The last few weeks have been an extraordinary time in UK politics and in economic policy-making.
The currency and, more importantly, the bond market’s reaction to the 23rd September mini-Budget called time on the UK government’s unsustainable fiscal stance. It has led to a Chancellor resigning after only 38 days and to a Prime Minister and government teetering on the brink.
But this is not a stand-alone episode. It is the culmination of a few years in which economic expertise has been labelled by some as surplus to requirements. In 2016, most economists highlighted the likely negative economic impact of Brexit on UK economic growth through the impact of lower trade flows and inward skills migration on productivity. This was labelled as ‘Project Fear’ by many Brexit-supporting politicians. But, sadly for populist politicians, it appears that we do need experts after all.
To be clear, the difficulties of the last few weeks are not wholly attributable to Brexit. That particular dividend is still to come. So far, the economic data shows that the UK’s trade volumes have not recovered as quickly as continental Europe from the Covid shock, and our business investment flows have been very slow since 2016. It’s very likely that there is a Brexit effect there, but it’s too early to estimate the full impact.
If Brexit does, as most economists predict, lower our trend rate of growth in the next decade, it will make the current fiscal policy trade-off much more difficult to manage. If growth is slow, the increasing demands on public services will force an even higher tax burden even on middle income families.
Instead, the current UK crisis was triggered by an excessively imprudent mini-budget, which was also poorly executed. The then Chancellor and the UK Government signalled clearly what kind of budget they were planning: new major short-run spending promises to protect households from the energy price increases, but also unfunded and open-ended tax cuts and reversals of previously announced tax and national insurance increases. It was clear that this would make it impossible to meet the previous administration and Chancellor’s aim to bring the debt to GDP ratio down in the medium-term. But it was also poorly executed.
The incoming administration took a number of measures which signalled that any expert voices providing contrary advice would not be listened to. The Permanent Secretary to the Treasury was effectively sacked, the Bank of England’s Monetary Policy Committee (MPC) were not briefed on the government’s fiscal plan ahead of their crucial interest-rate decision meeting, and the Office for Budget Responsibility (OBR) were told they didn’t need to opine on a mini-budget that was a major departure from previous fiscal plans. We should not be surprised that the markets reacted to this uncertainty, and were already on edge prior to the mini-budget announcements.
The Government now has a very difficult hand to play. The Institute for Fiscal Studies has highlighted the size of the challenge in their update last week and today’s commentary. The OBR in Spring 2022 had forecast that the previous government’s plan to bring down public sector net debt as a proportion of GDP was going to be met by a margin of just under £30bn.
The costs of the energy price guarantee (net of the energy profit levy) will be substantial, even with the (new) Chancellor’s decision to unwind the scheme after six months rather than two years. But you can imagine the political sensitivities around this if energy prices don’t begin to fall next year.
In addition, public sector inflation has eroded the value of budgets for key public services, and higher interest rates will increase the debt service burden compared to the OBR’s March forecast. The IFS forecast that by 2023-24 debt service will be £103bn relative to the £51bn forecast by the OBR in March.
Lower tax, lower spend
The tax cuts and reversals of tax increases add to the unsustainable fiscal mix. The IFS estimates – based on the Citi forecast for the UK economy – that total government revenues in 2024–25 would be £32bn lower than the OBR forecast in March. The precise figures are very sensitive to the GDP growth forecast, of course. A 0.5% faster or slower economic growth rate between now and 2026-27 can account for £56bn of a difference. This highlights why re-booting growth for the UK economy is so crucial to fiscal sustainability, especially as interest rates are increasing. This is also why, if Brexit exerts a drag on the UK’s economic growth, it could be damaging to public services.
The decisions from Jeremy Hunt as the new Chancellor confirm that everything is in play in attempts to restore confidence. Almost all of the proposed tax cuts have been scrapped, and the Chancellor has signalled that departmental spending limits will be revisited. It is possible that capital spending budgets will be raided as happens in many emergency budgets. That of course may not be the smartest move in terms of adding to economic growth, but it’s a well-trodden path.
But there may be a silver lining here. This may be a wake-up call that populist policies need to pass the credibility test when it comes to foreign exchange and bond markets. Except in autocracies which isolate themselves economically from the rest of the world such as the Soviet bloc did in the post-war era, this is a binding constraint. In general, the smaller the country the tighter the external constraint (unless you have a large accumulated sovereign wealth fund as a buffer). As a populist government you can control many facets of domestic markets, but you cannot regulate foreign creditors.
The financial journalist Frances Coppola on her Twitter feed yesterday reminded me of a 1989 paper by the economists Rudiger Dornbusch and Sebastian Edwards. In it they warned against the ‘macroeconomics of populism’. In it they highlighted that in Latin America in the 1980s many populist leaders were irresponsible. They sought to address social injustices but did it through profligate fiscal policies. This resulted in balance of payments crises and debt defaults which ended up in policy reversals, and which aggravated those very social injustices which they sought to overcome.
In the 30 years since that contribution, the populism of both the left and right has had occasionally to come to terms with the limits of poorly thought-out policies that defy basic economics. Let’s hope that the UK’s current plight may result in better policy-making. There are lessons here for the UK but also for many other countries.
Featured image of Liz Truss: Policy Exchange (https://flic.kr/p/dQF6X5, resized, CC BY 2.0 https://creativecommons.org/licenses/by/2.0/)
Further reading: Liz Truss versus The Markets Douglas Fraser, BBC Scotland business and economy editor; A response to the mini-budget reversals, IFS; Good riddance to Trussonomics, FT; A massive day in politics north and south of the border, Fraser of Allander Institute (various):