Next Chancellor faces a Herculean task

Whoever becomes Chancellor after our new Prime Minister – likely Liz Truss – is announced on September 5, will have to get to work immediately.

Truss has promised an emergency budget. 

The top priority will be to deal with the inflationary and cost of living impacts of the rise in gas prices that will be announced for October.

And the economy is likely to go into recession. This may not be avoidable but the new Chancellor will want to ensure that it is as short as possible and will want to minimise the pain it causes.

Beyond that, the new Chancellor will have to get to grips with a series of problems. 

He or she will have to reconcile pressure to reduce a rising tax burden with bringing the fiscal deficit under control. 

There will be a need to improve incentives to work while at the same time protecting the poorest in society. 

The greening of the economy is likely still to be a priority while at the same time the Chancellor will want to avoid this creating inflationary cost increases. 

Meanwhile many parts of the public sector are claiming funding shortfalls while at the same time public sector costs are rising. 

And the UK’s perennial problems of balance of payments deficit and weak productivity seem to have been enhanced by the aftermath of the pandemic. 

The reorientation of UK trade promised by Brexit is also only just starting to make progress.

There is a major need to make the UK more productive and more competitive.

Then there are structural questions like the independence and mandate of the Bank of England and whether the Treasury itself should be broken up.

Where to start?

The initial priority must be inflation and the cost of living. The Treasury will have prepared some options, many of them likely to be unpalatable to Truss. Though the effect of higher than expected inflation combined with fiscal drag gives some headroom – possibly as much as £60 billion by 2024/25, though again the Treasury is likely to downplay the scope.

My advice would be to assume a lot more headroom than the Treasury/OBR is suggesting. They will of course retort that this will risk higher interest rates. But these are coming anyway – we are likely to see interest rate policy increasingly determined by the need to defend sterling against the impact of a highly hawkish Federal Reserve Bank. A bigger deficit may have some impact on interest rates but it is quite likely that it will be marginal.

This would leave scope for raising benefits by current rather than retrospective inflation. They were raised in April by the Consumer Price Index (CPI) rise for September 2021, 3.1%, and would be likely to be uprated again next April by the September 2022 CPI which is likely to be around 10%. But the higher gas prices will hit in October and it would make sense to carry out the April uprating 6 months early. Benefits are currently running at £80 billion so a 10% rise would cost £4 billion for 6 months. Moving up pensions in line as well would cost a further £2.5 billion for 6 months.

Truss has promised to reverse the national insurance increase and the corporation tax increases announced by Sunak when he was Chancellor. Expect Treasury pushback on this. Combined these are predicted to raise over £30 billion per annum by the mid 2020s when the adjustments reach fruition. These estimates are probably on the high side, particularly when the likely tax losses if companies restructure or move abroad in the face of higher taxes are fully taken into account.

Because the costs of the early uprating of benefits are temporary, there is perhaps £20-30 billion further scope for additional measures besides the reversal of the NIC and corporation tax hikes if we assume £60 billion of headroom by 2024/25.

 A 2.5% permanent reduction in the VAT rate would in the short term (and even the long term according to many models) bring inflation down by over 1% and delivering an equivalent boost to living standards. But it would cost £20 billions and use up much of the headroom.

Reversing the failure to index tax allowances and thresholds could cost as much as £40 billion, depending on how retrospective this is. But if indexation started from the next budget the cost would be much smaller, perhaps no more than £10-15 billion.

Although these tax cuts would eventually affect the economy and could have a significant impact on inward investment, they are unlikely to make a major boost to the supply side of the economy in the near future. Most worthwhile supply side improvements affect the economy only gradually – indeed it took until the late 1990s before many of the Thatcherite reforms from the early 1980s really started to bear fruit.

If the government is going to be relatively generous by inflation proofing benefits, it can probably be a bit tougher on the other side of the coin, making the provision of universal credit more dependent on willingness to work. Up to a million workers seem to have disappeared from the workforce (as I predicted in Reaction Life as early as May 2020). The cost of living will force some of them back to work but the government should also reintroduce the sanctions previously linked with universal credit now that there are jobs available again.

Once the emergency budget is out of the way, the new Chancellor and Prime Minister can look at more structural issues like the Bank of England mandate and the structural reform of the Treasury. 

The Bank of England has had a chequered track record in recent years, both in forecasting and decision making. Yet few economists think that politicians would be better at interest rate and other monetary decisions, particularly if they are heavily reliant on Treasury officials who also failed to predict the recent inflation. A change of mandate to targeting nominal GDP could make sense but much more important is to force both Whitehall and the Bank to take into account the diversity of views available from the private sector when both forecasting and making policy. Obviously I am talking my own book but the UK has one of the largest and liveliest private economics consultancy sectors in the world, generally consisting of economists who are just as skilled as and much more on the ball than those in Whitehall.  

One of the biggest weakness of economic policy making in the UK has been the failure to draw on these private sector skills and over-reliance purely on those with a public sector or academic history. The problem is enhanced by the UK private sector’s ability to attract those whom we think are more able and rounded economists away from those sectors. These bright people are a resource which has been ignored for far too long.

In addition, economists with a greater belief in the impact of monetary policy than is the current academic and Whitehall consensus need to be appointed to the Monetary Policy Committee. Monetarism isn’t a panacea but the absence of attention paid to its recommendations looks to be a key factor in recent policy failures.

Should the Treasury be broken up? This has been tried before by Harold Wilson’s government in 1964 which set up a separate Department of Economic Affairs (DEA). For the first ten years of my working career I was effectively the apprentice to (and eventually successor to as Chief Economic Adviser of the CBI) Sir Donald MacDougall, who had been the Director of this Department. 

Sir Donald’s take on why the previous attempt to break the Treasury up failed was that it was due to the failure to devalue in 1964, thus subjecting the UK to a series of balance of payments crises where the short term priority of keeping the pound’s value up reinforced the Treasury’s continuing primacy.

Meanwhile the DEA’s energies were subsumed into preparing a voluminous ‘National Plan’ ( not so voluminous that the late Sir Samuel Brittan could avoid being blamed for allegedly having lost it, though Sir Samuel claimed it had merely been left behind some files!). This plan, assuming 4% growth and sharply rising productivity, seemed to be based on the idea that if employers and employees could talk together, barriers to improved investment and better utilisation of labour would miraculously disappear.

With the pound floating and trade union power in the private sector much diminished, would now be a time to break up the Treasury again? The answer depends on whether a clear role for the new DEA can be established. Many of those who want such a body believe that the key reforms that could drive higher productivity in the UK require decisions from government. On the other hand, the UK’s most successful tech sector is the so-called Flat White Economy which I identified, now well over 10% of GDP, which allegedly flourished because of lack of involvement from government. The lack of success of Rishi Sunak’s Future Fund does not bode well for the government in trying to pick winners. One wag once described a government’s industrial policy as “more losers picking governments than governments picking winners”.

But in the modern world, the government and the private sector are again being drawn into greater interdependence. Transport policy, environmental policy, levelling up policy and energy policy need to be integrated with the post Brexit need to make the economy more competitive. Until now policies in most of these areas have been developed with little economic input and little assessment of the likely economic costs. If a clear role for a new department covering economic affairs could be defined, then there is a good chance that it could succeed in a world very different from Sir Donald’s 1960s. Provided it has clearly defined responsibilities. Probably it will do its best work in stopping and potentially rolling back uncosted and badly thought out proposals from other government departments, though to do this it will have to have the authority to override badly thought out legislation, especially on transport and the environment.

With an election due within not much more than two years, the new Prime Minister and Chancellor will only get early tasters of the results of any economic changes they make. And in such a short period, luck will play a major role in determining whether they appear to be successful. On one scenario, the recent falls in shipping costs, food prices and oil prices will feed through to make the economy look much less unhealthy next year. Combined with a helpful budget, by next year the worst could be over. On the other hand, the Ukraine war is precariously poised; Chinese troops are undergoing training near Taiwan and the Middle East again risks boiling over. All these could worsen the scenario, just when the ammunition box had already been raided.

So whoever is the next Chancellor will have to hope that he or she is one of Napoleon’s ‘lucky generals’.

Douglas McWilliams is Founder and Deputy Chairman of Cebr.