Wishful thinking on UK inflation

 

I have been surprised by the extent and persistence of UK inflation over the last few months, along with many others. So what did I get wrong?

Why is UK inflation so persistent?

Let’s start by looking for clues. The biggest is that inflation is proving more of a problem in the UK than elsewhere. Here are a couple of charts from Newsnight’s Ben Chu. The UK has the worst headline inflation in the G7

and the worst core inflation (excluding energy)

That Brexit would make Inflation worse in the UK than other countries is not a surprise. I talked about this over a year ago, although back then US core inflation was higher than in the UK. In that post I listed various reasons why Brexit could raise UK inflation (see also here). Could some of those also account for its persistence?

The one most commonly cited is labour shortages brought about by ending free movement. Here is the latest breakdown of earnings inflation by broad industry category.

Annual earnings growth	Jun/Aug 22	Feb/Apr 23
Wholesale, retail, hotels and restaurants	7.5%	5.1%
Construction	5.1%	6.4%
Manufacturing	4.6%	7.0%
Finance and business services	6.0%	9.2%
Private sector	6.3%	7.6%

Around the middle of last year the labour scarcity story was clear in the data. One key area where there was a chronic shortage of labour was in hotels and restaurants, and wage growth in that sector was leading the way. However if we look at the most recent data, that is no longer the case, and it is finance and business services where earnings growth is strongest. This dovetails with a fall in vacancies in the wholesale,retail, hotels and restaurant sectors since the summer of last year (although the level of vacancies remains above end-2019 levels). Has there been a recent increase in vacancies in finance and business services? No, the explanation for high earnings growth in that sector lies elsewhere.

Before coming to that, it is worth noting that any earnings growth numbers above 3-4% are inconsistent with the Bank’s inflation target, and the labour market does remain tight, although not as tight as a year ago. One partial explanation for UK inflation persistence is that it reflects the consequences of persistently high (in excess of 3-4%) wage inflation, which in turn reflects a tight labour market.

UK price inflation is no longer just a consequence of high energy and food prices, as this breakdown makes clear.

While energy and food prices are still higher than average inflation, the most worrying line from the Bank's point of view is the green one for inflation in all services. It is this category where inflation is (slowly) increasing, and the latest rate of 7.4% is the main reason why UK inflation appears to be so persistent. It is no longer the case that UK inflation is being generated by external factors that cannot be influenced by the Bank of England. That is also why it can be a bit misleading to talk about inflation persistence or sticky inflation, because the prices that are going up now are not the same as were going up just a year ago.

This high level of services inflation could be a response to high nominal earnings growth, with perhaps still some lagged effect from higher energy costs [1], but recent data for profits suggests a third factor involved. Here is the share of the operating surplus for corporations (i.e. corporate profits) to GDP since 1997.

UK Profit Share

Apart from a spike in the first quarter of the pandemic, this measure of the profit share has stayed below 24% since 2000, averaging about 22% between 2000 and 2022. However the end of 2022 saw this share rise to 22.5%, and the first quarter of this year saw a massive increase to 24.7%. We have to be careful here, as this sudden increase in the profit share could be revised away as better data becomes available. But if it is not, then it looks as if some of the recent persistence is coming from firms increasing their profit margins.

Why might firms be increasing their profit margins? This might not be unexpected during a period where consumer demand was very buoyant, but with the cost of living crisis that isn’t happening. It may be that firms have decided that an inflationary environment gives them cover to raise profit margins, something that seems to have happened in the US and EU. However another factor is Brexit once again. EU firms now face higher costs in exporting to the UK, and this may either lead them to withdraw from the UK market altogether, or to try and recover these costs through higher prices. Either way that allows UK firms competing with EU firms in the UK market to raise their prices. If you look at what I wrote a year ago, that effect is there too, but it was impossible to know how large it would be.

What is to be done?

The mainstream consensus answer is to use interest rates to keep demand subdued to ensure wage and domestically generated price inflation start coming down. It doesn’t matter if the inflation is coming from earnings or profits, because the cure is the same. Reducing the demand for labour should discourage high nominal wage increases, and reducing the demand for goods should discourage firms from raising profit margins. In this context, the debate about whether workers or firms are responsible for current inflation is beside the point.

That does not necessarily imply the Monetary Policy Committee of the Bank was right to raise interest rates to 5% last week. Indeed two academic economists on the MPC (Swati Dhingra and Silvana Tenreyro) took a minority view that rates should stay at 4.5%. I probably would have taken that minority view myself if I had been on the committee. The key issue is how much of the impact of previous increases has yet to come through. As I note below, the current structure of mortgages is one reason why that impact may take some time to completely emerge.

That demand has to be reduced to bring inflation down is the consensus view, and it is also in my opinion the correct view. There is always a question of whether fiscal policy should be doing some of that work alongside higher interest rates, but it already is, with taxes rising and spending cuts planned for the future. Increasing taxes further on the wealthy is a good idea, but it doesn’t help much with inflation, because a large proportion of high incomes are saved. An argument I don’t buy is that higher interest rates are ineffective at reducing demand and therefore inflation. The evidence from the past clearly shows it is effective.

For anyone who says we should discount the evidence from the past on how higher interest rates reduce demand because the world is different today, just think about mortgages. Because of higher house prices, the income loss of a 1% rise in interest rates is greater now than it was in the 70s or 80s. Yet because many more people are on temporarily fixed rate mortgages, the lag before that income effect is felt is much greater, which is an important argument for waiting to see what the impact of higher rates will be before raising them further (see above). There is however one area where the government can intervene to improve the speed at which higher interest rates reduce inflation, which I will talk about below.

With the economy still struggling to regain levels of GDP per capita seen before the pandemic [2], it is quite natural to dislike the idea that policy should be helping to reduce it further. This unfortunately leads to a lot of wishful thinking, on both the left and the right. For some on the left the answer is price controls. The major problem with price controls is that they tackle the symptom rather than the cause, so as soon as controls end you get the inflation that was being repressed. In addition they interfere with relative price movements. They are not a long term solution to inflation.

Sunak at the beginning of the year made a deceitful and now foolish pledge to half inflation. It was deceitful because it is the Bank’s job to control inflation, not his, so he was trying to take the credit for someone else’s actions. It has become foolish because there is a good chance his pledge will not be met, and there is little he can do about it. When challenged about making pledges about things that have little to do with him he talks about public sector pay, but this has nothing to do with current inflation (see postscript to this)! As I noted last week, the Johnsonian habit of lying or talking nonsense in public lives on under Sunak.

The idea among Conservative MPs that mortgage holders should somehow be compensated by the government for the impact of higher interest rates is also wishful thinking on their part, reflecting the prospect of these MPs losing their seats. While there is every reason to ensure lenders do everything they can for borrowers who get into serious difficulties, to nullify the income effect of higher mortgage rates would be to invite the Bank to raise rates still further. [3] Sunak cannot both support the Bank in getting inflation down and at the same time try and undo their means of doing so. In addition there are other groups who are in more need of protection from the impact of inflation than mortgage holders.

Another argument against high interest rates is that inflation today reflects weak supply rather than buoyant demand, so we should try to strengthen supply rather than reduce demand. Again this looks like wishful thinking. First, demand in the labour market is quite strong, and there are no clear signs of above normal excess capacity in the goods market. Second, the problems we have with supply - principally Brexit - are not going to be fixed quickly. To repeat, it is the domestically generated inflation rather than the external price pressures on energy and food that represent the current problem for inflation.

A similar argument relates to real wages. People ask how can nominal wage increases be a problem, when real wages are falling and are around the same level as they were in 2008? Part of the answer is that, as long as the prices of energy and food remain high, real wages need to be lower. (The idea that profits alone should take the hit from higher energy and food prices is ideological rather than sound economics.) Because higher energy and food prices reduce rather than increase the profits of most firms, they are bound to pass on higher nominal wages as higher prices.

Yet there is one new policy measure that would help just a little with the fight against inflation, and so help moderate how high interest rates need to go. As I noted earlier, the sector leading wage increases at the moment is finance and business services. In finance at least, some of this will be profits led because of bonuses or implicit profit sharing. Bank profits are rising for various reasons, one of which is that the Bank of England is paying them more for the Bank Reserves they hold. There is a sound economic case for taxing these profits whatever is happening to inflation, and the fact that higher taxes on banks could help reduce inflationary pressure is a bonus right now.

What did I get wrong? Just how bad the state of the UK economy has become.

While the Monetary Policy Committee (MPC) of the Bank of England may have underestimated the persistence of UK inflation, I have for some time been arguing that the Bank has been too hawkish. On that, MPC members have been proved right and I have been wrong, so it is important for me to work out why.

A good part of that has been to underestimate how resilient the UK economy has so far been to the combination of higher interest rates and the cost of living crisis. I thought there was a good chance the UK would be in recession right now, and that as a result inflation would be falling much more rapidly than it is. It seems that many of those who built up savings during the pandemic have chosen (and been able) to cushion the impact of lower incomes on their spending.

But flat lining GDP, while better than a recession, is hardly anything to write home about. As I noted above, UK GDP per capita has yet to regain levels reached in 2018, let alone before the pandemic. If the UK economy really is ‘running too hot’ despite this relatively weak recovery from the pandemic, it would imply the relative performance of the UK economy since Brexit in particular (but starting from the Global Financial Crisis) was even worse than it appeared just over a year ago. If I am being really honest, I didn’t want to believe things had become that bad.

This links in with analysis by John Springford that suggests the cost of Brexit so far in terms of lost GDP may be a massive 5%, which is at the higher end (if not above) what economists were expecting at this stage. If in addition the UK economy is overheating more than other countries (which is a reasonable interpretation of the inflation numbers), this number is an underestimate! (UK GDP is flattered because it is unsustainable given persistent inflation.)

Of course this 5% or more number is really just our relative performance against selected other countries since 2016, and so it may capture other factors beside Brexit, such as bad policy during the pandemic, chronic underfunding of health services and heightened uncertainty due to political upheaval detering investment.

In thinking about the relative positions of aggregate demand and supply, I did not want to believe that UK supply had been hit so much and so quickly since 2016. [4] The evidence of persistent inflation suggests that belief was wishful thinking. It seems the economic consequences of this period of Conservative government for average living standards in the UK has been extraordinarily bad.

[1] The UK was also particularly badly hit by high energy prices.

[2] In the first quarter of this year GDP per capita is not only below 2019 levels, it is also below levels at the end of 2017!

[3] Higher interest rates do not reduce demand solely by reducing some people’s incomes. They also encourage firms and consumers to substitute future consumption for current consumption by saving more and spending less. However with nominal interest rates below inflation, real interest rates so far have been encouraging the opposite.

[4] I probably should have known better given what happened following 2010 austerity. While it is hard for politicians to significantly raise the rate of growth of aggregate supply, some seem to find it much easier to reduce it substantially.

Sunak is right to fear the Covid Public Inquiry, but the right wing press will remain unscathed by it

 

My rule of thumb for this government is if it trumpets that it’s doing something, it is probably doing the opposite. [1] George Osborne kept saying he had a ‘long term economic plan’ but in reality he kept changing rules to try and wrong foot the opposition for short term political advantage. May’s ‘strong and stable’ government was weak and volatile. When Johnson said he was going to ‘get Brexit done’, what he actually did was negotiate a deal that he intended to renege on almost immediately. When Sunak said he would lead with integrity, he meant he would lead with only slightly more integrity than Johnson. It is quite an effective political strategy for a media more interested in what politicians say than do, until it is found out.

One of the best examples was during the pandemic, when the government declared it was ‘following the science’. We soon realised this wasn’t true as the second wave began to gather force in the autumn of 2020. SAGE recommended a (temporary) lockdown but Johnson refused, under pressure from Sunak in particular. An early lockdown that got R<1 (R is the number of people on average a person with Covid infects) would have greatly reduced the loss of life from that second wave and reduced the length of time a lockdown was required, thus benefiting the economy as well. As I wrote repeatedly at the time, the health/economy trade-off that the government kept talking about is another example of my rule of thumb: there was no trade-off, because reducing R helps rather than hinders the economy.

We now also know that Sunak’s ‘Eat Out to Help Out’ scheme was never discussed by SAGE, the committee of experts advising the government. It is easy to ‘regularise’ this by suggesting it’s a typical example of government departments worrying about their own pitch and not talking to other departments (which is obviously true - see this Institute for Government study for example), but the failure went well beyond this. The Treasury is full of very bright people, and if I can work out that controlling Covid is just like controlling inflation, so can they. The scheme was bound to raise R, so they needed SAGE’s input to assess how much it would do so. That they didn’t bother suggests ministerial direction from Sunak.

SAGE member John Edmunds says “it was a spectacularly stupid idea and an obscene way to spend public money.” A study by Thiemo Fetzer in the Economic Journal found that the scheme was effective at getting people back into restaurants, and as a predictable result helped increase the spread of Covid by a significant amount. The Treasury line - that the scheme was successful at getting people into restaurants but had no impact on Covid infections - is just unbelievable. How exactly do they think Covid spreads! Whereas in the autumn of 2020 he just encouraged Johnson to make a choice that killed many unnecessarily, in this earlier case Sunak is directly responsible for some of the lives lost in the epidemic.

In these two cases ‘following the science’ either means ‘doing the opposite of what scientists suggest’ or ‘not wanting to ask the scientists because we will not like their answer’. We know less about what ‘following the science’ really meant in the early months of the pandemic. We know that Johnson was keen on herd immunity, but to what extent were SAGE consulted about possible alternatives to that strategy? Here Edmunds says

“We were asked questions and gave scientific answers but we didn’t know what strategy was being discussed by the government. It was written by them and we saw it the same day that the press saw it. They never said: ‘Here’s the strategy, what do you think of it?’ That’s not how it worked and that is why it’s always been so misleading for the government to pretend that it was following science. That’s just nonsense.”

The idea of herd immunity came from plans for milder pandemics, which were not severe enough to warrant lockdowns. But from Edmund’s account it seems that SAGE were never asked if this was the right strategy for this pandemic, once fatality rates were known. It seems the responsibility for looking at alternatives to herd immunity far too late rests somewhere between Johnson, his ministers and political advisors, together with Chris Whitty and Patrick Vallance.

Given Sunak’s central role in at least two of these three major errors during the 2020 pandemic, it is little wonder that he is trying to withhold information from the official Covid Public Inquiry. He is unlikely to succeed, but his aim may simply be to delay any damaging news until after the next election. The excuse that he was just looking after his ministerial interests is hardly likely to go down well when many lives were unnecessarily lost as a result of his advice and decisions. In any case the economy was worse off too, and he chose to ignore or go against the government’s own experts. Once upon a time a minister that got things this badly wrong (costing lives as well as money) would have resigned without having to be asked, and it tells us a great deal about the current Conservative party that he is now Prime Minister.

One reason for that, and unfortunately an issue that is unlikely to be central to the Public Inquiry, is the role of the right wing press. These newspapers very quickly decided that lockdowns were a bad idea, and they used their influence to promote that idea. That they did so tells you a great deal about what motivates the policies they promote. Losing money because less people were buying their papers was more important to their owners and editors than that scientific opinion was almost unanimous in saying that lockdowns before a vaccine was available saved lives. [2] The newspapers promoting this anti-lockdown agenda were prepared to see many of their readers die as a result of their advice. Their campaign to remove what has for centuries been a last resort of pandemic control continues to this day.

The right wing press has a considerable influence on what is discussed in the broadcast media. This meant far too much time was spent debating whether lockdowns were a good idea, and far too little discussing why quick and stringent lockdowns are much more effective (and much less costly in economic terms) than delayed or ineffective restrictions on social interaction. The right wing press has even more influence on Conservative MPs, and those working for them. It is part of the reason there were illegal parties in Downing Street and CCHQ. It is a key reason why too many Conservative MPs were opposed to lockdowns, and ministers (including the current and former Prime Minister) delayed imposing them at huge cost.

That the right wing press has such power with little or no responsibility or accountability is a familiar observation, but one that cannot usually be so directly linked to so many deaths. If the Covid Public Inquiry criticises either Johnson or Sunak for contributing to the UK’s relatively high death toll, Baroness Hallett will be taking on not just the Conservative party but also its newspaper wing.

With Johnson no longer an MP, it is in the interests of Sunak and the Conservative party to use him as a scapegoat. Corruption and sleaze, mistakes during the pandemic, and even the failures of Brexit can somehow be presented as a purely down to Johnson. Competence is back in charge, they will argue, after an embarrassing interlude involving an unfortunate fiscal event. The reality is, as my rule of thumb would suggest, quite the opposite. 

Conservative MPs and their press made Johnson leader despite his obvious unsuitability, Johnson’s Brexit was backed by Sunak and every Conservative MP before the 2019 election, these same MPs ignored the government’s own advice to wear masks in parliament’s chamber, it was Sunak as well as Johnson that made the wrong calls during the pandemic, it is Sunak who waved through Johnson’s honours list that included those who partied during lockdown restrictions, and it is Sunak and many Conservative MPs who dare not vote for the recommendations of the report that led to Johnson's departure. Johnson was adept at portraying his government as quite unrelated to the Conservative government that preceded him. It was nonsense then and it is nonsense for the government Sunak leads. As we shall see, Sunak has a great deal to fear from the Covid Public Inquiry. 

[1] As ever, this is borrowing from the US right. ‘Fair and balanced’ is the motto of Fox News. Trump’s version of twitter is called ‘Truth Social’.

[2] Scientific opinion is near unanimous in part because of the following simple logic. First, lockdowns reduce the social interaction that spreads the disease. Second, it makes sense to reduce infection as much as possible before a vaccine becomes available. Together this means lockdowns saved many thousands of lives during the pandemic.

The campaign against Labour borrowing to invest

 

One of the positive highlights of Labour's economic plans that I discussed last week, investment of £28 billion a year in greening the economy, has been scaled back. That figure will now only be achieved in the second half of a Labour government’s first five years. One reason given is that it will take time to get such investment going, which sounds reasonable but raises the question of why this point wasn’t understood when the original policy was announced.

Unfortunately the announcement has also been explained in terms of Labour’s commitment to meeting its fiscal rules, and the poor state of the economy created by the Conservatives. This echoes a campaign that has been getting an increasing amount of press, even in the neutral and sympathetic (to Labour) media.

So in the FTs recent analysis of Labour’s economic programme, we find this quote from Mike Riddell, a global bond fund manager at Allianz Global Investors: “Any additional unexpected borrowing risks another gilt meltdown.” Unexpected? Riddell says they have not been fully “priced in” by investors and could make investors “jittery” as they become headline news. If you believe that you will believe anything (as many people did in 2010).

Or this from New Statesman editor Jason Cowley, in an article on Reeves:

“Miliband led Labour to defeat in 2015 and concern is growing that he has inadvertently set a trap for his party – because Starmer and Reeves have not explained how they would fund the proposed £28bn a year for capital spending on green growth”.

In reality it is clear that public investment will be matched by additional borrowing, not higher taxes. The IRA in the US was financed from taxes because of daft budget rules imposed by Congress.

That Labour have partly succumbed to this campaign is bad news for two main reasons. First, by implying that fiscal rules come before anything else, they elevate the importance of these rules way beyond any reasonable assessment. Are these rules really more important than the survival of the planet and avoiding another energy crisis? Second, it plays into some of the worst aspects of mediamacro, which uses adherence to fiscal rules (however daft those rules are) as a measure of economic responsibility, and takes talk of jittery bond markets far too seriously.

This all goes back to a contradiction in the fiscal rules set out by Rachel Reeves, and many before her (including John McDonnell). The contradiction is between the laudable attempt to have rules that distinguish between current public spending and public investment, and at the same time having a target for a falling debt to GDP ratio (which makes no distinction between debt used to fund investment or current spending). I have long argued that the falling debt to GDP target is a bad fiscal rule, but even John McDonnell felt he had to include it for political/media reasons against my advice.

Unfortunately, the campaign to reduce the amount Labour would invest in greening the economy will only be encouraged by this announcement, and a media obsessed with fiscal responsibility will continue with that obsession. Unfortunately, just as the Global Financial Crisis gave spurious credibility to scare stories about the UK being 'on the brink' in 2010, what happened to Liz Truss and Kwasi Kwarteng has done the same for those campaigning against a Labour government borrowing today. Virtually everyone in the media has taken what happened to the ill-fated ‘fiscal event’ in September 2022 to be evidence that the bond vigilantes are real and just waiting to pounce on any government that borrows too much, whatever that means or whatever that borrowing is for. Even some economists have done so. In this FT article, Philip Coggan is sensible enough to note that most of the time markets take increases in deficits in their stride, as long as a country has its own central bank. But just occasionally, he says, markets do worry about them. What evidence does he give for this? The Truss/Kwarteng fiscal event. We seem to be back to treating financial markets as a Vengeful God, who we have to appease just in case they are in a bad mood.

It was why I looked at that episode in great detail, arguing that the market reaction had nothing to do with the chances of UK default, and everything to do with uncertainty over the path for future interest rates. By announcing tax cuts without also announcing by how much and (crucially) when public spending would be cut, the impact on demand and therefore the reaction of the Bank of England became much more uncertain, raising the risk premium on UK assets. [1]

But such a story is way too complicated for anyone in our 24hr media circus, so far easier to think that markets were just reacting to more borrowing. This is even though Kwarteng was committed to reducing the debt to GDP ratio, and said that spending cuts would follow. Easier in part because you will always find economists (particularly in the City) to start talking about nervous markets, as we saw above.

It makes sense to borrow to invest. I get tired of writing this because it really should be common knowledge. Every economist worth their salt would agree with this. Even Rogoff, who encouraged 2010 austerity in the UK, made it clear that he didn’t mean cutting public investment. (A large part of austerity in 2011 and 2012 involved cutting public investment.) Investment benefits current and future tax payers, so it makes sense for future taxpayers to pay as well as current taxpayers. Firms borrow to invest all the time. Consumers borrow to invest in a house. Yet when it’s a Labour government, or a Tory government that wants to cut spending, then suddenly all this common sense goes out the window and we hear instead about market jitters. If you really think the Truss/Kwarteng crisis was about too much borrowing, note that they were borrowing for tax cuts, not investment in the future. [2]

But what should make any sensible person, and not just economists, angry is that this is a coordinated attempt to cut back on green investment. Investment that is vital to save our planet as we know it. What could be more important than that? What is more, this investment will have the added benefit of making energy cheaper, at a point when the UK has had its worst cost of living crisis in decades as a result of high oil and gas prices. The US government is spending large sums to get this done, and the EU is doing the same. What kind of nonsense says the UK shouldn’t do the same?

The Tories, whatever Labour say, are bound to talk about a 'borrowing bombshell' before and after the next election. A solid and convincing response is that Labour are only borrowing to invest, and investing in worthwhile public projects is essential for growth, and never fiscally irresponsible. What could be more essential than green investment to make energy cheaper, as the US and EU are doing? That is a clear line to take, and also happens to make good economic sense. If you can associate 'investment' with borrowing in voters minds you undermine a lot of mediamacro's rhetorical power. That could have been Labour's line to take. When the media say 'how do you know the markets will not turn on you like they did on Truss/Kwarteng', the answer is they were borrowing to fund tax cuts, while we are borrowing to invest, just as firms and home owners do. Unfortunately now Labour have said spending £28 billion on worthwhile investment in its first few years would have been fiscally irresponsible, and could damage the economy. They have undercut what would have been a sound defence in economic and political terms to the borrowing bombshell attack, and the 'what about the markets and Truss' attacks. Rather than shore up the £28 billion pledge, they have opened the door to further attack.

[1] Further uncertainty was created by the credibility (or rather lack of it) of any announced spending cuts, given the dire state of public services and public sector pay. The key bit of evidence here is that sterling depreciated. If the prospect had simply been higher interest rates, sterling would have appreciated.

[2] The claim that Kwarteng's tax cuts are not unlike Labour's £28 billion pledge because the former included incentives to invest does not stand up. Kwarteng's tax cuts were mainly (in £ terms) lower corporation tax and lower national insurance contributions. The latter does not encourage investment and the extent to which the former does is very uncertain.

Rachel Reeves economic strategy

 

On 23rd May Labour’s Shadow Chancellor, Rachel Reeves, gave a speech in Washington DC and published a paper entitled “Labour’s plan for a stronger economy”. As Martin Kettle notes, it is something of a myth that political speeches are important. In addition, because speeches about economic policy are highly political and of the moment, they are generally frustrating to read for an academic economist. I understand, for example, why stressing that Labour would deliver economic security (“securonomics”!) makes a lot of political sense, but it has obvious problems as the basis of an economic strategy.

Having said that, I think this speech, and the paper that goes with it, does deserve serious discussion, not least because it may form the basis of the next government’s economic strategy. To what extent is this similar or different, for example, to the economic strategy introduced by Blair and Brown in 1997? What does it take or discard from neoliberalism? The two questions are, of course, interconnected.

The Role of Government

To answer the second question first, it clearly sees a much greater role for the state than neoliberalism ever did. Of course the state is important under neoliberalism. It upholds property rights for example. Some might argue that neoliberalism also allows the state to correct market failures, although in practice there is a tendency to diminish the true extent of those failures. But generally neoliberals want to diminish the role of the state in what they would call ‘interfering’ with markets.

Reeves argues that states always shape markets, and good governments consider how they should do so. To quote:

“As the economist Mariana Mazzucato has long argued, the state’s role is not simply to correct the failures and redress the negative externalities of free markets. It is a myth that the private sector alone can set a country up to take advantage of new opportunities. Success has always rested upon a partnership between the market and the state. The market can see what our current advantages are, but not necessarily what they could be in the future. It is not all that long ago that South Korea’s comparative advantage was in agriculture. Today, with far-sighted government action in partnership with a vibrant market, it is an advanced economy with cutting edge industries.”

Later on, in discussing what Janet Yellen describes as the ‘new supply side economics’, she writes:

“it places the government in partnership with the private sector, with the state creating the foundations on which a dynamic market can build. It means using the power of government to do what only government can do, while allowing business to do what it does best: innovating, competing and generating wealth.”

Such an approach is clearest, and largely unproblematic, in what Mazzucato’s calls missions. Labour’s radical proposals for large scale public investment in green energy, like Biden’s Inflation Reduction Act, can be thought of as a mission to get cheaper and sustainable energy, which involves public investment or government incentives in a wide range of industries, some of which will help achieve this mission and some which may end up failing to do so. An important part of missions is that overall success gives political cover to particular failures, where those failures are only obvious in hindsight.

Missions may also be a means of circumventing inappropriate rules or definitions. A good example is preventative health, which is one case considered in a nice article by Sam Freedman about why some policies that almost everyone agrees are a good idea never happen. Most people agree we should spend more money on preventing people getting ill, so that in future we (probably) need to spend less money on treating those illnesses. (See this interview by the FT’s Sarah O’Connor of Andrew Scott, for example.) Yet, to quote Freedman, “since 2015/16 the public health grant to local authorities – the main budget for preventative health - has fallen by 24% in real terms, even as overall healthcare spending has continued to rise.”

The problem is that governments find it easier to cut spending where those who lose out are diffuse and probably unaware of the cuts because benefits take time to emerge, than to cut spending with very immediate and specific pay-offs. It may require a mission to overcome those political incentives.

Growth

Things get trickier in what Reeves describes as “the mission for growth”. Some ways higher growth can be achieved are not problematic or contested, like improving education and skills. Others raise obvious questions, like how will an industrial strategy prioritise between industry and sectors? She herself criticises

“the idea that the people, businesses and places which contribute to a strong economy are few in number. This misconception suggests that all we need are a few dynamic cities and a few successful businesses to thrive. The usually unspoken implication of this is that the contribution of most people, most places and even most businesses simply does not matter. The result of this has been a paucity of ambition for too many places. The policy implication has been that nations have focused on maximising the national growth rate by growing the already prosperous regions, like London, hoping that economic gains will then trickle out to the rest of the country. As a result, a wide gap has grown between the most dynamic businesses, at the frontier of new technology, and the rest. It has also led to a neglect of what I call the ‘everyday economy’. The parts of the economy which provide the basics for a good life, strong communities and economic security – like childcare, social care, retail, hospitality and supermarkets – have been forgotten.”

This makes a lot of sense, but it elides a likely tension between achieving the maximum return from public money (in terms of higher growth), which will come from backing proven national successes, and spreading that money more widely in terms of regions (‘levelling up’) and supporting the everyday economy.

One way of resolving that tension is to create institutions with specific and well designed remits (like, perhaps, Labour’s proposed “national wealth fund”). Such delegation is unpopular with some because they imagine their favoured politicians as some kind of benign dictator who makes the right calls, and that the democratic process will ensure that those politicians will succeed. But this process is highly imperfect, as the lack of funding for preventative health illustrates, and is open to corruption, as the recent allocation of money for levelling up shows.

The recognition in the paper that market concentration has increased over the last two decades, and this reduces competition which is the “engine of productivity”, is welcome. One way to counteract that is to make it easier to start up new businesses, and there is a commitment in the paper to do that. The paper also talks about stopping the planning system holding back new investment. The importance of devolving power to allow regionally based growth plans is acknowledged, which is important as the department that Reeves hopes to run - the Treasury - is the major obstacle here.

Of course one key factor in reducing competition in the UK right now is Brexit, which also reduces the size of the market for new businesses. The potential size of the market can be a crucial factor in influencing investment and the supply side. As I have noted elsewhere, the paper’s desire to reduce trading frictions with the EU but to stay outside the EU’s customs union and single market is to a considerable (but not complete) extent a contradiction, but a contradiction that time should resolve.

Another area where there will be tensions with the ‘mission for growth’ is globalisation. For decades governments (and the UK in particular) have largely discounted the idea that issues of national security should be allowed to compromise growing globalisation (in trade, investment and ownership), but Reeves argues that this is changing. She writes that it is important that “that the government identifies the industries that are vital to its national interests and which need public backing”. In part this is doing what multinational firms themselves are beginning to do, which is to take more account of the risks of supply chain disruption because of international political disputes. As ever the trick here is to strike the right balance.

The stress of higher public investment, an active industrial policy and much else shows that we are not seeing a repeat of the Blair/Brown programme. To New Labour neoliberalism looked like a success story in boosting the UK’s relative economic performance, so much of what Thatcher did was preserved. Today the opposite appears true.

Fiscal rules and tax

The paper, which contains nearly 20 pages of text, contains just 6 lines on fiscal rules. That is as it should be, because fiscal rules are not nearly as important as improving economic prosperity and ensuring everyone benefits from it. (A detailed statement about fiscal policy, including how it will support the economy in recessions, can wait until Labour are in government, just as Labour did in 97/8.) Yet our media is and always has been obsessed by the idea that meeting fiscal rules is a key indicator of economic competence, and that in turn means that politicians will be as well.

A good example of that is this story, about how some shadow ministers want part of Labour’s £28bn green fund of public investment to be on infrastructure projects that have little to do with greening the economy. This story only makes sense if a future Labour government operates a form of fiscal rule that places an explicit or implicit cap on the amount of public investment. (This government had an explicit cap in the past.) Without such a cap, if an investment project generates a good social rate of return it should be funded in its own right, and there is no need to reduce other forms of public investment to make way for it.

Hopefully the emphasis Reeves puts on public sector net worth rather than debt (see also Andy Haldane here, and the party’s 2019 manifesto) should mean that a Labour government avoids having to ration good public investment of any kind. Better still would be to eschew any targets for stocks (net wealth or debt) and just have targets for flows (the current deficit), but just as Shadow Chancellor John McDonnell found that politically impossible to do, I fear that may also be true for Chancellor Reeves. I have written about what are good and what are bad fiscal rules elsewhere, and will not repeat that discussion here.

However I doubt a future Labour government will have its ambitions seriously compromised by its fiscal rules, in much the same way as the pitiful state of our public services after 13 years of Conservative government is not primarily because they chose bad fiscal rules. What has been more important in causing that damage is the obsession of Conservative governments with cutting taxes. Equally, what is most likely to stifle Labour’s ambitions is a reluctance to raise taxes, and thereby improve public services.

Another difference between the next election and 1997 is that back then Labour thought it needed to stick to Conservative spending plans to demonstrate their economic credibility. In contrast today, outside the shrillness of what Tim Bale calls the Conservative ‘party in the media’, most cannot wait for an economically competent Labour government to return. But whereas in 1997 the state of public services was just very poor, today they are in a critical state, and in at least one area that is having a macroeconomic impact. Labour could take a leaf out of Osborne’s playbook, do the unpopular thing of raising taxes as soon as they gain office, and this will make everything else that much easier.