Tag: Kwasi Kwateng

Boris Johnson promised us that we could have our cake and eat it. So we ate the cake. When his successor, Liz Truss, went to the cupboard to look for it, she found that it was all gone. The transition from the bounty of tax cuts and energy subsidies promised by Ms Truss when she took charge to the austerity being promised just a few weeks later is one the most dramatic policy reversals I have ever seen in Britain.

During her selection campaign for the leadership of the Conservative Party, Ms Truss railed against “Treasury orthodoxy”. This, she said, was responsible for the country’s strangled growth since the financial crash of 2007-09. She knew what she was talking about since she had served as Chief Secretary at the Treasury for a stint in 2017-19. This was a widespread complaint. I heard it made by Lib Dems during the coalition years, especially as many ideas for long-term investment were shut down. The complaint was much more virulent from Labour supporters, for whom “Austerity” was the root of all evil. It is interesting to see these usual suspects being joined by the libertarian right, who have elevated high tax levels to the same heights of evil that the left has for austerity.

It is important to distinguish Treasury orthodoxy from economic orthodoxy – though most people seem to do just this. Treasury types are steeped in economic orthodoxy: you won’t get away with the “lump of labour fallacy” (the idea immigrants, for example, take away people’s jobs) if you talk to one of them. But it is tempered by an older belief, dating back to Gladstone and beyond, in “sound money”. They do not like to see high levels of government borrowing, leading to creditors being able to dictate policy. The divergence between Treasury and economic orthodoxy was especially evident in the coalition government of 2010-15. Many orthodox economists argued that austerity policies were at best overdone, or at worst completely wrong-headed. They suggested that there was significant slack in the economy, and that policies that reduced demand were a self-inflicted wound (whether there was as much slack in the economy as they thought, and whether the austerity policies were as destructive, are questions for economic historians). They produced as evidence more generous US policies at the time, leading to less economic hardship. The Treasury thought otherwise. In 2010 coalition ministers were scared witless by warnings of dire consequences in financial markets if austerity programmes weren’t followed. Both Tory and Lib Dem ministers accepted this basic premise, while quibbling with the details. The previous Labour government under Gordon Brown and Alistair Darling had as well. Almost all serious economic commentators now suggest that this was a serious mistake – and that the market position was not nearly as precarious as suggested.

Doubtless this is what gave Ms Truss the courage to take on the Treasury, though her central idea that tax cuts can be paid for through the growth they stimulate, especially when unemployment is at a record low and inflation on the rise, was a challenge to economic orthodoxy as well. She noted the substantial “headroom” in forecasts by the Office for Budget Responsibility (OBR) earlier in the year – doubtless brought about by stealth tax rises through holding tax thresholds down. She also noted that government debt levels were not as high as other some other big developed economies. So she appointed her close ally Kwasi Kwateng as Chancellor of the Exchequer, and his first act was to sack the leading Treasury civil servant, with talk of replacing him with an outsider.

It fell apart with startling speed. In the popular telling the “Markets” struck back, causing mortgage rates to shoot up. This has wiped out any feelgood factor brought about by tax cuts and energy interventions amongst a key constituency of Conservative voters. The talk about the power of Markets is a convenient shorthand, but oversimplifies things a lot. Media coverage as been very muddled. At first a lot of attention was focused on the pound – which at one point nearly sank to parity with the US dollar. But it was the gilt (government debt) markets that caused the mortgage rate problems. I think this took a lot of people by surprise, including, perhaps, our political leaders. In the common understanding interest rates are determined by the Bank of England, which was not due to meet until early November – so people probably expected any crisis on the mortgage front to approach slowly. In fact Bank of England decisions are only one factor amongst many – and mortgage providers need to look forwards at potential future rises. Then a crisis blew up with the liability matching policies in certain pension funds. I have read two tellings of this crisis. In one the pension funds had been indulging in reckless speculation camouflaged as prudent management of future cash flows; in the other prudent management was caught short by a temporary liquidity crisis dictated by the way certain financial markets are structured. The Bank of England rode to the rescue, but a temporary tiding over of a technical crisis was presented by many as something much broader. The Bank’s attempts to communicate what it was doing and why didn’t really help. Neither did Mr Kwateng’s attempts to shrug the whole thing off.

The muddle made things worse. The pound recovered, but gilt markets have not made life for mortgage providers any easier. But what has now been revealed to the world is what the point of Treasury orthodoxy is. Financial markets are complicated things, and they can affect the public in a number of ways. As with any market, they are the meeting place of people with many different agendas. If mismatches occur they can be destabilised quite easily. The Treasury tries to manage things by making orderly, predictable demands, and not pushing its luck. It builds up a reservoir of confidence which means that it can respond to emergencies. The timing of Ms Truss’s attempted coup could hardly have been worse. Rising inflation, low unemployment (showing limited capacity to expand the economy) and the energy crisis, coming after the trauma of the pandemic and alongside the destabilising effects of the Ukraine war, all pointed to this being a particularly delicate moment. Ms Truss’s attempt to blame the demise of her strategy on the markets is a bit like the Captain of the Titanic blaming the iceberg for the loss of his ship. Except that this was no stray iceberg, the government was steaming full-steam ahead the middle of a known iceberg belt.

Now the government, having destabilised things, is having to work very hard to restore order. Treasury orthodoxy reigns triumphant. The new chief civil servant is an experienced insider; an experienced senior politician has replaced Mr Kwateng as Chancellor; most of the tax cuts have been withdrawn; public spending cuts are back on the agenda; the energy price intervention has been scaled back. There was even talk of not raising the level of the state pension in line with inflation – the Treasury has long hated the so-called “triple lock” on pensions.

The dust hasn’t settled, but the effect of this change is chilling. It isn’t just tax cuts that have been put on ice – but hopes by politicians on the left of raising spending on public services and benefits now look much harder to fulfil. Suddenly Britain looks like a lonely nation living beyond its means in a hostile world. Hard choices lie ahead.

The British prime minister, Liz Truss, and her Chancellor of the Exchequer, Kwasi Kwateng, must be pleased with how things are going following the “fiscal event” last Friday, otherwise referred to as a “mini” budget. They cannot use the word “Budget” because it was not accompanied by independent forecasts from the Office of Budget Responsibility (OBR). Whatever one thinks of the content, the media narrative is going well. The lack of the OBR forecast has clearly helped the government to shape it, and the Opposition is failing to divert it.

The word generally used to describe the fiscal policies set out in the statement is “gamble”. You can make a case for this word for the politics – but it is also being used to refer to the economics. The government’s central message is that it is implementing massive tax cuts, without corresponding spending cuts, with the aim of increasing economic growth. This is exactly how most commentators are describing it – and they say it is a gamble because the growth (targeted at 2.5% per annum over a period of years) may disappoint. That suits the government fine – it suggests bold and decisive leadership – which presents a striking contrast with the chaos of the previous administration led by Boris Johnson. Difficult times need bold leadership is the sub-text. Meanwhile the Labour Party are mucking up their response, talking about something called “trickle-down economics” which few outside their own activist circle will understand, and not taking about the game of Russian roulette being played with the nation’s finances.

There are two problems with the government narrative. The first is that the measures are nothing like as bold as is being suggested. The second is that there is zero chance that they will lead to a sustained increase in growth. This may not matter politically, because the next election could take place before its failure becomes clear. But the government is also taking a big risk with the state’s finances – for no discernible economic benefit except to a lucky few. This is the Russian roulette. This isn’t gambling – it is a form of torture.

So why do I say that the budget is not nearly as bold as billed? Firstly, a lot of the tax cuts are in respect of changes that have been implemented recently (the National Insurance changes) or not yet applied (Corporation Tax) – so don’t represent a change on the situation that applied a year or so ago, when Ms Truss says the growth performance was inadequate. That leaves the planned cut to basic rate of income tax of 1%, and the abolition of the top rate of income tax (reducing the rate by 5% for a very small number of earners), together with a reduction in stamp duty. But this needs to be set against a significant amount of “fiscal drag” – extra tax revenues pulled in because tax allowances and thresholds are not being adjusted for inflation, while incomes are being driven upwards. That is why the Resolution Foundation has suggested that the bulk of taxpayers will be no better off in real terms. There is a game of snakes and ladders – with the government is only talking about the ladders.

This is one reason that the measures will not have a sizeable impact on growth, but there is more. There are two ways that tax cuts can increase economic growth – one is by increasing consumption by allowing people to spend more. But that can only work if the economy is showing slack – otherwise all that happens is that the country imports more and the benefit goes to other countries. Or the gains are lost to inflation. There is no visible slack, and indeed the Bank of England will be obliged to neutralise any effect by raising interest rates – like a car being driven with a foot on both the brake and accelerator. The other way that tax cuts can help is if they change behaviour and either draw more people into the workforce or encourage them to work more hours (though as first-year economics students are told, tax cuts can have the opposite effect), or increasing productivity by, for example, creating a more positive environment for investment. It is hard so see that the odd percentage point off tax here and there will change behaviour by much. The exception may be the freezing of Corporation Tax – as the change to marginal rate is more substantial. Of course the actual increases to the rate haven’t been implemented – but the proposed changes may have influenced corporate investment plans, and these might change again. There were other “supply-side” changes in the budget too – infrastructure investments, special investment zones, and so on. But this is all small beer and will take time to have any effect. There is nothing radical here, like a root and branch reform of the planning system, major changes to technical education, or any of the other changes that people who worry about Britain’s supposed productivity problem suggest. Of course the government may move on to such action later – but the hype is being applied to the statement itself.

But even a more radical programme would struggle to make much difference. Economic growth fully developed economies (i.e. those without a significant agricultural workforce) is driven mainly by demographics – the proportion of people working in the economy. Here the country is facing a severe headwind as the baby boom generation retires. It is this population bulge that explains most of the rate of growth in the later 20th Century, and why it has slowed in the 21st. There is little on offer from the government, as yet, to address this, for example by freeing up immigration or encouraging more mothers (and fathers) into the workforce by making childcare more accessible. Both would be politically tricky (the latter because it would involve more public spending – “handouts” in Ms Truss’s language). At least pension reform and the impact of inflation on pension savings will discourage people from retiring, and bring retirees back into the workforce – but that is hardly a political bonus.

The scale of impact of demographics on growth in developed economies (which I have posted on recently) is still not widely understood, even by professional economists. Instead most of the focus is on productivity. There is a specific narrative that Britain is suffering from lower productivity than other similarly developed economies – and therefore that there is an opportunity to improve it and generate a bit of catch-up growth. This view is currently being promoted by The Economist newspaper, and Ms Truss and Mr Kwateng are clearly both believers. I am personally sceptical, as I don’t think the comparative productivity statistics are reliable. In particular I don’t think that proper account has been taken of the fact that Britain has deindustrialised faster than other economies, and so has a smaller manufacturing sector – which is where higher productivity measurements are concentrated. Britain benefits from cheap imports – but this won’t be captured by the productivity statistics (though a falling pound undermines this). Certainly there are a lot of things that could be done to make the economy work better, but it is easy to exaggerate their effect on overall growth, as they will often be neutralised by, for example, people retiring earlier, or by the gains being ploughed into less productive parts of the economy, like health spending.

What is certain though is that the government’s policies set out in the budget will have little or no positive impact on economic growth. The best that can be hoped for is a temporary boost from some unforeseen change to the workforce or energy market.

So is the budget much ado about nothing? Actually no. The main issue is what it did not address. A much more significant policy announcement came just before the hiatus caused by the passing of the Queen – the generous package of measures to support the public and businesses suffering from high energy prices. This came on top of generous government support during the pandemic, and promises to deal with backlogs in the NHS and social care. All this entails a huge fiscal outlay, and nothing was said about how this is to be financed – just a question of borrowing more. The budget has simply added to the strain rather than reducing it.

Here we enter uncharted waters. The government has been able to borrow freely from domestic and world markets, financing itself in its own currency. It is now widely accepted that it panicked back in 2010 when the Great Financial Crisis caused a huge government deficit. They did not need to implement austerity policies – or not quite so hard – to prevent financing problems. The thinking is now that much higher levels of government debt are sustainable than previously thought. People used to be worried if overall public debt reached 60% of GDP. Now people are relaxed about it heading over 100%. Discussion of this is muddled by the politicians. There is a lot of confusing talk about piling up debt that later generations have to repay. But that confuses the financial economy with the real one. The wealth of future generations will be determined by the productive capacity of the future economy and not by how the government is currently financing itself. Unless, that is, there is a financial breakdown that has the effect of constraining that productive capacity. That has happened in Argentina, for example, but not here, unless you count the IMF crisis of the 1970s.

And yet the risks of just such a breakdown are rising. Because the currency is freely floating the risks are less than if we were part of the euro, for example, or if the gold standard applied, as it did in earlier eras. But the financial climate is becoming more hostile – and the country is running a significant current account deficit (3.1% of GDP according to The Economist). This means that the country’s finances are dependent to some extent on foreign finance. The country has been running large deficits for two decades now, without any major stress. I have seen no clear explanation of this remarkable performance. I can only speculate that the sale of residential property to foreigners has a lot to do with it. But since we don’t understand how this has been achieved, we also have little idea of when things will become more difficult. The symptoms would be the government struggling to sell gilts, and being forced either to finance itself through the money supply (causing inflation) or borrowing in foreign currency, or seeking help from the IMF. This would entail a major financial crisis, and the government being forced to raise taxes, cut spending, implement capital controls, or other such unthinkable measures.

Although the pound has depreciated badly I still can’t believe that the country is close to such a crisis. But the risk is rising. Much more likely is an intermediate sort of problem, with persistent inflation, rising domestic interest rates, and a weak pound. Ms Truss’s growth talk would be shown to be vacuous, and the government’s reputation for competence would be shattered. This is what I mean by saying that the government is taking a big risk with its finances. It really should be talking about higher taxes, not tax cuts. The timing is completely wrong.

So why has the government embarked on this suicide mission? The simplest explanation is that they believe their own rhetoric. They really think that doubling down on neoliberal economic policies will yield positive economic dividends. Mr Kwateng said that the government’s new turn in policy represented a new era. In fact it is the death throes of the old one.