Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 24 September 2022

A budget that harms everyone except the very rich


Before getting distracted by the spin put on Friday’s budget, it is important to be clear what the motivation for it is. It’s not a budget for growth, it’s a budget for the rich and those who fund the Conservative party. Abolishing the 45% tax band obviously benefits only the very well off, dropping the increase in corporation tax will mainly benefit shareholders who are mostly at the top of the income distribution, not extending the windfall tax on energy producers will exclusively benefit shareholders, not increasing NI rates benefit the better off far more than anyone else, ending the cap on bankers bonuses benefits the already very rich, and so on. Conservative MPs are much more right wing on economics than Conservative voters or even party members, and this is a budget for them, as long as it doesn’t mean they lose their jobs.

The Resolution Foundation calculates that almost two thirds of the tax gains go to the richest fifth of the population, with almost half going to the top 5%. They also point out that the stamp duty changes mainly benefit richer households in the South East. Of course poorer households will get a small amount of this giveaway, but less than is needed to cover the increased costs of essentials according to NEF. The IFS have looked at all the forthcoming tax changes (including frozen income tax allowances), and they calculate that your income would have to exceed £155,000 before you are better off, and if you earn a million a year you gain £40,000

It is also a budget that is highly likely to mean cuts in public spending after the next election. The OBR were not allowed to publish their post-budget forecast, for the first time in their 12 year existence, because if they had been their budget deficit projections would have shouted ‘not sustainable’. Not sustainable is just a shorthand way of saying that taxes will have to rise or spending will have to be cut, unless something very beneficial for the public finances turns up. But of course it’s equally likely that something detrimental to the public finances will turn up. You don’t get to announce the biggest tax cut for 50 years in a deteriorating economic climate without severe implications for future spending.

Here are the Resolution Foundation’s assessment of the deficit and debt, and here is the assessment by the IFS. Both suggest deficits in the medium term that are unsustainable. The new Chancellor also committed himself to reducing government debt relative to GDP in the medium term, meaning that if these deficit projections turn out to be even roughly right he is going to have to raise taxes or cut spending.

It cannot be stressed often enough that cutting taxes and spending less is a very unpopular policy to pursue, unless you are a Conservative party member or a large part of the commentariat. This is from the latest British Social Attitudes survey.

Just 6% of the population want lower taxes and lower spending on health, education and welfare, while 52% want the opposite.

So to the spin. What the government would like you to think is that this is about fairness vs growth. These measures are very unfair, but they say they are designed to increase long run growth so everyone will be better off (just the rich will be a lot better off than the poor). The spin, like the deficit spin that these same politicians lectured us with for the last 12 years but have now abandoned, is a load of nonsense. There is no relationship between tax levels and prosperity. Worse still, as I outlined here, the evidence clearly suggests that increasing inequality at the top reduces growth. Either the government is blind to the evidence, or they have to pretend it’s all about growth as a cover for the true reason for tax breaks for the rich: their ideology and party donors.

If this government really wanted to increase growth it would make trade with the EU easier, but right now it is doing the opposite. It would be focusing only on encouraging the energy of the future, green energy, which is now much cheaper than gas, Instead they are encouraging fracking (and saying you shouldn’t worry about small earthquakes) and more investment in getting oil out of the North Sea. If this government really wanted to increase growth, it would be helping the NHS reduce the number of people not working because they are sick by training more nurses and doctors and paying them more. Instead tax cuts now mean that in the future the NHS, with its record waiting lists, will be even worse than it is now, if it has a future at all.

If you (erroneously) think the markets know more about growth than researchers who examine the evidence at the IMF, then they too think the government is doing nothing for growth. If the markets believed this budget would increase long run growth, sterling would appreciate. Instead the uncertainty created by an unfunded tax giveaway for the better off has led to the cost of government borrowing rising substantially both just before and following the budget, and sterling has fallen against the Euro. (The latter is particularly significant, as you would normally expect an unfunded tax giveaway to appreciate sterling because of expectations of higher interest rates.)

Some of the criticism of this budget is also missing the point. It's very unlikely we will see a repeat of the Barber boom of the 1970s for two reasons. First and most importantly because we now have an independent Bank of England. Instead what this budget ensures is higher interest rates. (Can there be much doubt that if it was Kwarteng rather than the Bank that decided interest rates, then a short term inflationary boom would be a bigger possibility.) But as I noted in my last post, offsetting a short term inflationary boom with higher interest rate is not a precise art, so there is a possibility that the government might get lucky with three or six months of 2.5% annualised growth (or more) before the next election. The second reason we will not get anything like a Barber boom is that most of the tax cuts are going to the better off who save most of their extra money.

What has to be added is what was absent from this budget giveaway. There was only the smallest additional help beyond the price cap for those struggling to make ends meet, and instead more use of sanctions for claimants, sanctions which the government’s own research says caused more harm than good so they refused to publish it. Alongside higher energy prices, we have sharply higher food prices which the government is ignoring. It is indicative of where this government’s priorities are that their first fiscal actions have focused on giving the most money not to those who need it most, but those who need it least.

Why was this a uniquely awful budget, that led to higher government borrowing costs and a falling currency. Tax cuts aimed at the wealthy at a time when many less wealthy are finding it hard to make ends meet is pretty bad, but it is not unique in recent times. George Osborne cut the top rate of tax in 2012 in the middle of a sustained period of austerity, and cut corporation tax too. Nor is justifying tax cuts aimed largely at the rich by pretending they will boost long term growth a new excuse. Trickle-down economics has been growing as part of Conservative DNA since Thatcher. The growing evidence that it doesn’t work and will probably reduce growth has little chance when set beside growing party donations from the very rich.

What made this budget stand out from any UK budget over the last 30 years was the absence of any attempt to match taxes to day to day spending over the medium term. I’m not talking about the deficit fetishism of Osborne, Hammond and Sunak: that had long passed its sell by date. However for the last thirty years Chancellors have attempted to put their decisions within some kind of overall fiscal framework. Kwarteng not only failed to do that, but he stopped the OBR making that clear. That matters not just because it raised borrowing costs and depreciated sterling, but because it almost certainly means, if this government remains in power, spending cuts on the horizon. Cuts in spending that will be far deeper than anything George Osborne did, because UK public service provision is already at rock bottom and in some cases close to collapse.

When the mainstream media and non-partisan think tanks talk about this budget being a big gamble, they are going as far as they feel they can in condemning it. What the country and the economy needs right now is reducing the record delays for standard NHS treatments, reducing appalling waiting times for ambulances and A&E, allowing schools to fill the gaps left by the pandemic rather than not replacing teachers to pay energy bills, and so on. An economy where the public sector no longer works is an economy that no longer works. What this budget showed is a Chancellor who not only doesn’t understand this, but intends to make it worse.

Tuesday 20 September 2022

Going for growth?


In my last post, I missed out one potential benefit from the switch in emphasis from the deficit to growth under Truss and Kwarteng. During the dark days of Osborne’s austerity, the idea that the ultimate goal of fiscal policy was to manage the deficit became firmly established in the media. This idea was always absurd, although I analyse the origin of this belief here. The primary aim of fiscal policy, along with economic policy more generally, should always be to increase social welfare. While it is up to politicians how they weigh the welfare of different parts of society, pretending the government’s deficit is a proxy for this welfare was always nonsense.

Economic growth is related to social welfare, but we should never forget that they are not the same thing. The most obvious example of that, which I will talk about below, is a demand led boom that leads to higher inflation. In addition aggregate growth figures ignore how income gains are distributed among different groups. Furthermore, additional growth achieved today at the cost of yet lower growth tomorrow is not worth having. An obvious example of this is extraction of oil or gas that would add to growth today, but because of global warming would reduce the social welfare of future generations.

Before discussing the merits of Truss/Kwarteng saying they are targeting growth, we should ask why they are doing this. After all, and with the caveats above in mind, all governments before 2010 tried to raise the growth rate in various ways, so this is hardly something new. So why are Truss/Kwarteng making a big deal of it?

Part of the answer comes from the first paragraph of this post. They want to signal a departure from policy that placed a high weight on deficit targets. But another reason is also important. As many have noted recently (see myself here in February), at some point after the Global Financial Crisis the UK economy went from being a success story in terms of growth relative to other G7 countries to being a failure. For a long time the government successfully (in terms of the mainstream media) hid this decline by talking about the deficit (see first paragraph again) and repeatedly pretending we had ‘strong economy’, but now the decline has become undeniable. In addition it is also clear that this decline has happened under Conservative (or Conservative led) governments.

The implication Truss/Kwarteng would like you to draw is that the Conservative governments of the recent past allowed this era of decline to happen because they didn’t prioritise growth, and this new Conservative government will be different because it is going to prioritise growth. While I think there is a lot of truth in the first part of that sentence, I see nothing to suggest the second part is true.

Take, for example, the two major policy mistakes that in my view played a large role in creating this recent era of UK decline. Austerity at the depth of the GFC recession both killed any chance of a normal recovery and probably also reduced the long run level of UK output, but implicitly Sunak had already acknowledged that mistake by not repeating it during the recession caused by the pandemic. In contrast the second major policy mistake, Brexit, continues and neither Kwarteng or Truss show any sign of acknowledging the negative impact of Brexit on growth.

So compared to the last 12 years of economic decline, this new administration is keeping one of the main reasons why it happened and is agreeing with the last government about not repeating the other. In addition, its big idea about how to raise growth, tax cuts including low corporation tax, had already been tried without success by Osborne during this period of UK economic decline.

Behind the unashamed promotion of fiscal measures that increase inequality (not just tax cuts but not imposing additional windfall taxes on energy producers and lifting the cap on bankers bonuses) is the idea that greater inequality encourages growth. The evidence suggests either no such association or the exact opposite. Here, for example, is a quote from one IMF study: “Thus the combined direct and indirect effects of redistribution - including the growth effects of the resulting lower inequality - are on average pro-growth.” More recently the IMF points to a robust result that higher inequality at the top of the income distribution reduces growth. There are many reasons why greater equality might promote growth.

Tax cuts aimed at the rich, therefore, are if anything a growth reducing measure, and almost certainly reduce social welfare. That is why removing the cap on bankers bonuses, or not imposing a windfall tax on energy companies, is more likely to reduce rather than increase growth. The idea that the last 12 years of economic decline under Conservative governments were because those governments prioritised redistribution over growth is nonsense, as Jonathan Portes shows. Once again, fiscal measures that favour the rich were tried by Osborne and it did nothing to stop, and may even have assisted, the last 12 years of UK economic decline.

Its other big idea is to reduce the ‘red tape’ that they believe is holding back UK business. First, we should note the huge increase in red tape for our exporters to the EU created by Brexit, which the current government intends to continue. Second, there is no general relationship between regulations and economic growth. For example, the government has ordered a review into anti-obesity measures. It is not obvious why these measures hold back economic growth, but it is clear that more obese people implies a greater burden on the NHS, requiring either higher taxes to fund it or a reduction in social welfare as other care is rationed. Or take the absence of regulations, since Brexit, to keep our beaches and rivers clean, which benefits monopolies and their shareholders but is likely to encourage imports and reduce exports (UK residents taking holidays to cleaner beaches overseas and less overseas tourists coming to the UK) implying less growth.

The idea that less regulation always increases growth, just like the idea that lower taxes always raise growth, is just right wing wishful thinking. However, like much right wing wishful thinking, there is a whole industry out there trying to manufacture evidence to support these ideas sponsored by those that benefit from such measures. It should be no surprise, therefore, that Conservative governments keep enacting measures that favour wealthy interests rather than favouring growth, when they are advised by newspapers and think tanks funded by those interests. It’s very important that we avoid right wing wishful thinking becoming received wisdom in the mainstream media, as the wisdom of austerity was allowed to do.

Where there is good evidence that fiscal measures can assist growth tend to be on the government spending side: investing in certain types of skill for example. Right now the UK appears to be suffering a negative labour supply shock caused by a rise in long term illness, due partly to Long Covid but also because of the growing waiting lists for other treatments in our overstretched and understaffed NHS. Improvements in these areas can be achieved from more public investment or targeted incentives for private investment (better ventilation for example) but they also require permanent increases in public spending and therefore higher, not lower, taxes.

An indication that nothing has really changed is empty gestures. Having a target for 2.5% growth is just nonsense for two reasons. First, it’s GDP per head that influences social welfare, not GDP, so the target is for the wrong thing! Second, setting a target does nothing to help you achieve higher growth. At best it is an attempt to pass off measures that are rightly unpopular, like removing the cap on bankers bonuses or not extending windfall taxes on energy producers, as necessary to achieve the growth target, but of course neither will have any positive impact on economic growth. Equal nonsense is removing the Treasury’s permanent secretary for no other reason than wanting to show things have changed. One empty gesture might be an accident, but two perhaps suggest there is in reality little substance to this proclaimed change in direction.

If a growth target makes no sense, and none of the measures advertised so far will help increase growth, how will this work politically? It is possible that Truss/Kwarteng may try to cut taxes and increase spending, producing a sufficiently big enough increase in effective demand such that output growth exceeds their target just before the next election, allowing them to proclaim their policies a success. Comparisons have been made with the Barber boom of the early 1970s, a boom that helped create the largest rise in inflation in UK post-war history.

Today, with an independent central bank, such a policy combination would create a rapid increase in UK interest rates. For this reason among others, manufacturing an unsustainable short term boom is likely to damage long term growth rather than improve it. However raising interest rates to counteract fiscal largesse is not a precise science, and it is possible that for a quarter or two annualised growth could exceed 2.5%. If it does, expect many proclamations of a new dawn from Conservative politicians and their press. But even if that does happen, and it may well not, it will be yet another deception. This decade or more of economic decline will not end by cutting taxes, deregulation, making exporting harder, and increasing inequality.

Tuesday 13 September 2022

How to judge fiscal policy in the time of Truss


As expected, Truss has announced a freeze in energy prices. That means that inflation will not be as high as some recent forecasts, the cut in living standards will not be as great as in the most recent Bank of England forecast, and so therefore the Bank’s prediction of a prolonged recession with plummeting inflation is less likely to come to pass. All good news, but what about the government’s deficit, particularly if she keeps her promise to cut various taxes?

This is the question that many journalists, and I suspect opposition politicians, are currently asking. Despite furlough, much of the media continues with the ‘government as household’,’how will you pay for it’ version of macroeconomics. Partly for this reason, the Labour oppositions since 2010 have felt obliged to ‘be responsible’ by ensuring key spending announcements are accompanied by equal revenue raising plans. Does this all now need to change?

I have always argued that it should change. (On why debt targets are a bad idea, see here and here.) The emphasis given to the government deficit in the media is totally inappropriate, and can at times be extremely dangerous (as we saw after the Global Financial Crisis). However it is also true that the media takes very little notice of academic economics, and much more notice of what a government (particularly a Conservative government) is doing, so the media’s obsession with ‘the deficit’ would only have a chance of changing if the government changed its emphasis. It now has.

I suspect and hope we will see an end to two particularly silly aspects of deficit fetishism in the media. The first was monthly commentary on public borrowing, with associated ‘tax will go up/down’ headlines. That kind of commentary only makes sense when Chancellors have short term deficit targets, and I will be surprised if Kwarteng doesn’t ditch this aspect of Sunak’s policy. The second was around budget time, when annual movements in the deficit attracted far more attention than they deserved.

However those hoping that both the government and the media will completely ignore what happens to the government’s deficit will I suspect be disappointed. If I am right, at some point Conservatives will resume using an unsustainable government deficit to argue for spending cuts and a smaller state. The argument between Truss and Sunak was essentially political. Truss believed that, with two and a half years before the next election, playing the deficit responsibility card would reap few political dividends and might prevent the government from doing more popular things, like cutting taxes. Deficit obsession was never a fundamental part of neoliberalism, but just a useful tactic at certain times to achieve a smaller state.

So I would not be surprised to see Truss and Kwarteng still stressing the importance of fiscal ‘responsibility’. How will they square this with the fiscal largess implied by an expensive energy price cap and tax cuts (compared to previous plans)? It is actually easier than you might think.

The huge cost of the energy support package can be justified in the same way as furlough was: an exceptional response to exceptional events. After all, the main event that has had the biggest positive impact historically on government debt was a war, and the government could with some justification argue that the need for a large scale fiscal support package is the war in Ukraine.

The government is on trickier ground with any tax cuts, but even here they have an excuse within the spirit of some of the rules they themselves have set. A UK recession is still a strong possibility, and Conservative Chancellors since 2010 have generally recognised that fiscal rules can be set aside in recessions (or even milder economic downturns). So the new Prime Minister and Chancellor might try to justify any tax cuts as measures to prevent a recession, and still argue that they were being ‘responsible with the deficit’ in the medium term.

In macroeconomic terms this doesn’t wash for three reasons. First, if you were looking for a fiscal stimulus to prevent a recession, you would not choose cutting national insurance or corporation tax as effective measures to do that. The most effective and quick way of stopping a recession is to increase universal credit, because you can be reasonably sure most of that will be spent. In contrast, it’s not clear whether cutting corporation tax will have more than a tiny positive impact on aggregate demand during an economic downturn. The main influence on business investment is what is happening to output, not the corporate tax rate.

Second, and more importantly, effective fiscal stimulus during a recession is inevitably temporary. It is designed to either prevent a recession, or lift the economy out of one, and once that goal has been achieved you no longer need any stimulus. Truss, however, intends her tax cuts to be permanent, so the prospect of a recession is no answer to the ‘where is the money coming from’ question.

Third, outwith the lower bound for interest rates, it is monetary policy that should be worrying about inflation and recessions. In this light cutting taxes to avoid/moderate a recession looks very odd when the Bank of England is raising rates. Does the government think the Monetary Policy Committee of the Bank could be making a mistake? 

However all three points are unlikely to be made by most of those who will interview government ministers, so in political rather than economic terms the excuse of a possible recession is tenable. [1] What this means, I suspect, is that Truss and Kwarteng are not going to start saying the deficit doesn’t matter, implying everything Osborne and Sunak said about it was wrong. What it will mean is that the government can no longer use fears about the deficit under a Labour government as a political weapon. Instead they will just say that a Labour government will mean higher taxes.

Where I think the government is more vulnerable, and where I think the media will rightly continue to talk about the deficit, is following OBR or other reputable medium term forecasts. Absent unexpected good fortune, the OBR is likely to be forecasting in five years time government deficits which will imply either government debt or net wealth are unsustainable. This five year time horizon is important not because it is likely to happen, but because it’s a good assessment of the underlying level of taxes and spending, abstracting from short term shocks and the business cycle.

This will not imply any immediate crisis, and any impact on the exchange rate will have probably already happened. But it is important nevertheless, and it is why we should not ignore government deficits altogether. Persistent and large excess deficits (where excess means government debt is persistently rising or net wealth is persistently falling) generally indicate spending cuts or tax rises in the future as I suggested earlier. But if left unchecked, they can predict one of two things. The first is a persistent fiscal stimulus, which in absence of monetary policy would imply rising inflation. Of course with an independent central bank with a medium term inflation target persistent fiscal stimulus will imply higher interest rates to prevent higher inflation. While that upward pressure on interest rates was welcome when rates were stuck at the zero lower bound, that is not true today.

However persistent deficits need not imply that much inflationary pressure, if they take the form of tax cuts for businesses or the better off. The second possibility is that they signal a redistribution towards the most wealthy. If tax cuts directly benefit businesses or disproportionately those on high incomes, they will not add that much to effective demand in the economy because most of the tax cut will be saved. Instead they indicate a redistribution of income to the already rich.

In all cases projected persistent excess deficits are not a problem in themselves, but because of what they indicate could happen as a result of current fiscal plans: spending cuts or tax rises, or future higher interest rates, or future redistribution towards the wealthy.

In political terms this will be a problem for both the government and Labour. The government will claim that the OBR are underestimating the boost to growth that tax cuts will give, and higher growth will lead to higher taxes etc. Labour, along with the non-partisan media, should rightly describe this as wishful thinking not backed up with evidence. If it was backed up by the evidence the OBR would incorporate that in its forecast.

However Labour cannot say the same, so while they can blame the government for being fiscally irresponsible they will also be asked how they would deal with the problem if they win power. As Labour are likely to be repeatedly asked how they intend to close any funding gap, that should influence their stance when these tax cuts come into place. I suspect they will vote for tax cuts for ‘working people’ but against tax cuts for ‘big business’?.

So my answer to the question posed by this post’s title is to ignore any residual media interest in monthly borrowing numbers or the dynamic path of deficits in any budget, and instead focus on the medium term deficit implied by OBR (or other reputable) forecasts, where the inappropriateness of tax cuts will become clear. The increase in government debt implied by the short term energy price cap is not a problem and can be easily justified. Otherwise we should see a welcome change to an economic debate about what really matters: whether it is more important to cut taxes or instead provide sustained support to our underfunded public services and the less well off.

[1] Even if a journalist did make the points above, the government’s response would be that tax cuts lead to more growth and more revenue.

Tuesday 6 September 2022

The Cost of Living Crisis, its macroeconomic implications and Truss economics


Support for energy users

When I wrote about higher energy prices back in March, I argued for what would become two months later the UK’s approach. I preferred that to the policy adopted in, say, France, where prices had been pegged to near pre-crisis levels.. I argued then it was best to let energy prices rise, tax away the resulting profits of domestic energy producers and give money to those who would have difficulty paying the higher prices. The alternative of keeping prices low was worse because you lost the incentive for consumers and businesses to economise on energy use.

For any country, including the UK, we can think of the impact of higher energy prices in terms of incentive effects and distributional effects. The incentives to economise on using carbon are good both in the short term (reducing Russia’s leverage on those countries supporting Ukraine defend itself) and the medium term (reducing man-made climate change). However there is no reason why energy producers (and their shareholders) should benefit from these higher prices, so it makes sense to tax away excess profits if you can. The only thing that prevents most countries redistributing all the benefits of higher energy prices from producers to consumers is that the energy producers (rather than suppliers) are taxed overseas.

Since then energy prices have continued to rise, and so policy makers once again have to make a choice. Do they let prices rise further and give cash to those who cannot afford those higher prices, or do they force suppliers to keep prices at their summer level and give money to these suppliers (as Labour are suggesting)?

As @TorstenBell points out, there are a number of distractions from this basic choice. One from the left is nationalisation. Nationalisation may be part of holding down prices, but it is not necessary for this, and nor does it make it any cheaper for a government to do. An argument against windfall taxes from the right is not 'interfering with markets'. Nothing in economics says that the owner of a finite resource (energy in the form of carbon) has to get richer when the price of that resource rises, and that becomes especially so when we don’t want that owner to be incentivised to extract more of the resource. (Unfortunately Sunak’s windfall tax does just that, illustrating how anti-green the government already was before Truss became its leader.) One final distraction is trying to relate the size of any government spending on support to the size of the increase in windfall (or any other) taxes. With future prices very unpredictable there is no reason why these two should be related in the short term.

There are two good reasons why a UK policymaker might want to switch from allowing prices to rise and supporting those who need it to a strategy of holding prices down at their current (higher) level. The first is that most of the incentive effect has already been obtained by the initial increase in prices, as there are limits to how much households can (or should) economise in the short term. The second is that with even higher prices, directing support to where it is needed gets much more difficult.

As Torsten Bell notes here, only around 45% of the poorest half of the population receive benefits. In addition there is a wide variation in energy use within different income groups, particularly among the poorest. Many disabled people are also intensive energy users. Designing a scheme that relates how much support each household receives to their income and energy use is difficult but not impossible. An easier route is just to cap prices at their summer level, continue with the May support scheme and compensate the energy suppliers, as Labour suggests. In either case, substantial windfall taxes on energy producers making massive profits are what any sensible UK policymaker would do.

Unfortunately, higher energy prices are not the only problem facing poorer households this winter. Food prices have also been rising rapidly, and rents may do the same. There remains a strong case for raising the level of universal credit, irrespective of and in addition to whatever is done about energy prices. In addition, the benefit cap for large families continues to lead to child poverty. Extending free school meals is also an obvious move for any government interested in the health and education of its children.

The longer term response to higher energy prices for any government interested in the future has to be massive investment in green energy and energy efficiency (like help with home insulation). This should be the case even if the current price increase proves short lived. Recent climate changes emphasise the need for urgent action to reduce carbon use, and recent events show how dangerous it is to be be dependent on energy produced in countries that are not democracies.

Macroeconomic consequences and interest rates

Higher energy prices are having dramatic macroeconomic consequences. Right now everyone is focusing on higher inflation, which in most countries is largely due (directly or indirectly) to higher energy prices. However this inflation is generating falls in real income in most countries, which are likely to lead to a recession in many. As energy prices stabilise or fall, the impact on inflation will unwind, and concern will shift to stagnant or falling output and rising unemployment. (For the impact of energy prices on the level of real incomes to be reversed, energy prices would of course have to fall back to the level they were before they started rising.)

It is really important to recognise that most of the increase in inflation and drop in real income as a consequence of higher energy prices, and not some failure in monetary policy. As Tony Yates points out, real incomes would be falling right now even if the monetary authorities had managed to keep inflation at target by anticipating higher energy prices and the Ukraine war. The difference would be that interest rates would be sky high, nominal wages would be falling and a recession would be certain and much deeper.

That so many people miss this basic point is partly a consequence of the centrality of inflation targets, and the natural but erroneous implication that central banks can or should always control inflation. What central banks really do is manage aggregate demand with the objective of hitting some level of inflation in the medium term. Why would central banks try to create substantial deficient aggregate demand following an energy price shock? The only good reason is if medium term inflation expectations had risen, and unsurprisingly there is little sign of that with a possible recession on the way.

This is important, because it looks to me (and Tomas Hirst) as if the European Central Bank, and perhaps the Bank of England, may be raising rates in part because of the high inflation generated by higher energy and food prices. Indeed it seems as if the higher inflation goes the more pressure there is to raise rates further. This would be a serious mistake, and will only increase the probability of a demand-deficient recession. We are not seeing a rerun of the 1970s. Instead real wages and real incomes are falling substantially which will itself reduce aggregate demand, and there is no need for central banks to add to that. Demand-deficient recessions are rarely inevitable, and often represent a failure of foresight or policy.

There is a widespread view that other central banks have to follow the US, where rates did have to rise to stabilise excess domestic demand. Some even say that without this ‘follow the US’ tactic, currencies would collapse against the dollar pushing inflation up further. I am very sceptical about this argument, which flies in the face of the standard logic for floating exchange rates. If US domestic demand is excessive, and European demand is deficient (which is what most estimates say), an appreciation in the dollar is how you correct both. In addition, the best theory we have about the relationship between interest rates and exchange rates does not imply currency collapse if European rate rises fail to match US rate increases. As any rate gap is likely to be temporary (say 2 years), the impact on European inflation in not following the US will be marginal compared to current levels. [1]

Truss economics

Incredibly, given the urgency, we still have no clear idea what the UK government will do to tackle the latest energy crisis. The contest to be the next PM has paralysed the government because under Johnson government has become far too dependent on its Prime Minister. Johnson, Truss and Sunak could have agreed something during the contest, leaving households and businesses facing less damaging uncertainty, but that was it seems beyond them.

What we do know is that Truss as Prime Minister will create a shift to the right on economic policy. Truss intends economic policy to follow a Tufton Street/Britannia Unchained path. Johnson when he became PM increased public spending in some areas (but not nearly enough), and Sunak’s concerns about the deficit meant that taxes were raised substantially. In contrast, Truss is intent on cutting taxes, despite the need for a great deal of government support following higher energy prices. Her justification for doing this is ‘trickle down economics’, an idea supported by the wealthy but not by the evidence. She even describes such policies as ‘fair’. What they are not, however, is an effective way of avoiding a recession, as the better off or corporations spend little of any tax cut, particularly a tax cut that looks very temporary because the deficit is rising fast.

This lack of concern about the impact of her policies on the deficit should not fool anyone into thinking this makes her policy stance less right wing. Deficit obsession on the right was always a device to achieve a smaller state: Osborne cut taxes as well as spending. An alternative tactic, used in the US, to achieve the same end is called ‘starve the beast’: cut taxes today, and later demand spending is reduced because of the higher deficit lower taxes create. For this reason, as I argued here, the Truss-Sunak contest was about the best tactics to achieve a smaller state rather than a contest about ideologies. It has to be said that in the current situation with multiple crises reflecting inadequate public spending, arguing for a yet smaller state is just crazy.

Yet the new Chancellor would like you to think it’s a new strategy. In his article for the Financial Times, the prospective Chancellor derides “the same old economic managerialism [that] has left us with a stagnating economy and anaemic growth, with labour productivity growing at just 0.4% a year since the financial crisis”. What is this ‘old economic managerialism’ that is to blame for what is indeed a woeful growth performance. He should know, as nearly all of it occurred when his government was in power?

Unfortunately the 2010 government also believed that tax cuts and deregulation would inspire more rapid economic growth. Osborne cut corporation tax substantially, raised income tax thresholds and cut its top rate, and since 2010 we have not had a government piling on new regulations. So this Chancellor’s criticisms of his previous Conservative Chancellors must be about the obsession with the deficit. Fair enough, and also pretty relevant as we may be heading for another recession where deficit obsession would be disastrous.

Yet 2010 austerity was a disaster mainly because it led to cuts in government spending at a time when the opposite was required. It was not a disaster because taxes were raised, as many taxes were cut. Yet Truss talks a lot about cutting taxes, and very little about the need to raise public spending. (In most cases the direct effect of a change in government spending is an equal increase in GDP, while a change in taxes will only directly increase GDP if it is spent.)

This means that there is no big change in government strategy. All Chancellors want higher growth - it’s what they do to try and achieve it that matters. The underlying strategy under Truss will be just more of the same as we had after 2010: cutting ‘red tape’ and taxes. In addition, given her backers in the ERG, she will find it hard to deviate from a path of confrontation with the EU. This new Conservative administration is doing nothing more than doubling down on an already failed economic strategy, hoping one last push will reverse the stagnation we have seen since that strategy was first applied. It seems that the Conservative party mean to carry on what they have done since 2010, which is to harm the economy by their actions or neglect.

[1] An expected 2 year gap of 1%, say, in interest rates between Europe/UK and the US would lead to a 2% depreciation in the Euro/Sterling exchange rate against the dollar. Model estimates suggest that in turn would raise inflation in Europe over time by around 0.2% directly, but activity would also be stronger.