Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 24 October 2022

The UK Treasury since 1976


Fed up with the Conservative Party’s current psychodrama? This could be a useful distraction.

Aeron Davis has a new book out that is a 40 year history of the UK Treasury (HMT). As I found his previous book ‘Elites at the End of the Establishment’ fascinating, and as I’m always interested in anything about the most powerful economic institution in the UK which also gave me my first job, I was looking forward to reading this. It does not disappoint.

Like that previous book it is based on lengthy interviews, in this case with the key political and civil service people at the top of the Treasury over this period. As a result, it is very far from a jargon filled analysis of the details of macroeconomic policy over 40 years. Its brush is much broader, covering many themes from the growing influence of finance (financialisation), neoliberal ideas, and an internationalist viewpoint, but also dealing with the big historical crises of the period. As the book also roughly covers the years I have been working as an economist, what follows is not so much a review as a selected mixture of my own thoughts and those of the author. I’ll do my best to distinguish between the two.

The book starts, appropriately, in 1976 after the IMF crisis. I’ve written about this before based on Richard Robert’s book, and I agree with Robert’s interpretation of that crisis as mainly about fear of devaluation rather than the government no longer being able to borrow. Aeron is right that HMT used the shock of that crisis to re-establish its control of government spending, much as it did later in 2010. However I think the 1970s is more significant because of three large intellectual failures within HMT.

The first, which I discuss in that earlier post, was the pervasive view in the Treasury that it could cheat the Phillips curve using various forms of prices and incomes policy. The second, again touched on in that earlier post, was a failure to adjust to a floating exchange rate regime. It was clear to me while I was working there that while many junior economists understood how floating rates worked, those at the most senior levels did not. Both failures were central to understanding 1976, but were largely corrected by the end of that decade. [1]

A third failure that was not corrected was how to deal with the bonanza of North Sea Oil. It is today standard in the macroeconomics of resource rich countries that any temporary gain due to the discovery of a finite resource should be largely invested. That macroeconomics was not as developed at the time, but the basic choice for the government of consumption (cutting taxes) or investment was discussed at reasonably senior levels while I was there. Norway made the right choice but the UK did not, although how much that was down to politicians at the time is difficult to tell.

As Davis points out, this failure wasn’t just about North Sea Oil revenues, but was repeated with privatisation and council house sales. During the Thatcher period selling off public capital was treated as just another form of revenue, which is nonsense because unlike taxes it is not permanent. Sometimes people question why the OBR does 50 year forecasts for government borrowing, an innovation that started under Gordon Brown, and the abuses of the Thatcher period are one obvious answer.

A recurrent problem here and throughout any discussion of HMT is to separate out the views of officials and the politicians they served. In my own rather limited and out of date experience, those working in HMT have very varied views, and in a way this is helpful when the government changes. The arguments against can quickly become the arguments for when the political tide turns. One of the strengths of this book and the many interviews on which it is based is to try and tease out what decisions were political and which were down to thinking within HMT.

A good example, which Davis is right to discuss at length, is the pervasive doctrine within HMT that national firm ownership didn’t matter. A quote from an interview with John Grieve sums up the issue:

On ownership, right from the ’80s, from Big Bang onwards, and indeed before, there’s been a running worry in government and in commentary about are we wise to let foreigners buy everything? … but in fact, there’s been a longstanding policy, successive governments have decided not to do anything about it … And, you know, of course most other countries think this is mad, and that ownership does matter.”

Aeron correctly links this to internationalist, finance orientated and free markets attitudes within HMT, but I also suspect there is a hangover from the period before 1976, when poor UK management, leading to deteriorating export performance and productivity growth, was a constant concern.

One of the points often made about the people working in HMT is how clever they are. That of course does to necessarily translate into good policy. I can think of two examples that illustrate this point which are not covered at length by Aeron Davis: ERM entry in 1990 and Euro non-entry in 2003. In the first case the good work done outside HMT on an appropriate exchange rate for the pound was ignored, and the debacle of Black Wednesday was a direct result. In contrast the opposite happened in 2003, and the intellectual weight of HMT work helped Brown to convince Blair not to join the Euro.

The end of the book is dominated by three crises. The first is the Global Financial Crisis. Aeron effectively shows that no one wanted to hear warnings about the growing fragility of the UK banking sector, but my own personal view is that there was one person in particular who was best placed to react to these warnings, and that was Mervyn King. The book includes the following quote from an official.

[King] managed to spin a narrative over the next few years that the Bank of England lacked the tools and powers to do anything about it … I call him the Keyser Soze of the financial crisis. The greatest trick he ever pulled was persuading everyone that his responsibility for the financial crisis didn’t exist … Mervyn, can you point to where you said that prior to the financial crisis? Why did you cut the financial stability stuff? You were obsessed with monetary policy, weren’t you?”

Aeron also deals with how the Labour government failed to hold an inquiry into how the crisis had been allowed to happen.

The second crisis is austerity. There are some lovely quotes here, illustrating that what Aeron Davis calls the ‘posh boys’ regarded economics as a political means to an end. Here is a quote from his text.

Those who had been part of the New Labour regime, such as Ed Balls, Dan Corry or Gus O’Donnell, got rather excited when speaking about economics, even with a noneconomist academic. It was the same with Alan Budd, Terry Burns and Nigel Lawson when talking about the Thatcher years. But for those leading the Coalition, economics was just another consideration in the wider matrix of Westminster party strategizing and news media lobby management.”

What Osborne and Cameron were interested in was media management, and they were experts at it. Unfortunately the advice they were getting proved no corrective to their macroeconomic ignorance. Here is a quote from Aeron reflecting on his interview with Rupert Harrison, Osborne’s economics advisor and now advising Jeremy Hunt.

When I asked him directly about the broader inspirations of his economic thinking, Harrison responded that he had no interest in macroeconomic thought. His policy views were ‘shaped by more general reading’ and by being ‘a centre-right leaning person’.”

I’m afraid this was painfully obvious from Osborne’s speeches at the time. [2] The origin of the last twelve years of economic decline can be found in politicians who put party political interest above the health of the economy.

Unfortunately that gap in knowledge and concern was not filled by HMT. Senior HMT officials at the time were more than happy to go along with fiscal consolidation at the low point of a recession. In this sense austerity was also another massive intellectual failure for HMT. However I also think it reflects a key power dynamic within the department, a battle between those trying to control government spending and those managing the economy. This tension has been there since the advent of Keynesian economics, and is the basis for repeated calls for the two roles to be split into separate departments.

I have set out my own views on this, as part of the Kerslake review, in a post here. As Aeron Davis notes, one of the unintended consequences of first Bank of England independence, and then the creation of the OBR, was to diminish the weight of macroeconomists within HMT. Nevertheless, all those running HMT should have had a good understanding of Keynesian economics. I accept that they could do little to change the overall policy of Osborne/Cameron, but the cuts in public investment in 2011 and 2012 that did so much damage to the recovery were not a core part of that policy, and I think the HMT could at least have tried to prevent them.

The third crisis was the Brexit vote in 2016. Aeron Davis argues that the Leave vote was not only devastating to most Treasury officials (many were economists, after all) but also that it reflected past failures in Treasury management. To quote

“For one, I hold the Treasury (and successive governments) responsible for ushering in an economy that was so unbalanced and unequal. Years of trickle-down economics, and years of favouring finance over manufacturing, large foreign multinationals over home-grown companies, large asset-holders and rentiers over others, London over the regions, monetary rather than fiscal activism had had a cumulative impact. Austerity economics only exacerbated such trends, with several commentators linking that to the vote outcome.”

Of course any vote that close can have many things that help tip the balance. To the extent he is right, the Brexit vote represents a fitting ending for the book, as it represents many of the themes the author examines coming home to roost. In fact it is not the end, as there is a postscript entitled ‘reckless opportunists gain control’, which covers Johnson and partygate but not Truss’s ill-fated reign.

It should be clear from this short review that this book is not just an interesting overview of the Treasury over the last 40+ years. It is also an invaluable record of what some of the key political and official actors involved in UK economic policy thought they were doing at the time and how they view that in retrospect. I thoroughly recommend reading it to anyone interested in the recent economic history of the UK.

[1] I say largely because the new Conservative government’s advisors did not foresee that money supply targets would lead to a large appreciation in sterling a la Dornbusch, which decimated UK manufacturing.

[2] Austerity, by which I mean embarking on spending cuts in a liquidity trap recession, represented ignorance of everything Keynes talked about in the General Theory, as well as state of the art macroeconomics. On the positive side a form of fiscal council (the OBR), something that I had argued strongly for, was created after being rejected by Gordon Brown. On the whole it seems easier for new rather than existing governments to introduce reforms that take away discretion from politicians.

Tuesday 18 October 2022

Why it is crucial to understand why financial markets move, rather than worry about the role of markets in aiding the downfall of a Chancellor and Prime Minister



The media sometimes uses a financial crisis in much the same way as religious leaders might have once used natural disasters. Because market moves are the result of the actions of large numbers of traders, who have heterogeneous views and are mainly interested in predicting each other, this allows commentators to say almost whatever they like about the causes of these moves without much fear of being quickly proved wrong. Mysterious or vague language is used, like ‘credibility’. In addition and for the same reason it encourages hysterical pronouncements like ‘there is no floor to sterling’ or ‘no ceiling for interest rates’. In short, financial markets are sometimes treated as a vengeful god, with no shortage of priests around to tell us why it is displeased.

As the commentators the media generally uses to interpret market movements are City economists, this leads to a rightwing bias in such commentary. (It is just a bias: there are of course some very good City economists who are not right wing.) We saw the worst side of this in the UK in 2009 and 2010, when too many City commentators said the markets ‘were looking for austerity’ and without it various disastrous things would happen. As I noted here, half the City economists surveyed by the Financial Times agreed with the nonsensical statement that the 2013 UK economic recovery proved austerity was vindicated.

The market reaction to the Truss/Kwarteng fiscal event was different from this for two reasons. First, because large market moves happened just before and after what was in effect a budget, it was less easy to make up nonsense stories, and in addition many of the economic correspondents commenting on the budget nowadays are rather more grounded than the City economists who thought austerity was a great idea. Second, we have good reasons for thinking that the immediate interpretation of what was happening in the markets as a result of September's ‘fiscal event’ was correct.

September’s market reaction

As there is still some confusion about why the budget led to these market moves, in the appendix I go through the reasons for thinking that the fiscal event substantially increased the uncertainty involved in predicting UK short term interest rates, and therefore in holding sterling assets more generally, using as simple language as I can. However the fiscal event did not increase the chances of the UK government defaulting on its debt, or increase the chances of ‘fiscal dominance’, and nor was it just about the expectation of higher interest rates.

Instead the increase in uncertainty caused by September’s tax cuts was fundamentally about announcing tax cuts without making clear whether or how this would be matched by spending cuts. But it goes further than that. Whatever spending cuts might have been announced, cuts to spending right now are far from credible. A government may promise spending cuts, but with levels of public spending already so low following 2010 austerity, and further squeezed by recent inflation, these cuts may not actually happen. Equally they may be offset by the government being forced to give in to public sector workers whose real pay has steadily fallen in recent years compared to the private sector.

The net result is that tax cuts have produced great uncertainty about the size and economic impact of the spending side of fiscal policy, which translates into uncertainty about the future path of short term UK interest rates, which in turn influences the future return on UK government debt (gilts) and the exchange rate itself. When the future price of a currency’s assets suddenly becomes more uncertain, because most people in the market are risk averse, they want to reduce their exposure to those assets or demand a higher return. Anyone selling those assets, like pension funds, suddenly finds a reluctance to buy.

You can certainly raise a question about whether pension funds should have exposed themselves to this kind of risk, but the risk arose because of the tax cuts in September. However the fact that the Bank of England had to step in as ‘market maker of last resort’ raises uncertainty again, because of what is sometimes called ‘financial dominance’. This is the idea that future Bank monetary policy actions will be compromised because it might lead particular UK financial institutions to get into difficulties. It is an additional level of uncertainty for UK assets above and beyond uncertainty over spending cuts.

Unfortunately I think there is a third and final level of enhanced uncertainty created by September’s tax cuts which goes deeper than those described above. When a group of politicians commit one important act of self-harm, Brexit, you can tell yourself it’s a one off and otherwise the government remains competent. When they do it again, September’s tax cuts, you begin to worry there may be yet more along the line. That is not because the markets are interested in economic competence per se, but because it too could have an impact on the future path of the interest rate the Bank of England sets, and so that also increases the uncertainty involved in holding sterling assets.

The “power of the markets”

When I talked about the market reaction to September’s fiscal event in earlier posts, I received some criticism that I was using a right wing narrative. This was just nonsense: the market reaction happened, and a theme of this post is that it is important to understand why it happened rather than leave that field open to others with an axe to grind. The idea that talking about unsustainable deficits is pandering to an austerity narrative is also nonsense: I have always made it clear that my passionate opposition to austerity does not imply deficits never matter. However there is an ever present worry on the left about the power markets seem to have to occasionally dictate and perhaps even reverse government policy, because it stands in opposition to power won democratically?

I remember being invited to speak at a Labour conference fringe meeting after we had been forced out of the Exchange Rate Mechanism in 1992. That was another occasion where markets struck a fatal blow to the Conservative Party’s economic reputation, yet when I pointed out that currency speculators had done the UK economy a huge favour, there were howls of disapproval from the audience. What I said was true, but to point out that currency speculators had forced sterling to where it ought to be was not popular among that audience.

But that episode and the current one show clearly that the idea that financial markets impose right wing policies on left wing leaders in advanced countries is inaccurate. What financial markets mainly do is try to anticipate future events, and so they can expose the implications of, or ambiguity with, macro policy before either becomes clear to others. The problem, as we have just seen, is invariably with the government’s policy and not the markets. No one would say that firms have illegitimate economic power when they fail to invest because of uncertainty, so why does it make sense to make this statement about financial markets? [1]

What is a problem is treating the markets like a vengeful god, rather than just one part of a macroeconomic system with understandable behaviour. Doing so allows commentators to constantly invoke imagined market reaction as a way of judging policy. In the last week we have seen plenty of this, from those absurdly claiming that September’s market reaction justified austerity [2], to those suggesting the markets are demanding spending cuts. No sensible economist would ever recommend doing what Kwarteng did in his September event, and all the markets did was confirm this fact. It is obvious, therefore, that the best way of restoring market confidence is to reverse all the permanent tax cuts announced in September. It is therefore not surprising that this is what the new Chancellor partially did on Monday.

Does September’s market reaction have lessons for a Labour government after the next general election? In short, no. Nothing in the market reaction to unfunded tax cuts says you cannot borrow to invest in greening the economy. Nothing in the market reaction to unfunded tax cuts says you cannot spend more on public services as long as you raise taxes to do so. What the market reaction to unfunded tax cuts does tell us is that your macroeconomic policy should be transparent, credible and sustainable, and that is something that Labour Chancellors and shadow Chancellors normally understand.

If I had to pinpoint one weakness in a future Labour government’s macro framework, it is maintaining a goal for falling public debt to GDP in the medium term. Nothing in the market reaction to unfunded tax cuts says you need this particular target: Kwarteng said he was going to achieve it in his fiscal event and it made no difference. Such a target potentially conflicts with large scale public investment, and that conflict itself increases uncertainty. Setting targets for medium term current deficits that are sustainable, and implementing tax and credible spending decisions consistent with that, is all fiscal policy needs to maintain market confidence.

To summarise, just as people should have been pleased that the markets forced the government to abandon a ruinous exchange rate peg in 1992, we should also be pleased that the markets have inflicted pain on a government that thought unfunded tax cuts made sense when public services are in dire trouble. The entire Conservative party’s obsession with tax cuts, in an environment where many factors mean the demand for health services will rise as a share of GDP over time, has been and always will be damaging to the UK economy. Brexit, and ‘living with Covid’, have just made that harm more acute. Unfortunately it will require much more than recent events for the Conservative party to understand their error.

[1] There is an entirely separate question about how much an economy should want to expose itself to financial market uncertainty, particularly when that uncertainty might have little to do with your own economy.

[2] To suggest that the only alternative to 2010 austerity were unsustainable deficits is just silly. Good macroeconomic policy is about doing the right thing at the right time. In 2010 the priority was a strong recovery from the deepest recession since WWII, not balancing the books. If, once a strong recovery was complete, deficits were unsustainable then raise taxes or cut spending. By getting the timing horribly wrong, 2010 austerity killed the recovery and we are probably all poorer as a result.

Appendix: why September’s budget influenced the markets

While only the most biased commentators in the media have tried to suggest that the market moves immediately before and after September’s budget had nothing to do with that budget, there remains some disagreement still about the reason why the budget had such a marked effect. At one extreme we have Larry Summers saying “I cannot remember a G10 country with so much debt sustainability risk in its own currency.” At the other we have some saying the reaction was just about anticipation of higher interest rates. While it is impossible to know for sure who is right, I think it is important to be clear what explanations are reasonable and what are not.

There are two ways a government that sells debt in its own currency (called ‘gilts’ in the UK) can default. The first (legal default) is that the government chooses to no longer pay the interest on its debt (or even repay the debt) that it has previously contracted to pay. The second (economic default) is that it inflates away the value of the part of its debt that is fixed in nominal terms. There is no chance that the UK government will legally default, and there is equally no chance that the government will stop the Bank of England using interest rates to try and control inflation. Therefore we can be reasonably sure that the rise in gilt yields just before and after the fiscal event does not reflect changes in expectations about default.

What about the alternative explanation, which is that the market was just anticipating higher short term interest rates. To be clear, the logic is as follows. The ‘fiscal event’ cut taxes. (It also subsidised energy bills, but that had been leaked well before the budget so it cannot explain what happened just before or after the budget. Markets respond only to news.) Lower taxes, if they are not saved, will lead to higher consumption or (with corporation taxes) perhaps investment, which increases aggregate demand. But higher aggregate demand will tend to raise inflation, and the Bank of England is currently raising rates to bring inflation down. So anything that increases aggregate demand will mean the Bank has to raise interest rates further.

We know this is part of the story of what happened, because expectations about short term interest rates did increase. But we also know it is not the full story because of what happened to sterling. If it had been the full story, then expectations of higher short term interest rates would have led to an immediate appreciation in sterling. In fact the opposite happened. Sterling depreciated against the Euro as well as the Dollar. So something else was also going on.

Various people have described the combination of exchange rate depreciation and higher interest rates on UK government debt as reflecting a higher risk premium on UK assets: Krugman (following @darioperkins) called it a ‘moron risk premium’. But what risks are we talking about here, if it isn’t legal default risk or inflation risk? I think it all goes back to the unique feature (at least for the UK over the last few decades) of the ‘fiscal event’, which is that the announced tax cuts were completely unfunded, by which we mean that we had no idea whether they would be paid for by cutting spending or permanently higher borrowing.

That last sentence is a little unfair on the Chancellor. He did say that he remained committed to seeing the government debt to GDP ratio falling in the medium term. If we are being generous in thinking that the Chancellor would not be so foolish to believe that tax cuts paid for themselves, then his statement does imply spending cuts at some time. But that leaves markets with a lot of guesswork to do. We could think about two extreme possibilities.

The first is that the spending cuts would all be pencilled in to occur after the election, with no spending cuts this year or next. The second is that the tax cuts are entirely matched, £ for £, with spending cuts that will take place in each and every year before the election. It is this second possibility which causes the problems, because tax cuts matched by equal spending cuts could reduce aggregate demand, and therefore lead to lower short term interest rates.

The reason goes back to the point that tax cuts can be saved as well as spent. Now if you think a tax cut is permanent, you are inclined to spend all of it, because your post-tax income will be permanently higher. On the other hand if you think a tax cut is temporary, perhaps because the government that made it will lose the next election and the party that wins the election might raise taxes, you will be inclined to save most of the tax cut, unless your income is so low that you need to spend all the money. With the tax cuts in the fiscal event this latter possibility must be quite high, so a lot of the tax cut will be saved.

In contrast, spending cuts tend to feed straight through into aggregate demand. (This includes cuts to welfare payments, because they mainly go to poorer people who have little in savings and so will reduce spending by something close to the amount of the welfare cut.) So tax cuts matched by equal spending cuts will almost certainly reduce aggregate demand, which reduces inflationary pressure and should lead the Bank of England to reduce interest rates.

So we have two possible extremes, and the possibility of some mixture of the two happening. We know that on average markets expected the net effect of the fiscal event and any subsequent budget to be inflationary, but the possibility that after the budget interest rates might be lower cannot be ruled out. What the fiscal event did, therefore, was to increase the uncertainty around future short term interest rates. While the market expected short term interest rates to rise as a result of the fiscal event, there was also the possibility that they might fall because of the subsequent budget.

That uncertainty about what would happen to short term interest rates made sterling assets more risky. If sterling assets become riskier, then we get a depreciation in sterling. Furthermore, unless gilts are held to maturity, their future price becomes more uncertain (because the price of gilts depends on expected future short term interest rates), so you would want a higher return to holding them.

To summarise, because the fiscal event was one sided (unfunded), it increased the uncertainty involved in holding sterling assets, which would lead to a depreciation in sterling and higher returns on UK government debt. This is why calling this effect a moron risk premium is justified, because normally UK governments are not so stupid as to announce tax cuts without saying how they will be paid for.

Tuesday 11 October 2022

The self-destructive political right


Forecasting which political party will win the next election three or more years out, much like economic forecasts of what growth or inflation will be in two years’ time, is setting yourself up to fail [1]. But learning from errors can still be useful. Only a year and a half ago, I wrote a long post entitled “As things stand, the chances of defeating Johnson at the next election are minuscule”. It was full of analysis about why Johnson had won in 2019, about how Labour would have to appeal to social conservatives to win and how difficult that would be without, at least, some form of progressive alliance.

I stand by that analysis, and indeed by being friendlier to the Liberal Democrats and social conservatives Labour have gone down the route I suggested they needed to do (given a FPTP electoral system). [2] However the title of that post now looks embarrassing, with Johnson forced out and the polls suggesting an overall majority for Labour if an election was held today.

I made two big mistakes in that post. The first was not anticipating a global cost of living crisis. I did expect the V shaped recovery we got. What I didn’t foresee (along with pretty well everyone else) was the extent of commodity price increases that this global recovery would bring, now exacerbated by Putin’s war against Ukraine. It was clear from the analysis in that article that a Labour opposition would do better fighting on economic rather than social terrain when economic events were not being helpful to the government.

The second mistake is what I want to focus on in this post. What I missed was the ability of a plutocratic populist right of the Johnson/Trump ilk to self-destruct through overconfidence. In mitigation I began to suspect my mistake just three months later, when I wrote a post entitled “Will the Trump/Johnson base lead to its destruction?”.

In the US Trump and large parts of the Republican party, by pandering to their base through denying the severity of the attack on Congress and elsewhere, were alienating everyone else. In the UK the political right’s obsession with wokeness was winning them few votes. But I made a mistake in that second post too. What I got wrong was that the growing distance between Johnson (and Conservatives generally) and expert opinion on the pandemic would also be an own goal. It was in medical terms, but politically I underestimated how much most people wanted to believe the pandemic was over.

However it was another part of Johnson’s attitude towards the pandemic that would confirm the idea of the plutocratic right’s ability to self-destruct. What still seems extraordinary about No.10 breaking their own rules by holding parties is that they thought they could get away with it. People tend to focus on Johnson’s own belief that he was above the rules, but more surprising was that the very people giving political advice to Johnson were taking actions that would not only lead to his growing unpopularity, but ultimately would cost him his job. I suspect that can only come from overconfidence, encouraged by a large majority and a largely biased or tame media.

Since then other developments on both sides of the Atlantic have confirmed the ‘self-harm through overconfidence’ idea. In the US we had the Supreme Court overturning Roe vs Wade. Of course the SCOTUS is not supposed to be political, but the Republican majority on it certainly are. As I speculated at the time, doing this before Republicans had taken back either Congress or the Presidency risked bringing out the Democrat vote, and the polls so far suggest that might happen.

In the UK we have the more recent events of Truss winning the leadership and her Chancellor’s ill-fated budget. As I noted here, as has Chris Grey at greater length, it was the most right wing, pro-Brexit MPs that got Truss onto the party members ballot for leader. Letting party members choose the party leader will not inevitably lead to the selection of a politician who is far better at pleasing party members than the wider electorate, but it does seem that is more likely to happen the more recently that party has been in power. That Truss and Kwarteng thought they could get away with an unfunded budget that cut taxes for the better off when most people are finding it harder to make ends meet suggests self-destructive overconfidence.

In an Annex to that original post, I included a diagram from the Financial Times of where the majority of voters from different parties were clustered in the space of their economic and social views. It was designed to show how the Conservatives had been so successful in 2019 by attracting the votes of many left wing social conservatives through the means of ‘getting Brexit done’. Thankfully John Burn-Murdoch has recently updated the diagram, shifting the economic axes to allow for the election of Truss.

Conservative MPs may be attracted to the idea of lower taxes and public spending, but as I noted here this puts them to the right of not only most voters, but also Conservative voters and even party members. This is the main reason why both Conservatives and Republicans prefer to fight elections on ‘culture war’ issues. Johnson understood that, which is why he was prepared to raise taxes and some areas of public spending. [3] [4]

Truss and Kwarteng with their budget not only made this gulf between Conservative MPs and voters explicit, but it was probably to the right of where most Conservative MPs dared to go. This is the core analysis behind why Truss and the Conservatives are now so unpopular.[5] And if you are going to advertise your small state, help the rich ambitions, the time not to do it is when everyone is being hit by higher energy and food prices after a decade of stagnation.

However, with over two years to go before an election, there is time for the Conservatives to claw back some support. The likelihood is that 2024 will see much lower inflation and interest rates. In addition, it’s possible we may see lower energy prices and a recovery in the economy. But the economy had been reasonably healthy for some years before 1997, and the Conservatives still lost. [6] The big worry for the Conservatives must be that Truss and those around her seem intent on doing many of the stupid things she promised party members in the summer, and yet more things that are just politically dumb. Yet their biggest fear must be that she seems unwilling or unable to bend her policies and those of her cabinet of like-minded loyalists to the very different views of the vast majority of voters.

[1] As ever, we have to distinguish this unconditional forecasting from conditional forecasting. Conditional forecasting is where you say how an event will change things, like ‘this budget will reduce the Prime Minister’s popularity’. Conditional forecasting is easier, and as Brexit and austerity showed with economics, has a much better track record.

[2] Social liberal voters are concentrated in big cities, and their vote is divided among three UK based parties, so an election fought between social liberals and social conservatives would almost certainly lead to a Tory majority. As Brexit was supported overwhelmingly by social conservatives, that is what happened in 2019.

[3] Osborne got away with austerity because he reframed it after the Global Financial Crisis as an issue of responsible budgeting rather than the desire for a smaller state.

[4] If it hadn’t been for the pandemic, this strategy might have worked for Johnson. Unfortunately, even without the parties, Johnson’s wish to ‘live with Covid’ (in practice doing almost nothing to prevent infection once the country was vaccinated) meant there was a step up in the demand for NHS services to treat those with Covid, with no corresponding step-up in resources to do so. Thus a large increase in NHS spending, paid for by higher national insurance contributions, turned out to be completely inadequate, leading to ever growing waiting lists for treatment.

[5] Unfortunately for Truss there is more besides. The market reaction to the budget shattered what remained of the Conservatives erroneous reputation for economic competence, much as Black Wednesday had done before.

[6] In contrast, growth (in wages as well as the economy) did help Cameron to victory in 2015. However, it is easy to think of many reasons why the Major loss is a better analogy than Cameron’s victory.

Monday 3 October 2022

The Budget has left the UK economy with no good options, so why did this government make such an expensive mistake?


Did the dreadful budget of 24th September create a crisis? It all depends on how you define a crisis, of course, but some of the commentary which focused on sterling was looking in the wrong place. It was interesting that sterling depreciated, but it only looked like a crisis if you mixed up dollar strength with that depreciation. Here is what happened to the Sterling Euro rate.

There was a significant depreciation around the budget, for sure, but of a similar magnitude to what happened at the end of August or the beginning of May.

What was far more dramatic was the rise in yields on UK government debt. On the 22nd of September, the day before the ‘fiscal event’ was announced, the interest rate on 5 year government bonds was 3.4%. By the 28th it had risen to 4.7%, at which point the Bank of England stepped in to buy government debt because the market was ‘disorderly’, which in this case meant some pension funds were getting into serious difficulties. [1] That is a dramatic move, and would come under most people’s definition of a small crisis.

The combination of falls in sterling and higher interest rates on government debt tells us that the UK government’s budget seriously damaged the government’s credibility. A fiscal stimulus would normally imply higher short term interest rates when the central bank is trying to control inflation, which would in turn imply higher interest rates on government debt but also an appreciation in sterling (anticipating the central bank setting higher rates). The fact that sterling depreciated tells us that the biggest impact of the budget was to increase the risk premium associated with this UK government, or “doomsday cult” as one City economist called it.

The ‘starve the beast’ strategy is to cut taxes today, and then wait for the deficit to increase. A year or two later that strategy involves saying we have to do something about the deficit, so let’s cut government spending. For the strategy to work in political terms (in the UK at least) you need that gap between cutting taxes and cutting spending so that the media and voters do not link the two actions. (In the UK, cutting taxes to cut spending is pretty unpopular, but to cut spending to cut taxes on the rich is very unpopular, which is why the idea of cutting the top rate of income tax has been abandoned.)

If the government’s strategy was to ‘starve the beast’, or (incredibly) wait until rapid growth generated by tax cuts made spending cuts unnecessary, the market reaction to the tax cutting part has blown that out of the water. The government will now have to be explicit about ‘where the money is coming from’ in November, when the OBR will publish. (Abandoning cuts to the top rate of tax has little impact on the size of the overall package of lower taxes.) The problem the government has is that the negative market reaction was not just about the unfunded part of tax cuts (and not wanting the OBR to quantify the medium term funding gap), but also any guess the markets made about paying for the tax cuts looked very damaging for the economy. Looking at all the problems facing the UK economy, how much public services have been cut since 2010 and noting that inflation itself is producing a squeeze anyway, I wrote here that “tax cuts are an abomination”, and it looks like markets agreed.

This market reaction has made the government’s predicament [2], and more importantly that of the UK economy, worse for a number of reasons. First, the OBR forecast will now have to integrate higher borrowing costs into its forecasts, creating a bigger medium term gap for the government to fill. Second, using November to just pencil in large spending cuts starting after the election (replicating in economic if not political terms the starve the beast strategy) is a can kicking exercise that rather reinforces the market view that the smaller state policy is currently toxic.

Third, any hopes that the government might be open to compromise when it comes to public sector pay now look remote, and so the government will be trying to impose much larger real wage cuts on the public sector than are happening in the private sector. (Nurses will no doubt respond to government claims that any strike is irresponsible by asking why they think tax breaks for the well off are more important than paying them a living wage.) Big wage cuts will in itself reduce demand, but it will also lead to strikes across the public sector which will also be damaging. If we get another Covid wave this autumn/winter, the government will not provide the resources required to stop waiting times increasing still further, which among other things will reduce growth.

Fourth, the Bank of England will feel pressure to raise rates by more than they might otherwise have done to show that their gilt buying after Friday’s budget was not the monetary financing of tax cuts. The Bank was always going to try and neutralise any short run fiscal stimulus in the budget (although arguably they had already anticipated some energy support), but the fear now must be that they go further than that.

For all these reasons and more [3], a short term economic outlook for the UK that already looked grim just got significantly worse. At the best of times spending cuts matched by tax cuts are likely to reduce demand and output, because some of the tax cuts will be saved. However when the tax cuts benefit the better off, and may be reversed after a general election, the negative effect on the economy will be that much bigger because more of the tax cuts will be saved. This remains true if a large part of any spending cuts involve reduced welfare payments. The net result will no longer be a tug of war between fiscal and monetary policy, but instead both will be pulling the economy down. [4]

As I have pointed out many times, macro forecasting is a mugs game: the world is so unpredictable that unconditional forecasts are only ever right through luck. However what we can say is that the chances of a UK recession, which were already quite high, just got significantly higher, and the chances of a deep recession also increased. This is for an economy that is the only one of the G7 not to have regained pre-pandemic output levels. This will be the third time in the last twelve years that the UK government has made a recession much more painful than it needed to be, with austerity and failing to lockdown quickly during the pandemic being the other two.

How can a government keep doing so much damage? The answer for the recent budget is not difficult to find, but it all ultimately comes back to Brexit. First, as I have often stressed, Brexit was an excellent sorting device. Those politicians who followed the evidence lost out, and those that ignored evidence got into power. (As the pandemic showed, if you ignore the evidence on what determines international trade you are also likely to ignore evidence on how to best deal with a new virus.) The evidence that tax cuts for the well off certainly don’t increase growth, and might well reduce it, was never going to matter much to this government run by Brexiters.

Policy made by Brexiters was therefore always going to be fantasy-based policy. This is how to understand the government’s attack on ‘economic orthodoxy’. The orthodoxy they attacked with Brexit were two very robust empirical relationships: international trade’s gravity equation that says you trade most with your nearest neighbours, and additional bureaucracy in trading adds to costs and so inhibits trade. Equally the idea that cutting taxes on the rich reduces growth is not based on some arcane economic theory but instead comes from the data. For ‘orthodoxy’ read ‘evidence’. In addition the idea that since 2010 governments have been putting up taxes on the wealthy and on firms will come as news to George Osborne who did the opposite, and the UK’s economic decline started with or just before Chancellor Osborne.

But what determines the fantasy they push? What helped get us Brexit and what has had a major influence on policy ever since has been very rich party donors or newspapers owned by the very rich. The Mail cried “At last. A True Tory Budget” as the markets gave their emphatic thumbs down. What rich donors want from their political party are lucrative contracts (see the pandemic again) and tax cuts. The one major policy that Trump and a Republican Congress got done was tax cuts focused on the rich, and so it is hardly a surprise that a UK plutocracy would do the same. Truss/Kwarteng may well actually believe that cutting taxes for the rich is the key to unlocking growth, but they are where they are because they believe it.

Which brings us to the second reason why Brexit is the ultimate cause of the current debacle, which is that the ERG section of Tory MPs got Truss into the leadership run-off because she seemed closest to being a Brexit fanatic. (Converts often are the most devout.) She won that run-off because she said warnings from Sunak about the dangers of cutting taxes immediately were project fear, and that’s what the well off Brexit supporting Conservative party members wanted to hear.

But Johnson too was a convert to Brexit, so why is Truss so much worse. The warning signs should have been clear when Truss said she didn’t mind being unpopular if she was doing (in her mind) the right thing. Truss’s combination of right wing economics and socially liberal (libertarian) beliefs are shared by only a small section of the population, and previous Conservative leaders including Johnson understood that. Whatever their personal views they had to act as social conservatives and not make right wing economics their main story. Indeed Johnson started by saying austerity was over and increased some areas of public spending. In short, whatever their own views, previous Conservative leaders knew that they had to compromise to win elections.

In contrast Truss failed to adjust from trying to please one electorate (Conservative party members) to trying to please the wider electorate. [5] That was something Johnson could do easily because his only strong opinion was his own self-worth. In contrast Truss seems not only to believe the nonsense she is fed by right wing think tanks, but seems willing to pursue these very unpopular ideas in the belief that she will be vindicated in the long run. The market reaction to her Chancellor’s budget told her she will not be vindicated, and what the polls are reminding her is that she doesn’t have a long run. Unfortunately the UK economy will also pay the price of her mistake.

[1] The Bank was not buying government debt to ease monetary policy, but buying government debt the pension funds needed to sell. It was a classic ‘lender of last resort’ action, providing liquidity to otherwise solvent institutions. Ironically higher interest rates on government debt make pension funds more solvent rather than less in the long term, but their financial engineering proved dangerously unrobust to large market moves. Frances Coppola argues here that the Bank’s real concern was not pension funds but banks. On how pensions funds evolved over the last thirty years see here.

[2] The political problems for the government are obvious and have been discussed at length elsewhere. Cutting spending and taxes together is very unpopular outside parts of the commentariat, but cutting services that are already on their knees to fund tax cuts for the very rich is a political disaster. Higher interest rates, leading to lower house prices, are also a vote loser.

[3] The sterling depreciation increases import prices and inflation, adding to interest rate pressure. Normally that might be offset by higher exports, but after Brexit our export sector looks much weaker. Higher long term interest rates will also add additional deflationary pressure on firms.

[4] Kicking the can down the road on spending cuts would be best for the economy, if we assume a change in government after the election. Is it possible to cut spending without hitting the economy? They could scrap overseas aid, but that is too small on its own. Cutting defence procurement if those cuts meant not purchasing goods made overseas works, but this government is committed to increase defence spending. I cannot think of anything else. The easiest thing for the Chancellor to do is cut public investment, but that would also be the cut that would hurt growth the most, as Osborne found out in 2011/2.

[5] Many have made comparisons between the election of Truss and Corbyn: in both cases, it’s suggested, party members chose a leader that matched their views rather than those of the electorate. However the analogy ignores the 2017 election, when the combination of many social liberals accepting the referendum result and a left wing economic programme gained large support. As the diagram in this FT article makes clear, there is widespread support for left wing economic ideas, and almost none for those Truss is championing.