, official development assistance and non-investment spending on schools were continued through to 2019-20, then, under the Autumn Statement plans for total departmental spending, other ‘unprotected’ areas of spending would need to be cut [in real terms] by 27.0% after 2015-16. This would take the total cut since 2010-11 to 42.0%.”

So where does this leave us? If the Conservatives win the next election and impose spending cuts of the magnitude planned in the Autumn Statement, they would damage the economy. As yet, the government has no detailed plan for how it would run a police service with half the real resources it uses now, or how the army would function with a real budget a third lower. That is not to say it cannot be done. Undoubtedly there are big potential efficiency savings in government. But those require a proper plan, yet the government does not seem to have one, and the public are wholly unprepared for the type of changes these figures would require, in part because the ruling Conservatives give the impression it would be straightforward. In big picture terms, the Autumn Statement assumed the UK government would spend less as a proportion of GDP in 2020 than the US does now.

Our best judgement is that the Conservatives would be unable to implement cuts of that magnitude. Whoever forms the next government will probably have to raise taxes, and all parties will manage less austerity than assumed in the Autumn Statement. Turning again to the IFS, it said: “12 months following general elections have often seen significant tax-raising measures being announced. For example, the 12 months after the 1992, 1997, 2001, 2005 and 2010 general elections all saw large net tax increases being announced ... In many cases, these tax increases were not ones that had been openly discussed prior to the election.” In the end, the wild rhetorical differences in policy seen now would probably not be reflected in actual policy. Labour would probably tax and spend a bit more and the Conservatives less. As it happens, with interest rates close to zero, less austere spending plans would be less damaging to the UK’s prospects and investors’ views of them. Less austerity would allow the Bank of England (BoE) to hike rates earlier than currently expected, maybe pushing up sterling.

Table 3: Autumn Statement assumed implausibly large departmental spending cuts

Latest planned change in

real spending, 2010/11 to

2015/16

Real terms change, 2015/16-2019/20 under illustrative

scenarios for each party

Autumn

Statement

Conservative Labour Liberal

Democrat

Health 6.2% 0.0% 3.2% 3.2% 3.2%

Education -7.4% - - - 0.0%

Defence -10.7% -36.2% -13.8% -4.6% -10.2%

Home Office -24.9% -46.3% -18.7% -7.4% -14.6%

Ministry of Justice -34.3% -45.3% -18.3% -7.2% -14.1%

Business, innovation and

Skills

-25.3% -40.1% -15.7% -5.7% -11.9%

Transport -6.5% -5.7% 1.1% 4.1% 3.2%

Includes capital spending as well as day-to-day running costs. Education ignored for Conservatives and Labour as the former are only just now

announcing policies for it. IFS, Tables 7.4 and 7.10. Source: IFS.

Other policies

The remaining differences between the parties, on balance, do not favour one over the other, in our view. Labour plans a series of targeted tax rises (mansion tax, raising higher rate threshold, for instance) that would yield relatively small amounts which could be used to make token adjustments to the health service budget. The more damaging part of Labour’s plans is its meddling in industries. Over the past few years, it has announced a plethora of statist policies, such as: a utility price freeze; a bank break-up; and compulsory purchasing land from housebuilders if they do not develop on it as fast as the party would like. Those policies do not amount to much for the economy as a whole, but the risk is that they are simply the tip of the iceberg, and therefore they do seriously deter investment.

The Conservatives have a more business-friendly tax and regulatory policy. But they are the only main party willing to play chicken with the UK’s position in the EU. In a way, then, it is strange that they seem to command more business support. Presumably that is because firms expect the UK to vote to remain in the EU. We do too, but it is a hell of a risk.

Economics

10

Scenarios

Either major party would need to gain substantial support relative to current polls to deliver a majority. While that is possible, and much more likely for the Conservatives than for Labour, it remains an outside bet. We put a 20% chance on a Conservative majority and a 5% chance on a Labour majority. The latter may even be too high, but it would be foolish to assume a zero probability. We put the chance of a hung parliament at 70% overall.

The following describes our take on the main scenarios.

Conservative-led government – 60% probability

● Conservative majority – 20%

Bad: UKIP voters switch back to the Conservatives in significant numbers when they are in the polling booth while Labour loses further support during the election run-in. Conservatives just scrape over the 326 seat threshold. Mr Cameron stays as Prime Minister. Significant austerity is set in train, damaging growth and the functioning of government, sapping long-term potential. The Conservatives implement English votes for English laws, boosting support for Scottish independence. The Brexit referendum weighs on inward investment, and there is a risk that the vote is brought forward from late 2017 as the government’s slim majority gives a lot of power to recalcitrant Eurosceptic back-benchers. That could shift the probability of Brexit above 50%. The potential for government to crumble amid infighting over Europe rises. There is another election within three years.

● Conservative-Liberal Democrat formal coalition – 15%

Good: The Liberal Democrats have haemorrhaged support, but their core voters remain steadfast, giving them 25 seats. The Conservatives gain at UKIP’s and Labour’s expense, matching their 2010 seat total, or even doing a little better, and meaning the two current coalition partners can (just) muster a majority of parliamentarians again. Nick Clegg resigns, but his successor plumps for the Conservatives rather than Mr Miliband’s statist approach. The precedent of the past five years convinces markets that the coalition would not be a disaster. There are smaller spending cuts than the Conservatives plan, and English votes for English laws is avoided. The Brexit referendum is delayed until 2017 as part of a coalition agreement. The UK stays in the EU. But the (very) thin majority makes government precarious.

● Conservative minority – 25%

Possibly okay: The Conservatives are the largest party but fail to secure an outright majority as UKIP takes plenty of votes, while disillusionment with past falls in living standards mean Labour’s vote holds up. The Liberal Democrats win 25 seats but refuse to join a formal coalition in the light of their huge losses since 2010. However, they prefer a Conservative-led government to a Labour one beholden to the Scottish nationalists, so the Liberal Democrats agree to support a minority Conservative government on a “confidence and supply basis”. That means they vote for the government on budget matters and in confidence votes, but are otherwise free to disagree. Northern Ireland’s Democratic Unionist Party agrees to a similar deal. There is less austerity than Mr Osborne plans now. There is no English laws for English votes. If the Brexit referendum is agreed – which would not be guaranteed if the Conservative Party does not have a majority – it is held in late 2017. The UK stays in the EU. The requirement for deal-making means few radical policies. A minority government is unlikely to last the full five years of parliament.

Labour-led – 35%

● Labour majority – 5%

Okay for a while: Against all the odds, Scottish Labour manages to overturn the SNP’s current massive lead while Mr Miliband stems losses in England with a focus on the NHS. Voters switch from the Greens back to Labour, while UKIP voters shun the Conservatives. More government spending means stronger growth and more-realistic funding for health and education. But statist interventions and a plethora of meddlesome tax changes sap the economy’s growth potential and hurt investment. The pound may fall moderately initially, though the BoE could hike rates sooner and faster than otherwise. There is no Brexit referendum. However, the slim Labour majority makes governing difficult. Mr Miliband is deposed amid plummeting approval ratings.

Economics

11

● Labour-SNP – 10%

Very bad: The SNP takes almost all of Labour’s Scottish seats. Labour comes second to the Conservatives in the popular vote, but the Liberal Democrats are almost wiped out, preventing the Conservatives from being able to construct a coalition with a majority of seats. The SNP agrees to back Mr Miliband on a “confidence and supply basis” to keep the Conservatives out of power, and to take advantage of a weak Labour Party by pushing through yet more devolution. A full-on left-wing statist programme hits the UK’s growth potential. The government is vulnerable. Any plans for austerity crumble. Nationalists unpick the union as the price of their support for the government, and rising English resentment saps the willingness to offer concessions. The one upside is that no Brexit referendum is held. An English backlash against Labour cuts its popular support below the post-war low of 2010.

● Labour-Liberal Democrats – 10%

Okay: Labour falls short of a majority but, against the current poll trend, it boosts its vote by 7 May and wins 301 seats. The Liberal Democrats hold up on 25 seats, giving the combination a majority of 1. Plaid Cymru offers informal support, as do the Greens. The Liberal Democrats rein in Labour’s more statist leanings. There is less austerity, but extra meddling still saps growth potential. The government soldiers on for a couple of years, but finds it hard to get much business done with such a thin majority. No Brexit referendum is held.

● Labour-SNP-Liberal-Democrats – 9%

Very bad: The Liberal Democrats do not side with the Conservatives, but neither a Labour-Liberal Democrats combination nor a Labour-SNP one has a majority between them, so they all team up together. Government would be very unstable as small factions from the SNP and Liberal Democrats would wield a lot of power. They would not always be pulling in the same direction. As the price for that support, the Liberal Democrats dilute Labour’s statist urges and the SNP’s want-away independence agenda. There is less austerity. No Brexit referendum is held. A backlash against Labour and the Liberal Democrats boosts the Conservative vote to levels not seen for many years, delivering a stable government next time round.

● Labour-SNP-Liberal-Democrats-Greens –1%

Very bad: Labour is unlikely to be in a position where it has to look for a fourth coalition partner, but Mr Miliband may want the Greens to dilute the SNP and the Liberal Democrats. This group would be hard to keep together, given that they will be pulling in many different directions. There is less austerity, but chaotic government and economic policy saps growth potential.

Chaos followed by new elections – 5%

UKIP and the Greens do much better than expected, with the former gaining 20 seats and the latter five. The SNP takes all of the Labour and Liberal Democrat Scottish seats. Liberal Democrats crash to 10 seats while the Conservatives gain 290 seats to Labour’s 252. The Conservatives cannot form a coalition with a majority and neither can Labour. Labour, anyway, does not want to join with the SNP. A long period of negotiations over a coalition worries the markets. A grand coalition would obviously solve the problem, but is extremely unlikely. Both major parties would prefer to team up for the two-thirds majority required to call a second election under the Fixed Term Parliament Act.

Economics

12

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