Osborne aka Brown

George Osborne spent much of his early years in Parliament studying Gordon Brown.  The Autumn Spending Review bears many Brownian hallmarks.

First ensure expectations are set low; off-the-record media briefings about the savage cuts that would be required from many departments meant that cuts to the non-protected departments were expected to be about 27% over the life of the Parliament with even the police having to suffer.

Second, use optimistic expectations for the end of the period when, you desperately hope, you will no longer be Chancellor but will be Prime Minister and not seen as responsible for failing to deliver.  In this Osborne has been handed a huge bonus from the Office of Budget Responsibility (OBR) who have, since the summer budget, found him an extra £27bn, based on higher expected tax receipts even though economic growth is not expected to be any greater and lower interest rates on government debt, on the assumption that the BoE keeps rates lower for longer. These assumptions could turn out to be wrong, particularly as they were made before the recent very disappointing public finance data for September which showed much weaker tax revenue than expected.

Third, find several ways to extract more tax from the economy without it creating negative headlines. Parliament has only recently passed legislation preventing the government from raising Income Tax, National Insurance and VAT. There are at least 3 tax increases in this Review. First, the 2% precept that local authorities will be able to charge on top of Council Tax to pay for social care.  The costs of social care are the responsibility of local authorities and the introduction and proposed increases in the National Living Wage mean that these will be a major problem for local authorities, in addition to the rising demand for such services from an ageing population.  Local authorities, rather than the government will take the political flak for this tax increase. Second, there will be a 0.5% Apprenticeship Levy applied to employers payrolls where these exceed £3million, so only the larger companies will pay. Third the increase in stamp duty for second homes and buy-to-let-investors will target those who are clearly well-off.

Finally, in your speech to Parliament, deliver lots of positive surprises to the low expectations you have set so that the news media will appear to be reporting a triumph.  In particular the total withdrawal of the plans to taper tax credits and an increase in spending on the police

This was an Autumn Spending Review that Ed Balls would not have been too unhappy to have given, had he been the Chancellor, albeit he would have run slightly higher deficits one suspects.  If he had it would have been labelled as a ”Tax and Spend” Review – both revenues and spending are about £30bn higher than was expected at the time of the Summer Budget.

There is little impact on UK economic growth and inflation forecasts from the Review, so bond yields and the pound should be little affected.  For some companies with significant labour costs though the Apprenticeship Levy, if the costs cannot be recouped through other cost controls, could be damaging to profits.

As for George Osborne, he will he hoping, in  much the same way that Gordon Brown did that the OBR’s assumptions prove correct, the economy continues to grow, the budget deficit continues to fall, and that he becomes Prime Minister before the next recession appears.

Time for Mitt to take the gloves off

The US Presidential election is between two candidates, one of whom believes that it is not worth worrying about the 47% of voters who do not earn enough to pay income tax, and the other who tells small businessmen that it was the government that enabled their business to be successful. Such a clear ideological difference should mean that the result matters greatly to Wall Street and financial markets.

Yet, 2012 has seen little impact on markets from US politics – the headlines this year have been about the Eurozone debt crisis, the Federal Reserve’s policy and the Chinese economy. The election should be close given the poor performance of the US economy (though not its stock market) under Obama, but the lack of strong Republican candidates has left them with the rather uncharismatic Romney as their best choice. His gaffes in recent weeks leave him currently trailing Obama in most of the key swing states as the contest enters the final straight.

There are three election debates to come, which could turn things around, but it seems unlikely that the experienced and eloquent Obama would lose out so badly to the more formal Romney in head-to-head debate.  A Romney win from here would be a big surprise but would in all likelihood also come with Republican majorities in both Congress and the Senate This is typically a combination that Wall Street would cheer. However an Obama win would be combined with a continued Republican majority in Congress and the only question for markets would be what happens to the Senate. Currently the Democrats have a 51-47 majority with 2 Independents – with 33 Senate seats being contested in November. Of those 7 (6 of which are currently held by Democrats) are believed to be races that are too close to call.

This all matters because of the “fiscal cliff”. This is (i) a number of previously agreed tax cut measures which expire on December 31, and (ii) the penalty clause US politicians set for themselves if they were unable to agree on long term measures to reduce the budget deficit, which make roughly equal cuts in defence and welfare spending. The idea of the penalty clause was that each side would be forced to make compromises on a longer term deal in an attempt to avoid large cuts in the area that most concerned them (defence for the Republicans and welfare for the Democrats) – sadly it didn’t work. The combination of all these measures would be to tighten fiscal policy by about 4% of GDP in 2013 and would send the US economy into recession.

No one seriously believes that such a massive tightening of policy would be allowed to happen, but to avoid it , the “lame-duck” sessions that occur from the election until Christmas with the old membership of both Congress and Senate, will have to agree to some compromises. It is perhaps understandable that, before the elections, neither side were prepared to make any compromises, but the hostility shown by many in the Republican Party towards Obama since he became President has taken the working relationship in Washington between the two parties to a very low ebb. It is not clear that this would change if Obama were to be re-elected and still faced a hostile Republican party in the two Houses. It is possible that an angry and upset Republican Party would not make any compromises and let the US economy fall into recession.

Markets are currently pricing in an Obama victory, and then some sort of compromise over the fiscal cliff that doesn’t drive the US economy into recession. A Republican victory would lead to a rally on Wall Street, but a bad-tempered defeat for them where emotions ran high would be a very negative development for America and the world.

Coming soon – a real electoral debate about the US fiscal deficit and a weak 2013

Recent general election campaigns in fiscally-challenged countries such as the UK, Spain and France have been noticeable for their politicians’ reluctance to spell out specific measures that they would introduce to bring down the enormous fiscal deficits in these countries. The electoral success of the right-of-centre parties in the UK and Spain was however immediately followed by significant programmes of cutbacks to government spending as well as some tax increases.

It is now clear that the US Presidential election will be between Obama and Romney (who would have believed five years ago that a US election would be between an African-American and a Mormon). With Obama having presided over trillion dollar deficits throughout his term in office, how best to manage these deficits and the ensuing government debt will be the key battleground of the election campaign. The two candidates will argue from the two opposing economic and political traditions. Obama, the Keynesian, a believer in public spending acting as a stimulus to the economy to offset private sector deleveraging against Romney, the orthodox conservative, a believer in small government and balanced budgets. Obama wants to tax the richest 1% more and maintain government benefits to the poorest in society whilst Romney wishes to cut taxes, particularly for the wealth-creators, and cut all areas of government spending except for defence (in practice this means welfare  and health spending). It is only in America that Obama’s tax plans for the top 1% would be called “class warfare” and many would agree with that assessment.

Both men are highly intelligent, clear thinkers, who can produce very articulate presentations of their respective cases and let the American people then make an informed decision as to in which direction they want their country to go for the next four years. It could be democracy’s finest hour (or three months) although the history of recent elections tends to suggest that other rather more superficial issues will also get much attention.

The end of this year though is critical for US public finances, as both sides have put off all the difficult decisions regarding the budget until after the November election. If nothing changes between now and next January 1st then 2013 will see the expiry of the Bush tax cuts, which heavily benefit those whose income is high and generated from corporate dividends, and the Obama payroll tax cuts which benefit those in work. In addition, spending cuts affecting both defence and welfare in roughly equal measure are due to come into effect. If all these measures are allowed to come into being at one time the aggregate effect is likely to be to drive the US economy straight into recession. However no one expects all these measures actually to occur though – if Obama wins he will seek to reduce the welfare cuts and extend the payroll tax cuts and if Romney wins her will seek to reduce the defence cuts and extend the Bush tax cuts.

Financial markets do not appear to have these measures in focus just yet, or be paying attention to the fact that whoever wins there will be significant fiscal consolidation in 2013. They should be because Europe’s recent history demonstrates clearly that this consolidation, also known as austerity, necessarily involves reducing people’s disposable incomes, either because taxes are rising or because government spending is falling, and that this has to have an initial, deflationary effect on private sector demand. 2013 is very likely to be a pretty bad year for the US (and thus probably also for the world) economy. Markets tend to look 6 to 9 months ahead, so the next few weeks should see them begin to discount this weakness – this should be good for government bonds but less good for equities.