The new Government is clearly in an almighty mess, but I’ll leave the political commentary to others. Here are some thoughts on the economics and the markets.
Let’s start by summarising what went wrong. The tipping point was the mini-Budget in September. The mistake here was not the Energy Price Guarantee, or the cancellation of the increases in National Insurance and Corporation Tax. After all, these measures had already been discounted. It was not even the absence of the usual OBR analysis. That omission was not a surprise, either.
Instead, investors were spooked by the unexpected announcements of the additional cuts in income taxes, and by Kwasi Kwarteng’s apparent doubling down on tax cuts on Sunday, despite the markets’ obvious and growing concerns about fiscal credibility.
It is just about conceivable that this storm could have passed. Many independent economic commentators initially welcomed the broad thrust of the package. For example, NIESR predicted it would shorten the recession and raise annual GDP growth to around 2% over 2023-24.
The CBI heralded “day one of a new UK growth approach”, including the commitments to more infrastructure projects, planning reform, and a “simpler, smarter approach to tax”. Even as doubts grew in the following days, the CBI noted that the Government’s target of 2.5% growth “has unlocked far greater thinking about our long-term productivity and competitiveness than we have seen in over a decade.”
In an alternative reality, Kwasi Kwarteng and his colleagues in other departments could then have spent the next few weeks rolling out an extensive programme of supply-side reforms, culminating in the publication of a credible medium-term fiscal plan, with the necessary OBR blessing, in November.
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Unfortunately, the adverse reaction in the markets gained a momentum of its own. This was partly just bad luck. The fall in the pound was compounded by the broad-based strength of the dollar, which made sterling’s slide look more dramatic than it really was. This week, for example, the Japanese yen has fallen to a 32-year low against the US currency.
At the same time, the rise in gilt yields was exacerbated by the increased use of leveraged liability-driven investment (LDI) funds, in which many ‘defined benefit’ pension schemes invest. As the Bank of England has explained, “this led to a vicious spiral of collateral calls and forced gilt sales that risked leading to further market dysfunction, creating a material risk to UK financial stability”.
Even this could probably have been manageable. But the turmoil in the mortgage market also dominated the headlines. As it happens, mortgage rates would have jumped anyway as UK and global interest rates returned to more sustainable levels. Indeed, mortgage rates have also surged in the US. However, by now the Government had lost any control of the narrative.
The final nail in the coffin was the widespread belief that large cuts in public spending would now be needed to balance the books. The IFS suggested that annual savings of £62 billion would be required by 2026-27. Again, this was hardly challenged. Indeed, the Government’s reluctance to confirm that non-pensioner benefits would be uprated in line with inflation only fed this narrative.
So, what next? The Prime Minister has decided to sack her Chancellor and to backtrack further on tax cuts in an attempt to reassure the markets. The main rate of Corporation Tax will now rise from 19% to 25% in April 2023, as previously planned by Rishi Sunak.
This has perhaps bought some time. But it is doubtful that this will be enough in the face of an overwhelmingly hostile media and opposition from within the Conservative Party itself.
But looking just at the economics, there is a way out that could keep the project on track. In the past few days the focus has understandably been on the volatility in the yields in longer-dated gilts. However, it is shorter-dated yields – and swap rates – that matter most for the economy and the mortgage market.
Currently the Bank of England is expected to hike interest rates to somewhere between 5% and 6% over the next year or so. Getting these expectations down to (say) 4% would help enormously…
A number of factors could contribute here, including better news on global inflation, a less hawkish US Fed, and a further recovery in the pound. But this also increases the importance of the fiscal statement on 31 October, which is just before the next meeting of the Bank of England’s Monetary Policy Committee.
Jeremy Hunt will now have the unenviable task of preparing and delivering this statement. The key of course will be to present a credible medium-term fiscal plan to get debt down as a share of GDP, without cutting spending or backtracking further on tax cuts.
This is not an impossible task. Even the IFS has acknowledged that boosting annual growth by 0.75 percentage points (pp) would be sufficient to stabilise debt (see page 32 of their recent report). The IFS is sceptical that this can be achieved. I’m more optimistic.
The UK economy has struggled with low growth since the global financial crisis. But the flipside is that there is plenty of scope for catch up if the “productivity puzzle” can be solved. Recall that annual productivity growth (output per hour worked) averaged less than 0.5% in the decade or so since the crisis, compared to around 2% in the decade before. Closing just half that gap would therefore deliver the required 0.75pp of growth.
The difficulty will be persuading the OBR that this is achievable. Perhaps the best the new Chancellor can do is suggest that the OBR includes an ‘upside scenario’ for growth that squares the circle, alongside what is likely to be a more pessimistic ‘central scenario’.
This approach may seem like a fudge, but it would at least provide some clarity on where the risks and differences lie, and would be reasonable given all the uncertainties involved. Frankly, it is ridiculous to say with any confidence that there will be a “black hole” of £X billion in five years’ time, let alone that policy should be adjusted now on the basis of such a forecast.
As for the reinstatement of the hike in corporation tax, this is clearly disappointing. The empirical literature on the negative impact of higher corporate taxes on economic growth is ambiguous. But the theory is sound, and common sense says that it is a bad idea to raise any taxes when a recession is looming.
The latest U-turn also adds to a growing list, including the abolition of the 45% upper rate of income tax. This will embolden opponents of the supply-side reforms needed to boost growth. Many of these, such as planning reform, are extremely controversial. It may be even harder for a “lame duck” Prime Minister to push them through.
In short, “Trussonomics” can survive. But this would require far better political judgement, market intelligence, and plain luck, than the new Government has had so far.
Julian Jessop is an independent economist and Fellow at the Institute of Economic Affairs. This article first appeared on his blog.