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.