In my last post, published on Sunday, I suggested that the British prime minister Liz Truss and her Chancellor Kwasi Kwateng should have been pleased with how their budget was going down. The messaging was clear, and the opposition response muddled. By Monday, though, the story had moved on. Bond and currency markets were giving the statement a spectacular thumbs down, and there was a whiff of panic in the air. The panic has passed, but it is evident to almost everybody that the pair have dug their party into a very deep hole. Today the Bank of England announced that it would be forced to finance a portion of government debt through money creation. It’s not a good look.
The market rout begun on Friday, especially in the gilt markets – but on Sunday Mr Kwateng clearly felt things were going well enough to double down on his tax cutting plans, and suggest there were more cuts to come on. But by Monday he was forced to try and calm things down, with promises a proper plan for national debt. Faithful supporters have been doing their best to mount a rearguard action, though no minister has put their heads above the parapet. They have tried to deflect the currency problems onto the US dollar, which doesn’t explain the sharp devaluation since Friday, evident against even such currencies as the Turkish Lira. All suggested that there was more to come to make things better. Tory MP Andrew Bridgen suggested the government might like to cancel the flagship HS2 rail project; John Redwood, a veteran MP who is somewhat more economically literate, said that the government was about to reveal a tranche of supply-side reforms, so the markets hadn’t seen the full picture. These messengers were helped (on BBC radio at least) by the lack of economic grip of their interviewers, who did not press them on the obvious gaps in what they were saying. The BBC also helped when remarkable criticism came in from the IMF, by highlighting their comments on inequality -rather that the much more damaging criticism that the budget threatened to create a recession rather than head it off.
The darkening mood was no doubt caused by the prospects for mortgage rates. The reason that markets stabilised was that traders came to appreciate that interest rates would go up in reaction to the budget. Mortgage providers reinforced this point. Commentators quickly showed that increases to mortgage payments for homeowners would quickly overwhelm any extra cash coming from tax cuts. And this is a critical group to Conservative electoral prospects. The criticism by government supporters of the Bank of England not raising interest rates earlier (“asleep on the job” according to Mr Bridgen) doesn’t really help here. Once the government’s ability to finance itself comes into question it has no attractive option to dig itself out. Monetary financing at a time of inflation is hardly going to stabilise things. Reversing the tax cuts would be a humiliating retreat which could taint the Conservatives for a generation. Spending cuts on the scale needed would alienate a large part of the party’s base, as would letting interest rates rip (though a different part of that base). Supply side reforms would have to be big and spectacular to reassure markets. Release immigration controls? Re-enter the EU Single Market or Customs Union? Stop Russian sanctions and invite oligarch money back?
What makes things worse for the government is that they were warned well in advance. During his leadership campaign former Chancellor Rishi Sunak warned Conservative Party members that handling the energy crisis and making tax cuts did not go together. Ms Truss poo-pooed this as “Treasury orthodoxy” which had ended up in years of sub-standard growth. There is certainly a baleful aspect to Treasury orthodoxy that requires intelligent challenge – but the Treasury also has experience of navigating the treacherous world of government finance. FT columnist Janan Ganesh says that the government has fallen into the trap of trying to apply policies appropriate to the United States to a medium-sized archipelago whose currency is not used as a global reserve. Success in running British economic policy is a delicate balancing act which depends on maintaining confidence, not thumbing your nose at the rest of the world.
What of Labour? They can hardly believe their luck. The initial response was fumbled. They went on about the tax cuts for the rich (and the abstract idea of “trickle-down economics”) – leaving the much bigger charge of being reckless with the country’s finances muted. But by Monday, with their party conference in progress, they started to find their feet. Their shadow chancellor, Rachel Reeves, delivered a worthy speech, in which she gave emphasis to financial stability. She also started on an alternative growth narrative that did not depend on tax cuts – through green investment and such. It is important that the Tories are not allowed to win the growth argument by default, of which there was a distinct chance, so ruthless and repetitive has been their messaging.
This has been complemented by an orderly conference, with its leader, Sir Keir Starmer, clearly in control. Dissent has been modest. I listened to two interviews by senior members of the party’s socialist wing: John McDonnell and Diane Abbott. Neither created trouble (and Mr McDonnell was distinctly more in command thad than Ms Reeves). The party was able to develop a narrative of a government-in-waiting.
Still, there are two big problems with Labour’s stance. The first is that they lack an alternative fiscal policy. They only said that they would reverse the higher rate tax cut, which has little fiscal impact – and said would not reverse the national insurance and basic rate income tax reductions. So how would they try to fill the evident gap? We just got obfuscation. When challenged about how the party was would maintain spending on the NHS and social care, Ms Reeves suggested that there was no problem because Mr Kwateng said so. They are trying to accept the fiscal package and disown it at the same time. To be fair, they did not say anything about not increasing Corporation Tax, and they have suggested higher windfall taxes on energy companies. But surely they are going to need something more. Tony Blair and Gordon Brown, who the leadership would like to emulate, solved a similar problem in the mid 1990s by adopting an austerity stance on spending – shadowing the Conservative government’s spending plans. This would take the party out of its comfort zone – but something like this will surely be necessary.
The second big problem is engagement with the European Union, as pointed out by Danny Finkelstein in The Times. The party understandably does not want to reopen the Brexit debate. But how to create a credible path for the country outside the union while shadowing so many EU policies on worker protection and the environment? This surely creates a competitive weakness. Mr Finkelstein thinks that the party, once in power, would surely be forced into a closer trading relationship, sacrificing many of the sovereignty gains as a result.
So Labour is trying to have its cake and eat it. Boris Johnson could get away with that, but it is harder to see that Sir Keir can. However the hole that Ms Truss has dug for her party is so deep that it probably doesn’t matter.
UPDATE, 30 Sep 22. The first quarter’s current account deficit was reported by the FT as being over 8% – compared to the 3% figure which I took from The Economist. According to the FT report (which dated from before the statement), this was making gilt markets nervous. This makes sense, though I would prefer to know exactly where the funding vulnerabilities are rather than relying on these broad aggregates. All this shows that there was lots of evidence that Mr Kwateng (and Ms Truss) were skating on very thin ice before the statement, but they chose to ignore it. Mr Kwateng’s decision to keep on digging the hole deeper in Sunday media interviews is quite astonishing.
To my mind, the first problem for Labour, – the lack of a fiscal plan – does matter deeply. The fact is that there is a lot more for Governments to do than there use to be, in servicing an ageing population, in combatting global warming, in managing plagues (as they used to be called), and in meeting increased expectations about quality of life. There is also a relative price effect, that the cost of labour intensive public services (such as education, or the administration of justice) go up faster than average inflation. So public costs rise – an experience in developed economies generally. Yet the British culture probably is averse to seriously high tax levels, seen by some as an infringement of their property rights. How Labour would tackle this problem is likely to come under increasing scrutiny once the immediate reaction against the Tory’s new policies ceases to be the only show in town.
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The British can’t seem to decide whether they want tax and public services on the American model or the European one. In the end I think we are Europeans – but not even Jeremy Corbyn was up to biting the bullet on taxes.
There’s only one sensible fiscal rule for any Government. If the economy is sluggish and resources are going to waste Government needs to spend more and/or tax less. If the economy is overheating and demand is too high it needs to spend less and or tax more.
Another fiscal rule would be that rising prices don’t always show that demand is too high. If there is a supply problem rising prices can be seen to be a rationing mechanism.
The problem is that when there are unused resources in the economy, inevitably the government finances, from a household perspective won’t be in good shape. I know mainstream economists will say they know the national economy isn’t like a household but that doesn’t stop them treating it as one. So their argument will be that “we can’t afford it”. However, whenever the economy is in reasonably good shape there won’t be many spare resources so any attempt to increase spending on things we can supposed afford will be inflationary.
There’s also only one sensible monetary policy. Try to decide what interest rates we need and stop adjusting them so often. Reducing interest rates to stimulate the economy encourages the creation of more private debt. Increasing rates to slow it down, at least at the speed we are doing now, will turn a high level of private debt into a high level of bad private debt. Like melting snow on an Alpine slope everything looks stable until suddenly it isn’t. The avalanche hits and we have have another 2008 style crash.
Is this the best way to slow anything down?
I think mainstream economists are heading your way on fiscal policy. That’s one reason that Truss thought she had headroom for her tax cuts – completely ignoring the bit about inflation – and the current account balance.
On monetary policy though, mainstream economics is in a muddle. I understand why the changes to rates are so incremental – since mortgages are so politically sensitive. Still I struggle with the justification for very low rates – I can’t see that capital markets can function efficiently at a near zero rate – and I don’t think they have been. In theory it should be set by supply and demand for savings – but this seems a very hard thing to judge. I’d agree that the old Neo-Keynesian consensus that interest rates do the heavy lifting on business cycle management while governments ran fiscal policy conservatively has no stood the test of time.