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.