The single biggest mistake of the Thatcher era was the 1981 budget, delivered by the then-chancellor Geoffrey Howe. Inflation at the time was around 15 per cent. In combination with the monetarist central banking that was fashionable at the time, it threw the economy into a steep recession, and almost cost Thatcher re-election two years later. 

It was the second-worst fiscal policy error of our lifetimes. The worst was the austerity imposed in the euro area during the sovereign debt crisis. The euro area is still suffering from this episode today. Thatcher’s UK recovered faster because it was accompanied by structural reforms that raised potential growth during the 1980s. The macro regime also became much more stable.

The UK is now repeating Thatcher’s mistake on a grander scale, but without the reforms. What can possibly go wrong? We will not get all the details of the 2023 budget until the release of the autumn statement on 17 November, 10 days from now. But the frightening contours of the Sunak government’s fiscal policies are now emerging. Liz Truss bet on a massive fiscal expansion. Her successor is betting on massive fiscal contraction. Both are wrong. 

Macroeconomics has regressed in the last 30 years, a decline that is mirror-imaged by the quality of macroeconomic policy, with its return to 1970s boom-and-bust cycles. We criticised Rishi Sunak’s fiscal support schemes during the pandemic as excessive. The austerity he is now ordering is just as excessive. It is interesting that the fiscal policy debate in the UK is reduced to extremes: those of Kwasi Kwarteng and Jeremy Hunt. The big spender versus the accountant. 

One of the great advances of late 20th century economic policy was the adoption of medium-term fiscal targets. It all went wrong with the global financial crisis, which set a death spiral in motion. We went from Whatever It Takes to Nothing Goes. In fiscal policy, and monetary policy at the same time.

In the UK, the government is currently scrambling to meet a self-imposed target of £50bn in savings, possibly with a 50-50 share of higher taxes and lower spending. This compares with George Osborne‘s 20-80 version of austerity. What we already know is that corporation tax will go up from 19 per cent to 25 per cent. The UK will keep personal allowances and tax thresholds at existing nominal levels, and not adjust for inflation. This constitutes a stealth tax, a phenomenon also described as fiscal drag. These are pro-cyclical tax increases that will kick in just when the economy is sliding into recession.

A measure we would approve of is to end the inflationary triple lock on pensions. Under the triple lock, pensions rise by either 2.5 per cent, average earnings, or inflation, whichever is the highest. Inflation is the highest by far right now. If the triple lock were applied, pensions and benefits would rise by over 10 per cent, which in itself would contribute to future inflation. The sensible thing is to use average earnings as the threshold. Just as it would be sensible to protect the poorest households against energy price rises, rather than the entire population. 

We think 10 per cent income rises are too high, but 2 per cent is too low. We hear that one of the savings measures would be to curtail public sector wage rises to 2 per cent. Again, we think the average earning rise of 5 per cent would have been a much better benchmark. What is happening here is an example of yo-yo fiscal policy. 

What we think will happen is that austerity combined with inevitable monetary tightening, but without structural reforms, will be self-reinforcing. It will lower economic growth, and will lead to more austerity. The right policy would have been to start with the structural reforms proposed by Truss, supported by a fiscal policy that straddles the extremes. 

One of the enduring lessons of the 1970s is that recessions don’t cure inflation. This is also the mistaken assumption in current central bank economic models, which are hard-wired to forecast inflation to return to the target. When faced with an aggregate supply shock, policymakers can, of course, reduce aggregate demand to bring the two in line, but that approach risks another supply shock. This is what happened in the UK in the early 1980s. An additional factor in the UK is the government‘s priority to curtail legal immigration even further by raising minimum salary thresholds. This drives up costs in the all-important services sector.

It would have been far better to bring aggregate demand and supply in line over a period of time – say three years – through structural reforms to raise output, like a rise in legal immigration, deregulation of rules inherited from the EU that were designed specifically for the single market, and a liberalisation of land use to build more homes. Fiscal policy should revert to medium-term targets, but continue to act in an anti-cyclical manner, based on automatic stabilisers as opposed to discretionary measures. In this situation monetary policy would still have to do the heavy lifting, as it did in the early 1980s, but at least fiscal policy would maintain a stabilising function. 

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