Did the dreadful
budget of 24th September create a crisis? It all
depends on how you define a crisis, of course, but some of the
commentary which focused on sterling was looking in the wrong place.
It was interesting that sterling depreciated, but it only looked like
a crisis if you mixed up dollar strength with that depreciation. Here
is what happened to the Sterling Euro rate.
There was a
significant depreciation around the budget, for sure, but of a
similar magnitude to what happened at the end of August or the
beginning of May.
What was far more
dramatic was the rise in yields on UK government debt. On the 22nd of
September, the day before the ‘fiscal event’ was announced, the
interest rate on 5 year government bonds was 3.4%. By the 28th it had
risen to 4.7%, at which point the Bank of England stepped in to buy
government debt because the market was ‘disorderly’, which in
this case meant some pension funds were getting into serious
difficulties. [1] That is a dramatic move, and would come under most
people’s definition of a small crisis.
The combination of
falls in sterling and higher interest rates on government debt tells
us that the UK government’s budget seriously damaged the
government’s credibility. A fiscal stimulus would normally imply
higher short term interest rates when the central bank is trying to
control inflation, which would in turn imply higher interest rates on
government debt but also an appreciation in sterling (anticipating
the central bank setting higher rates). The fact that sterling
depreciated tells
us that the biggest impact of the budget was to
increase the risk premium associated with this UK government, or
“doomsday
cult” as one City economist called it.
The ‘starve the
beast’ strategy is to cut taxes today, and then wait for the
deficit to increase. A year or two later that strategy involves
saying we have to do something about the deficit, so let’s cut
government spending. For the strategy to work in political terms (in
the UK at least) you need that gap between cutting taxes and cutting
spending so that the media and voters do not link the two actions.
(In the UK, cutting taxes to cut spending is pretty
unpopular, but to cut spending to cut taxes on the
rich is very unpopular, which is why the idea of cutting the top rate of income tax has been abandoned.)
If the government’s
strategy was to ‘starve the beast’, or (incredibly) wait until
rapid growth generated by tax cuts made spending cuts unnecessary,
the market reaction to the tax cutting part has blown that out of the
water. The government will now have to be explicit about ‘where the
money is coming from’ in November, when the OBR will publish. (Abandoning cuts to the top rate of tax has little impact on the size of the overall package of lower taxes.) The
problem the government has is that the negative market reaction was
not just about the unfunded part of tax cuts (and not wanting the OBR
to quantify the medium term funding gap), but also any guess the
markets made about paying for the tax cuts looked very damaging for
the economy. Looking at all the problems facing the UK economy, how
much public
services have been cut since 2010 and noting that
inflation itself is producing a squeeze anyway, I wrote here
that “tax cuts are an abomination”, and it looks like markets
agreed.
This market reaction
has made the government’s predicament [2], and more importantly
that of the UK economy, worse for a number of reasons. First, the OBR
forecast will now have to integrate higher borrowing costs into its
forecasts, creating a bigger medium term gap for the government to
fill. Second, using November to just pencil in large spending cuts
starting after the election (replicating in economic if not political
terms the starve the beast strategy) is a can kicking exercise that
rather reinforces the market view that the smaller state policy is
currently toxic.
Third, any hopes
that the government might be open to compromise when it comes to
public sector pay now look remote, and so the government will be
trying to impose much larger real wage cuts on the public sector than
are happening in the private sector. (Nurses will no doubt respond to
government claims that any strike is irresponsible by asking why they
think tax breaks for the well off are more important than paying them
a living wage.) Big wage cuts will in itself reduce demand, but it
will also lead to strikes across the public sector which will also be
damaging. If we get another
Covid wave this autumn/winter, the government will not
provide the resources required to stop waiting times increasing still
further, which among other things will reduce growth.
Fourth, the Bank of
England will feel pressure to raise rates by more than they might
otherwise have done to show that their gilt buying after Friday’s
budget was not the monetary financing of tax cuts. The Bank was
always going to try and neutralise any short run fiscal stimulus in
the budget (although arguably
they had already anticipated some energy support), but the fear now
must be that they go further than that.
For all these
reasons and more [3], a short term economic outlook for the UK that
already looked grim just got significantly worse. At the best of
times spending cuts matched by tax cuts are likely to reduce demand
and output, because some of the tax cuts will be saved. However when
the tax cuts benefit the better off, and may be reversed after a
general election, the negative effect on the economy will be that
much bigger because more of the tax cuts will be saved. This remains
true if a large part of any spending cuts involve
reduced welfare payments. The net result will no longer be a tug of
war between fiscal and monetary policy, but instead both will be
pulling the economy down. [4]
As I have pointed
out many times, macro forecasting is a mugs game: the world is so
unpredictable that unconditional
forecasts are only ever right through luck. However what we can say
is that the chances of a UK recession, which were already quite high,
just got significantly higher, and the chances of a deep recession
also increased. This is for an economy that is the only
one of the G7 not to have regained pre-pandemic output
levels. This will be the third time in the last twelve
years that the UK government has made a recession much more painful
than it needed to be, with austerity and failing to lockdown quickly
during the pandemic being the other two.
How can a government
keep doing so much damage? The answer for the recent budget is not
difficult to find, but it all ultimately comes back to Brexit. First,
as I have often stressed, Brexit was an excellent sorting device.
Those politicians who followed the evidence lost out, and those that
ignored evidence got into power. (As the pandemic showed, if you
ignore the evidence on what determines international trade you are
also likely to ignore evidence on how to best deal with a new virus.)
The evidence
that tax cuts for the well off certainly don’t increase growth, and
might well reduce it, was never going to matter much to this
government run by Brexiters.
Policy made by
Brexiters was therefore always going to be fantasy-based policy. This
is how to understand the government’s attack on ‘economic
orthodoxy’. The orthodoxy they attacked with Brexit were two very
robust empirical relationships: international trade’s gravity
equation that says you trade most with your nearest neighbours, and additional
bureaucracy in trading adds to costs and so inhibits trade. Equally the
idea that cutting taxes on the rich reduces growth is not based on
some arcane economic theory but instead comes from the data. For
‘orthodoxy’ read ‘evidence’. In addition the idea that since
2010 governments have been putting up taxes on the wealthy and on
firms will come as news to George Osborne who did the opposite, and
the UK’s economic decline started with or just before Chancellor
Osborne.
But what determines
the fantasy they push? What helped get us Brexit and what has had a
major influence on policy ever since has been very rich party donors
or newspapers
owned by the very rich. The Mail cried “At last. A True Tory
Budget” as the markets gave their emphatic thumbs down. What rich
donors want from their political party are lucrative contracts (see
the pandemic again) and tax cuts. The one major policy that Trump and
a Republican Congress got done was tax cuts focused on the rich, and
so it is hardly a surprise that a UK plutocracy would do the same.
Truss/Kwarteng may well actually believe that cutting taxes for the
rich is the key to unlocking growth, but they are where they are
because they believe it.
Which brings us to
the second reason why Brexit is the ultimate cause of the current
debacle, which is that the ERG section of Tory MPs got Truss into the
leadership run-off because she
seemed closest to being a Brexit fanatic. (Converts
often are the most devout.) She won that run-off because she said
warnings from Sunak about the dangers of cutting taxes immediately
were project fear, and that’s what the well off Brexit supporting
Conservative party members wanted to hear.
But Johnson too was
a convert to Brexit, so why is Truss so much worse. The warning signs
should have been clear when Truss said she didn’t mind being
unpopular if she was doing (in her mind) the right thing. Truss’s
combination of right wing economics and socially liberal
(libertarian) beliefs are shared by only a small
section of the population, and previous Conservative
leaders including Johnson understood that. Whatever their personal
views they had to act as social conservatives and not make right wing
economics their main story. Indeed Johnson started by saying
austerity was over and increased
some areas of public spending. In short, whatever
their own views, previous Conservative leaders knew that they had to
compromise to win elections.
In contrast Truss
failed to adjust from trying to please one electorate (Conservative
party members) to trying to please the wider electorate. [5] That was
something Johnson could do easily because his only strong opinion was
his own self-worth. In contrast Truss seems not only to believe the
nonsense she is fed by right wing think tanks, but seems willing to
pursue these very unpopular ideas in the belief that she will be
vindicated in the long run. The market reaction to her Chancellor’s
budget told her she will not be vindicated, and what the polls are
reminding her is that she doesn’t have a long run. Unfortunately
the UK economy will also pay the price of her mistake.
[1] The
Bank was not buying government debt to ease monetary policy, but
buying government debt the pension funds needed to sell. It was a
classic ‘lender of last resort’ action, providing liquidity to
otherwise solvent institutions. Ironically higher interest rates on
government debt make pension funds more solvent rather than less in
the long term, but their financial
engineering
proved dangerously unrobust to large market moves. Frances Coppola
argues
here
that the Bank’s real concern was not pension funds but banks. On how pensions funds evolved over the last thirty years see here.
[2]
The political problems for the government are obvious and have been
discussed at length elsewhere. Cutting spending and taxes together is
very
unpopular
outside parts of the commentariat, but cutting services that are
already on their knees to fund tax cuts for the very rich is a
political disaster. Higher interest rates, leading to lower house
prices, are also a vote loser.
[3]
The sterling depreciation increases import prices and inflation,
adding to interest rate pressure. Normally that might be offset by
higher exports, but after Brexit our export sector looks much weaker.
Higher long term interest rates will also add additional deflationary
pressure on firms.
[4]
Kicking the can down the road on spending cuts would be best for the
economy, if we assume a change in government after the election. Is
it possible to cut spending without hitting the economy? They could
scrap overseas aid, but that is too small on its own. Cutting defence
procurement if those cuts meant not purchasing goods made overseas works, but
this government is committed to increase defence spending. I cannot
think of anything else. The easiest
thing
for the Chancellor to do is cut public investment, but that would
also be the cut that would hurt growth the most, as Osborne found out
in 2011/2.
[5]
Many have made comparisons between the election of Truss and Corbyn:
in both cases, it’s suggested, party members chose a leader that
matched their views rather than those of the electorate. However the
analogy ignores the 2017 election, when the combination of many
social liberals accepting the referendum result and a left wing
economic programme gained large support. As the diagram in this
FT article
makes clear, there is widespread support for left wing economic
ideas, and almost none for those Truss is championing.
