The cake has gone: the revenge of Treasury orthodoxy

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.

As the Tories implode, do the holes in Labour’s position matter?

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.

The budget isn’t a gamble: it’s Russian roulette

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.

Targeting help to the neediest depends on knowing who they are

This week’s Bagehot column in The Economist suggests that Labour’s policy of freezing energy prices is bad policy (actually “silly”) but good politics. It says that Labour has been too tied to “wonkery” – the design of policies that are clever enough to solve problems without the need to confront awkward choices. Their new policy is a welcome break form the current Labour leader, Sir Keir Starmer. But I don’t think the policy is quite so silly – even if Labour’s suggestions about how the costs will be managed mainly are.

The challenge is huge. British energy prices, especially for gas, have shot up this year. But that is just a foretaste. Further steep rises are in the pipeline: the graphic above, showing annualised costs, culled from the New Statesman (featuring widely quoted projections from Cornwall Insight – who seem to be the only people making them) shows the problem. The median annual household income is estimated to be £31,400 after tax – so costs are rising from 4% to maybe nearly 14% of income for the median household, and it could be double this for the bottom quartile. Other costs are rising too, and, for most people, pay is not keeping up (many senior executives and our local refuse collectors excluded). The media has little difficulty in finding cases of extreme hardship – of people choosing between energy and food for example – and, apparently, not even being able to heat that food up. In one case publicised by BBC News, somebody was selling their furniture to pay their bills. And that is before the forecast price rises have gone through, and before winter brings in the need for heating. Overwhelmingly the public feel that the government should step in to relieve hardship – although how many Conservative Party members share this feeling, while they choose their next leader, is not clear. So far, so clear.

This is where The Economist‘s wonkery comes in. The view amongst Britain’s policy wonks is that help needs to be concentrated on those that need it most. Trying to cap the price for everybody, a policy widely favoured in other European countries, is regarded as a bad idea. For two reasons: first it wastes public funds on people that don’t need it, and second it blunts the market signal that people should reduce energy consumption, and so ease the imbalance between supply and demand that is causing the problem in the first place. This thinking has guided government policy to date. British energy prices have been allowed to shoot ahead of those in the rest of Europe – while the government is trying to target the bulk of its help to the neediest. But this bumps into a major problem. How can the government tell who to help, and who can get along without it? They have two main ways of trying to do this. The first is to help those already entitled to other help, such as Universal Credit – and the second is to ask people to apply for help, and then to assess whether they actually need it.

Both solutions are badly flawed. A problem on this scale is going to hit many people not entitled to benefits, which have become notably stingier over time. I have seen this problem in a different context: the supply of free school meals to struggling families. Many families need the help but are just above the threshold for entitlement. The problem with asking people to come forward is that many will refuse to as a matter of pride, while others who don’t need the help will try their luck, and need to be weeded out in some way, or else the system will subject to allegations of widespread abuse. This last has been the case with help for businesses in the pandemic. This problem is what I have called the Information Gap. The state does not know enough about individuals or businesses to tailor its policies to specific need. It either creates universal entitlements, helping those who are not in need, or resorts to a number of very blunt instruments, which often create political backwash.

The Information Gap is not just some technical problem that can be left to policy wonks to solve. It is one of the central problems of the modern state, and everybody in politics, wonk or not, should be aware of it. There are three general philosophical approaches to dealing with the Gap. One is to use the best efforts of the state to gather information and close the gap, compelling disclosure as required. This is the approach we associate with the Chinese Communist Party; it is highly paternalistic, and seamlessly moves into the state intruding into our private lives in unexpected ways. And the state never gets enough information to solve the problem properly. Its opposite is the libertarian approach. This suggests that the state should not involve itself in helping individuals at all. It should establish a system of security and property rights, and not much else. This thinking is popular n the political right, though not amongst populists. The third approach is solve the problem through a combination of universal entitlements and high taxes. This has recently been popularised through the advocacy of Universal Basic Income. Of course nobody, or almost nobody, advocates taking any of these three approaches to the extreme. Practical statecraft involves balancing all three approaches. Politically, though, we need to develop a sense of in which direction is the site needs to tilt at the current time.

Alas politicians rarely succeed by being honest about the difficult choices involved. Tory leadership contender Rishi Sunak seems to be suggesting that we take the more paternalist approach – but without being clear as to how the information gap is to be closed. His past behaviour in the pandemic suggests that we will accept a high degree of failure and try to shrug it off. His rival, Liz Truss, is suggesting a more libertarian approach – but without being honest about the widespread hardship and business failure that is likely to result. And now Labour is suggesting the use of universal entitlements – but without being honest that this will lead to higher taxes. All three are displaying a dependence on magical thinking. Labour’s “costing” of its new policy is laughable – but the economic illiteracy it is showing is the rule amongst serious politicians, not an aberration.

Personally I think Britain needs to move further along the universal entitlements and high tax route – an approach derided by Ms Truss, but one which the better-run European states favour. That does lead to further problems. Public services will require more discipline to improve their effectiveness, which I believe will have to come alongside decentralisation – with political accountability moving in parallel. That will require deep reforms that people may support in theory, but will resist in practice. Without reform, services will simply gobble up resources without becoming more effective. A further problem, shown in other European countries, is that tensions over immigration have to be managed. If entitlements are high, the public resents people it sees as freeloaders – and there is political mileage in stoking up that resentment, whether fair or not.

So that’s two cheers for Labour – and indeed the Lib Dems whose policies Labour seem to be copying. Alas I don’t see any sign that either party is going to be honest about taxes. But the public, surely, will start to see the need for hard choices. The careers of the two British politicians most egregious in suggesting that no hard choices are required – Boris Johnson and Jeremy Corbyn – have both ended ignominiously.

Tackling inflation means a recession

I remember Britain’s inflation crisis of the 1970s well. I was a teenager, just coming into political consciousness. I started subscribing to The Economist newspaper in mid 1974, between the two British general elections in that year. Back then I was a firm supporter of the Conservative Party, which then entailed being a Europhile. Disillusionment did not overcome me until the end of the decade. Inflation remained the dominant economic issue until well into the 1980s. But these days most people in political power, political or economic journalism, or with economic responsibility are from a younger generation, who have only read about those times. I don’t think they have quite understood what is happening.

A number of things jar. The first is that discussion often fails to take in the difference between real and nominal statistics. Nominal data is simply the raw figures expressed in currency. These become of limited use when inflation takes hold, if you wanted to compare prices and values over time. So the concept of “real” data, adjusted for inflation, was developed. GDP data is expressed this way now as standard – as is almost all material in standard economics courses. Still, there has been a fashion of advocating monetary authorities targeting nominal GDP, rather than inflation. The concern was that if both real growth and inflation were very low, then the economy should be stimulated, even though inflation might not appear to be a problem. For a developed country, I think, the suggestion was that the target should be in the region of 5% per annum – allowing for 2-3% inflation alongside a “normal” rate of growth of about the same rate. It is now running at about 12% in the UK, showing an extreme overshoot. That suggests a case for hard monetary tightening – though, to be fair, with inflation at 9% and projected to go higher, an inflation-only target does the same job.

And that, if you read most comment, is exactly what the Bank of England is doing now, with a 0.5% rate rise recently, the highest increase since it became independent in 1997, we are told. But the “real” concept applies to interest rates too. The real rate base rate, by my calculation is around minus 7%. I find myself asking how can that can be described as tight. More seriously, it suggests that cash savings are being eaten away at a rate of knots. Other investments, apart from residential property, don’t look a much better bet either. Wealth is being destroyed at a rate we haven’t seen since the Great Financial Crisis – though conservative investors would have done well out of that episode in a way that they are unlikely to today (unless they held substantial amounts of index-linked stocks). Of course, it is not hard to see why people seem so unconcerned. The political weight of borrowers, and especially those with mortgages on their homes, has always been greater than that of savers. And higher nominal rates imply more cash flow stress on mortgagees, when income may not be guaranteed to keep pace. Still, I find it a bit jarring that there is so little political pressure to raise interest rates. A backlash from savers may yet emerge.

A further jarring side to the current discussion is that so many seem to think that inflation and growth are variables that are more or less independent of each other. An extreme example comes from Liz Truss’s campaign for the Conservative leadership. She seems to think that policies to support growth, or stop a recession, are independent of policies to curb inflation. she was a bit shocked when Chairman of the Bank of England suggested that attacking inflation would affect growth. At the same time, one her supporters, Suella Braverman, suggested that the Bank is to blame for inflation getting out of hand, and should have raised rates earlier – apparently impervious to the idea that this would have dented the growth that ms truss seems to hold as a sacrosanct economic objective. But growth and inflation are two sides of the same coin. You can’t stop inflation without putting pressure on demand, which limits growth. That’s politics, I suppose, but such comments should be enough for Ms Truss, and especially Ms Braverman, to be laughed out of court. If you you are in favour of tackling inflation, you should accept the risk to growth, and even welcome it. If you think inflation will disappear of its own accord (because it comes from external sources such as oil prices), then you should say so outright. But if you do, you face a tricky question on pay. If pay does not keep up with inflation, then real incomes will shrink – which means recession. So, if you want to avoid that, you should be more supportive of public sector pay increases. No senior Tory is in favour of that. In fact a growing part of inflation now seems to come from a wage-price spiral. This is exactly what you would expect when unemployment is as low as it is, and many employers face problems with recruitment, not least in the public sector. That means that any policies that support growth will make inflation worse.

Still, this is not the 1970s. Then the main industries were heavily unionised, and the public sector was huge, including public utilities, the coal and steel industries and a big car manufacturer. The size of payrises were front and centre of economic management and political discourse; strikes were commonplace, and not subject to the heavy regulation of today. It was much easier for inflation to become entrenched. It was also hard for major businesses, and especially the public sector, to push through productivity-improving changes to working practices. Stagflation was the result. Today, inflation should be much easier to bring under control.

Today’s discourse on inflation is right about one thing: one of the critical issues is hardship inflicted on the less well off. Funnily enough, I don’t remember people talking about this in the 1970s. Perhaps there was less financial insecurity, and benefits were relatively more generous – that is certainly a popular narrative on the left, but I would like to see more evidence before accepting that to be the case. It may just be my tilted memory. It is certainly one of the biggest talking points now, though it is hard to know just how widespread the hardship is. There is certainly plenty of it, as we can see even here in leafy East Sussex.

What is clear to me is that a recession of some sort is required to bring the economy under control. That means a reduction in overall living standards – and public policy should ensure that this burden mainly falls on those on middle and upper incomes. And that points to higher taxes and more “handouts” – at least in the short term. Alas our probably next prime minister is saying the opposite.

No, tax cuts won’t deliver economic growth

Elizabeth Truss – UK Parliament official portraits 2017
Photo: Chris McAndrew, CC BY 3.0 https://creativecommons.org/licenses/by/3.0, via Wikimedia Commons

I’ve been away on holiday for the last week, near Bakewell in the beautiful Peak District of Derbyshire. So I haven’t commented on the race to succeed Boris Johnson as leader of the Conservative Party – which under the UK’s unwritten constitution means the automatic assumption of the office of Prime Minister. I did watch (most of) the two televised debates. You will have to take my word for it that I was predicting that the final two would be Rishi Sunak and Liz Truss even as Penny Maudaunt was the 58% betting favourite to win the whole thing.

As I write, Ms Maudaunt may yet make it to the final two, to be decided by party members, and even Mr Sunak’s place there is not guaranteed. But let’s assume that things turn out as I predicted. Which one is likely to win overall? This is hard to predict. YouGov have made a valiant attempt as polling Conservative members, but to get their sample they are fishing in a large lake for a rare fish. Their polling suggests that Ms Truss has a comfortable lead. This fits with most commentators’ prejudices of the Tory membership, as most think they will prefer Ms Truss’s more ideological pitch – or may even be worried by Mr Sunak’s ethnicity. Actually I’m not so sure, and I expect Mr Sunak to prevail in the end.

These two candidates were always the strongest in the field of seven candidates left after Jeremy Hunt was eliminated. They have both held one of the great offices of state (indeed Ms Truss is still Foreign Secretary), and they are both well grounded in the sorts of choices governments have to make. The other candidates have come up with interesting debating points but show little evidence of actual grasp. Meanwhile both Mr Sunak and Ms Truss have come closest to putting forward coherent policy positions – and they clash. Mr Sunak has taken the continuity position, of keeping taxes and spending much as they are, and defending the various measures put forward to relieve hardship as the cost of living crisis takes hold. This makes sense as he was Chancellor of the Exchequer until very recently. This has been heavily criticised by Ms Truss. She says that the tax rises (National Insurance is going up, alongside Corporation Tax rates) will cause recession. Instead tax should be cut in the short term, to generate economic growth. Inflation should be curbed by the Bank of England – whom she suggested were in large part responsible for inflation in the first place.

Three questions are posed by this challenge. First, will tax cuts generate growth? Second, can Britain afford more public debt? And third, is the fight against inflation best left to the central bank? The first question is in fact quite complex one – and politicians of left and right often try to hide in the complexity to justify populist policies of lower taxes or higher spending.

There are a number of ways that tax cuts can stimulate growth. The most direct is by allowing people to spend more (assuming that it isn’t accompanied by public spending cuts) – which helps take up economic slack. Donald Trump’s tax cuts worked like this, at least to some extent. But there is very little sign of slack in the UK economy. Indeed this is one of the causes of the inflation crisis. Tax cuts will either fuel inflation or suck in imports (and the country is running a current account deficit). A second mechanism for tax to affect growth is by drawing in more capital – fixed or human – by improving incentives. The case for this is strongest for Corporation Tax – as this is something multinational companies factor into their choice of where in the world to invest – but there is little evidence that it is a big factor in the UK. But Corporation Tax is a very efficient tax, and low interest rates are keeping costs of investment generally low. There is in any case a big time lag between any tax cut and any change to investment behaviour – it will have little effect on whether the country avoids recession this year or next. The question of incentives for income taxes is much less clear – it is a classic essay question for first-year economics students. Lower taxes make work more rewarding increasing the incentive to do more, but also the could reduce the need to work to fund your chosen standard of living. If tax rates are very high (for example, the top rate of 83% current when I was calculating payroll deductions in 1976) the chances are that the former predominates – but the case is much harder to make at current levels. Tax cuts won’t help growth, especially in the short to medium term.

Can Britain afford to borrow more, meaning that it is easier to cut taxes without cutting spending too? The Conservatives promised not to do this in their 2019 manifesto. But Ms Truss suggests that we can get round this by classifying a chunk of debt as “Covid debt” to be paid off over a longer time frame. Mr Sunak says this is nonsense. Running a budget deficit in a country that controls its own currency isn’t necessarily a bad thing – it does not work like a household budget. If there is slack in the rest of the economy it is almost a national duty. And there is the argument that if the markets can’t stomach it, you can simply create the shortfall as money. But this can be inflationary, and there comes a point when the providers of finance insist on lending in other currencies. Britain has not been in anything like this danger zone since the early 1980s, when deficits from nationalised industries caused havoc to government finances. Inflation has made the picture more complicated, and debt levels are historically high (in part thanks to the covid crisis). But Ms Truss is probably right on this one – if you can deal with the arguments on inflation.

And here Ms Truss says the Bank of England can take more of the strain in turning the tide. Indeed she has suggested that the bank is partly to blame for the inflation crisis in the first place. In one of the debates she suggested that the Bank’s mandate should be modelled on that of the Bank of Japan. It is hard to credit this. The only way that the bank can fight inflation is to raise interest rates. This restrains growth – indeed the policy makes no distinction between restraining growth and restraining inflation – it tackles one through the other. From somebody who is suggesting that the problem is a lack of growth this is an extraordinary line to take. Further, the inflation problem has largely been brought about by problems on the supply side of the economy (oil/gas problems, Brexit, covid and a spate of early retirements in the workforce). It is hard to see how higher interest rates would have helped. It is simply a shallow attempt at blame shifting.

But none of the leadership contenders have wanted to confront the economic reality of Britain’s position. Britain’s workforce relative to its total population is shrinking due to demographic changes. Those same changes are placing public services under greater pressure, especially in health and social care. There are no soft spots on public spending – squeezing local authorities and benefits merely puts other services, especially the NHS and police, under yet more pressure. We have cut too much on defence. There is no productivity bonanza that will make public spending more affordable – or to be more precise, improvements in productivity are affecting a shrinking share of the economy, and cannot be expected to provide a get-out-of-jail-free card. All that points to higher taxes, or taking the country down the route of high inflation and currency and debt crises. By suggesting that he will only look at tax cuts once inflation has been dealt with, at least Mr Sunak has one foot on the ground. In the land of the blind, the one-eyed is king.

Funnily enough I have more sympathy with the Tory position than most on the left. Public spending (and taxes) should be subject to continual challenge. It is lazy to shrug our shoulders and suggest that nothing can be done. it is better for people to make their own choices n expenditure. There is a huge challenge in making public services more effective and accountable. But fantasy economics does not help.

Fully Grown: why economic growth has slowed down

This book was one of The Economist‘s books of the year in 2020 – and I bought in time for Christmas. It has taken me until now to read it. It tackles the question of why economic growth in the US, along with the rest of the developed world, slowed in the 21st century compared to the last half of the 20th. It is a topic that has troubled many, but the usual response is to attribute it to whatever the commentator’s pet theory happens to be, throwing in a few pieces of circumstantial evidence in support. I am as guilty of this as anybody: using my theory that it is mainly the Baumol effect – a switch in the economy from manufacturing to services. The virtue of Dietrich Vollrath’s book is that he is led by the evidence – though restricted to the United States. He concludes that, mostly, the slowdown arises from the problems of success, rather than being any failure of economic management.

Interestingly, Professor Vollrath admits to starting his search with his own pet theory: that the slowdown resulted from the growing concentration of big business, their consequent market power, and the resultant higher profit margins. That is doubtless why he devotes three whole chapters to it compared to one on Baumol – but his conclusion is that it did not have a major impact on growth – and its effect is even ambiguous. His overall conclusion is that the growth rate (in GDP per capita) slowed by 1.25% per annum, from 2.25% to 1.00% on average, and that 0.8% of this is due to demographics (i.e., a smaller proportion of people working), 0.2% is due to the Baumol effect, 0.15% due to a slower turnover of staff and firms, and 0.1% is due to a decline in geographic mobility. Changes to tax and regulation, rising inequality and trade with China were all examined but had an overall effect of nil. Both the demographic effects (smaller families, retirement, etc.) and the Baumol effect arise from choices to be expected as societies grow more prosperous – so he calls these the results of success. This, of course, fits in with what I have been saying for some time – though in my commentary the Baumol effect figured larger than demographics. Professor Vollmer finds this effect to be real but slow-acting, and dwarfed by the effect of demographic changes.

How much does this apply to Britain? According to some statistics I have found on an internet search, the growth of GDP per head in the UK was 2.4% per annum from 1950 to 2000, and 1.1% from 2000 to 2016 (actually a bit more than the US – but this may an issue with the statistical series) – a very similar level of decline. I don’t have comparable figures on demographics, but the same sort of thing was going on in the UK, with a clear baby boom in the 1940s and 1950s, followed by shrinking family sizes. If anything family sizes were shrinking further – and we had a lower rate of immigration. This week The Economist has started a series on Britain’s productivity problem – but it is hard to tie in their data with this book. It is looking at a shorter time period, and comparing output per hour worked with other countries. And Britain does seem to be less productive than many other countries – and productivity has fallen since the great financial crisis in 2007-09, though it is not so different from other countries in that (it has a similar decline to the US). But productivity figures are notoriously difficult to calculate, and they are not necessarily fully comparable from country to country, even in the same OECD data set. The most important conclusion arising from Professor Vollmer’s calculations is that, so far as the overall economy is concerned, productivity is liable to be trumped by demographics. And here the position in Britain post covid is grim. A lot of people have dropped out of the work force, though it is unclear why (early retirement looks the most likely). Immigration remains high, but with extra bureaucratic hurdles since Brexit, imported workers aren’t necessarily going to the places of highest stress.

One conclusion of this book is that it is hard to detect any growth effects from deregulation or tax changes – so it is hard to see that the government’s hopes for increased productivity will have much effect. The partial exception, according to Prof. Vollmer, is changes that allow greater housing mobility. Allowing more homes to be built in areas of high productivity is the leading aspect of this, and the government shows no sign of wanting to deal with this. One policy not talked of in the book is the idea of “levelling up” – of improving the productivity of lagging regions to be closer to that o the leading ones. According to The Economist Britain has a particularly big regional gap – so there is the possibility of growth through catch up. This probably entails substantial devolution of tax-raising and spending powers, which Westminster is fond of talking of, but never actually does much about. So the outlook for GDP growth in the UK looks weak – even if, as the book suggests, a lot of this is actually a problem of success.

This book does have a couple of major defects, which arise from the way the problem has been framed. The first is that there is no investigation of the impact of status goods (or services). These are significant because their economic characteristics differ from normal goods – the point of them is that they are expensive and so not generally accessible. Low productivity is often a feature, not a problem. It is to be expected that as an economy becomes more successful, the demand for status goods rises. This would have a very similar effect to the one Baumol identified (and, indeed it doubtless contributes to the Baumol effect, as a lot of services are status symbols). But I have seen no attempt to prove this statistically – and Prof. Vollmer does not even mention it. It may also be a factor in the rise of market power he discusses. Apple’s high margins, for example, arise in part from the fact that their products have become status symbols. Modelling the effects of status goods on the economy at large is complex, however – and it is not well supported by established statistical categories. So it is not surprising that the book ignores them. But a reduction in economic growth as a result of a move to status goods would support its “problems of success” thesis.

The second disappointment is the narrow way it deals with the effects of globalisation. It solely looks at the effect of workers displaced by the move of production in America abroad, and in particular to China. It finds a mild negative effect on productivity. Prof.Vollmer keeps any benefit of lower prices to American consumers from increased trade out of the scope of his analysis. This is disappointing, because I believe that it could be significant. I’m sure it was in the UK, whose economy is more exposed to world trade, as price reductions on imported manufacturing goods had a significant impact on overall prices in the first part of the 21st century. I’m not sure how this would work through into the statistics though (the D in GDP stands for “domestic” after all). This should manifest as a positive effect on growth in the late 1990s and early 2000s, going into reverse afterwards. But it would make the story significantly less tidy, so it is easy to see why Prof. Vollmer left it out.

This remains an important book, however. Economic growth attracts an awful lot of commentary from economists and politicians. Given that, it is surprising how weakly understood the phenomenon is, even amongst people who should know better. Alas that includes the writers at The Economist, whose article on Britain’s economic growth only mentions the effect of demographics in passing, and superficially at that. And that from a journal that made the book recommended reading. This is yet another sign of just how stilted most public discussion of economics remains.

Tackling the inflation crisis will require a change in the political narrative

The picture shows my rubbish bin last Thursday, our normal collection day. It had four weeks of rubbish in it, and was put out more in hope than expectation that it would be collected by the limited service in operation. It wasn’t. Our bin men have been on strike for a month, with no sign of a settlement in sight. It is just one facet of the inflation crisis that is engulfing Britain, and much of the rest of the world too. It has now reached the top of the political agenda. But just what can, and should, politicians do?

When I last posted on this, I contrasted two forms of inflation. One is a degradation in the value of the currency – the process of the prices of things generally going up, without relative prices between different things changing (and especially between consumer prices and wages). The other is a process of the economy reaching a new reality, typically because supply difficulties are reducing the standard of living. If the supply of oil, for example, is substantially reduced, and its price rises as a result, we have to consume less. Assuming that there are no cheap substitutes, then there is nothing that will stop society being poorer. How society should respond to either sort of inflation is different. In principle, the first can be stopped by processes of economic management (though whether it should be, or at what level, is another matter). Responding to the second sort is a question of distributing the pain – nothing will stop us being poorer, in the short term at least. Of course the second sort of inflation often leads to the first – if people respond by trying to avoid pain altogether by raising wages and benefits across the board. That is how the inflation crisis of the 1970s got going.

The inflation that is hitting Britain is mainly the second sort – prices rising as a matter of economic adjustment. This is driven mainly by three things: increased trading and labour costs as a result of Brexit (counting changed immigration patterns as part of that process, and the reduced availability of cheap labour – though some of that may well have happened without Brexit); the disruption of supply chains following the covid pandemic; and the war in Ukraine, and especially its impact on hydrocarbons, to be followed by its impact on foodstuffs. In the short term the question for public policy is how the pain can be shared equitably. Trying to escape the pain through increased wages and government handouts will simply stoke up the second sort of inflation.

This is not easy territory to pick through for public policy. The first question is whether inflation is an evil at all, or when. Many economists don’t feel that it should be, up to a point. Inflation makes it easier to make adjustments to relative prices (and especially reducing wages compared to consumer prices), and it also allows the possibility of negative real interest rates, reducing the possibility of a zero-bound trap. This idea weighs heavily on theoretical macroeconomists – the idea being that the lower limit on nominal interest rates is zero – which means that it is possible that interest rates can’t be eased when they should be – causing a recession. When I was an economics student in the mid-noughties I read lengthy discussions led by liberal economists such as Paul Krugman suggesting that Japan was caught in just such a trap and that it should implement radical policies to raise its inflation rate (some of mr Krugman’s ideas on how to do this were quite barmy). I have never been comfortable with this. The public does not share this equanimity with regard to inflation. To them the currency is a sacred bond of trust between the citizen and the government. The citizen trusts their savings to the financial system so that they can be used for investment; the government ensures that the currency maintains its value so that the citizen can spend the money later. Inflation is theft by complacent ruling elites – a transfer of wealth from honest savers to devious borrowers. Liberal economists tend to completely underestimate this sentiment, and the idea that inflation corrodes trust in the system of government. The popularity of the euro, for example, in France and Italy is reflection of this. Populist politicians who seek to take their countries out of the euro find that it is a sort of political third rail. Marine Le Pen and Matteo Salvini have both been frazzled on this. Liberal economists tend to think that the euro is an affront to sensible economic management, but to many it has restored their faith in money and civic governance.

So politicians need to take inflation seriously. But that leaves a conundrum. The two main methods of squeezing it out of the system are also unpopular. The first is holding back wages. That stops prices spiralling, allowing inflationary shocks to work their way through quickly. The second is raising interest rates. This should reduce borrowing and investment, deflating the economy and reducing the pressure on both consumer prices and wages. Raising interest rates can be popular with a certain class of conservative savers – but it also tends to dent property prices and cause unemployment, which give a sense of economic mismanagement. A third method of dealing with inflation is less talked of: increasing taxes to reduce the level of consumption. This faces some fairly obvious problems when used on consumption taxes such as VAT – as it just raises prices further; income taxes are more equitable, but hardly a popular alternative.

The British government has some things going for it when it comes to overcoming the inflation surge. The first is that wages are so far lagging consumer prices: by 7% compared to 9%. Moreover a lot of the 7% reflects one-off bonuses. The second thing is that tax rises are crimping people on middle and higher incomes, which in principle should reduce demand. National Insurance rates have gone up and the threshold for higher rate tax has been frozen, creating a fiscal drag effect. This should give the government some scope for alleviating hardship without raising demand excessively. There are three things the government needs to think about doing.

The first is raising benefits for the least well off. The inflation adjustments made to benefits was based on numbers prior to the main surge, and so are inadequate to meed the increased energy and food costs, never mind all the other costs that are going up. The most obvious thing to do is to raise Universal Credit, for which there is a precedent during the covid crisis. This would be costly, but it would also be the best targeted measure that they could devise. There are other benefits complementary to UC, which, apparently, are technically harder to increase. But it is hard to take this seriously as a reason not to act. The basic state pension is also another place to look. The government, however, is very reluctant to commit to serious increases here. The reason may be political – the recipients of these benefits are unlikely to be Conservative supporters (except the state pension). Instead the government has been looking at other benefits, and committing much less money than these measures would require. The rumours are that something is in the works.

The second issue is public sector pay. According to the ONS this has been increasing at the rate of only 1.2%. The government has raised the minimum wage by 6.6%, but otherwise is wants to keep public sector wages down. This would certainly serve to keep demand pegged – but just how realistic is it? My bin men aren’t the first to go on strike – and neighbouring local authorities have been forced to pay a lot more than they had planned. And they are still on strike after being offered an increase this year of “up to 17%” and parity with workers from neighbouring councils. Rail strikes are threatened. There is a staffing crisis in the NHS. If private sector pay is allowed to shoot ahead of that in public sector, there will be recruitment and retention issues. It is not hard to see serious trouble ahead.

The third issue is levying a windfall tax on oil and gas producers, who are making massive profits, and maybe other energy providers too. Economically this is something of a sideshow. A tax would not affect levels of consumption in the economy by much at all. Still, it is useful political theatre and reduces the pressure on national debt – though just how important this is remains hotly debated. The government is reluctant to do this, though the reasons offered look pretty weak – at least as far as the major public companies are concerned. Apparently the government is now trying to link such a tax to levels of investment. That is a theoretically sensible approach, but hard in practice.

Meanwhile the government, and many of its MPs, hope that they can cut income tax before the next general election, likely to in the autumn of 2023, or the following spring. This looks like a neoliberal delusion – a failure to understand the inevitable rise in the scale of government spending in the face of demographic and other pressures. Still, that delusion still seems to have powerful followers.

But the real hot potato is wages. Inflation the moment is primarily caused by supply disruptions that make us poorer. The more we try to keep levels of pay rising at the same pace as consumer prices, the longer the inflation crisis will persist. The biggest headache is in the private sector. The government has little influence over this, but the more pay rises there, the worse the pressure will be on the public sector. This is shaped by the zeitgeist. And here the narrative from the government – and other politicians – is muddled. There are no grave messages that the country is being hit hard by a number of things outside its control, and that we must grit our teeth to get through it. Instead the government wants to portray the economy as in fine fettle, and also that we should expect wages to rise as we move to high-wage high-productivity post-Brexit economy. Government politicians don’t want to admit that the economy is in fact in trouble. The opposition wants to suggest that it is all the result of incompetence that can be put right quickly with a transfer of power. They doubtless hope that the pressures will have eased by the time this transfer takes place.

So my guess is that inflation will persist. Public sector strikes will multiply, and interest rates will start to rise much more rapidly that the mainly token changes we have seen so far. Avoiding this will require strong political leadership of the type we are unlikely to get from anywhere.

An economic storm is coming – could this favour the Lib Dems?

Image: Whoisjohngalt, CC BY-SA 4.0 https://creativecommons.org/licenses/by-sa/4.0, via Wikimedia Commons

A bull market ends when the last bear has been beaten into submission. It felt that way last autumn. In 2020 I was astonished when, after an initial fall in response to the emerging covid crisis, financial markets bounced back and then became positively buoyant. How was this a rational response to the the catastrophe enveloping the world? But the bull market just went on.

Then last autumn I started to read articles suggesting that investors must fundamentally re-evaluate asset prices upwards. The argument was based on the idea that interest rates were fundamentally lower than historically, so we shouldn’t be using historical comparisons of yield and other such ratios, which were pointing to over-valuation. This felt a lot like the last bear caving in. There was certainly something crazy about financial markets at the time – shown not least by the craze for crypto-currencies. All this was reminiscent of the insane world of the tech bubble at the end of the 1990s. Loss is the new profit, and so on.

There is something very odd about the way the interest rate argument is used to justify high valuations. The logic is superficially soound. Anybody with a training in finance is familiar with valuation models based on a discount rate – which is the rate you should receive by investing your money in a zero-risk alternative. The lower the discount rate, the higher the valuation. But lower interest rates also suggest low rates of return on investing your money. So how is that investors get richer when returns fall? Common sense would suggest that a world in which the risk-free rate of return on investment is near zero (or negative after inflation) is one that is going to hell in a handcart. Something, somewhere is not making sense. In fact we should be expecting profits and rental incomes to stagnate or fall, and this should undermine valuations.

But asset prices are not set by the use of logically rigorous financial models. They are set by the laws of supply and demand. The modern economy is generating a lot of funds for investment, but there is an unwillingness for investors to use this for good old-fashioned projects that might generate a cash surplus at a future date. That leaves too much money sloshing around in bank accounts or low risk assets such as government bonds. That keeps low-risk returns down, and it also means that banks are willing to loan money at low rates of return. This generates demand for assets that might generate a return at expense of risk (though still not those boring real-economy projects, apparently). This does not necessarily lead to an asset-price bubble: investors could just be more patient. But it clearly has.

Central banks can do something to restore order by pushing commercial banks to raise interest rates, in their role as their regulator and the banker’s banker. For the last three decades they have chosen not to, using various arguments either to deny that there is a bubble, or to say that it isn’t their job to act against it – instead focusing on consumer price inflation and unemployment. It is difficult theoretical terrain, but it is hard not to see politics and the vested interests of the finance industry behind this.

What bursts bubbles? It is when the funds dry up and more people want to sell riskier assets than buy them, while demand often exceeds supply of less risky assets, causing a scramble. This is usually the result of chickens coming home to roost – high risk investments carry a high risk, after all. The great financial crisis (GFC) of 2007-09 was started by defaults in the US property market. It doesn’t help that in the modern world “funds” is a fluid thing and not the movement of fixed quantities of money as we might intuitively expect. This gives scope for chain reactions that can be global in reach. In the GFC this was truly spectacular and served to expand a minor crisis in US sub-prime real estate into a global banking catastrophe. That was the result of uncontrolled financial engineering across developed economies in the previous decade. There was something of a Ponzi scheme collapsing – but to this day supporters of Britain’s Labour government, which was an active supporter of the country’s role in building the Ponzi scheme (aka world-class financial innovation), insist it was nothing to do with them because it was all about US real estate.

The asset price bubble is clearly bursting now. The proximate cause is inflation, causde by widespread disruption to the supply side of the economy – which I discussed last week. Amongst other effects this is causing central banks to radically change course. Interest rates are starting to go up – though not by very much so far, given the levels of inflation. Perhaps more immediately threatening to markets is that Quantitive Easing (the central banks buying up bonds to keep long term interest rates low) is now moving into reverse. This upsets the balance of supply and demand in asset markets. Meanwhile the convergence of disasters affecting economic supply, from the war in Ukraine to covid in China, are clearly destined to make the world poorer, and this affects how people value assets.

The burning question is just how big will this financial crisis get, and what will its consequences be? I will focus on the UK – as we may find that things unfold quite differently in different countries. On the one hand the financial system is not as dangerously wound up on itself as it was during the GFC, limiting the chain reaction. The world banking system does not look in imminent danger. On the other hand, the outbreak of inflation knocks away one of the props upon which the financial system has been based for 30 years or so – the prospect of ever-lower nominal interest rates. This suggests that the crisis will be slower but longer-lasting. The most sensitive part of this is house prices. In the GFC prices dived rapidly as the financial system froze over and it became very hard to arrange mortgage finance. But conditions quickly eased, and prices bounded back. This time it looks as if nominal interest rates will rise steadily and may well stay up. This will impact new mortgages rather than existing ones, as most mortgages these days are fixed rate. So prices are likely to decline more slowly, but the effect could last longer. It is hard to tell about the wider economy. It depends n the state of business finances. If a harsher financial environment causes widespread bankruptcies, we could experience a significant recession. Otherwise things will be much slower moving and the economy will experience a long period of doldrums.

What will the political impact of these be? The accepted story of politics since the GFC is that the crisis provoked a backlash against metropolitan elites, which were seen as having caused the crisis and escaped its worst impact. It was the political right which managed to exploit this the best, with the rise of populist policies. In Britain this focused on Brexit. The Conservatives were the ultimate beneficiaries. Politically the old liberal elites have taken a pounding, though, and they are not such an obvious target for a backlash. An obvious culprit for the trouble is Brexit but the main opposition parties, Labour and the Lib Dems, are reluctant to invoke the B-word. Their sense is that Britons (especially the English) are reluctant to re-enter the polarisation and political warfare set off by the referendum in 2016. They were accused of trying to overturn a democratically fair decision, and many politicians in these parties have taken this message on board. Anyway, both parties want to win back voters who supported Brexit, as well as those who do not want to reopen the wounds.

But as yet I do not see a clear alternative line of attack. What should the government be doing to face the crisis that it is not? It is not obvious to the public whether the answer is more or less austerity. Swing voters tend not to been drawing non-pension benefits, which look inadequate. As yet there does not seem to be a tide of anger about the failure of the state pension to keep up with inflation. Immigration has failed to present as a burning concern to most. The opposition has to content itself with complaining that the government is incompetent and out of touch. But the public has to be convinced that they would do a better job.

But the point is that public anger is likely to gather pace, and it will attach itself to something – but we don’t know what yet. Where will angry, property-owning former Tory supporters go? Labour has not been positioning themselves for these voters since the departure of Tony Blair in 2007; it may forgotten how to. This could yet be a propitious moment for Lib Dems, who are increasingly focusing on this demographic. They have been courting these voters in by elections and local elections, with some spectacular successes. It is early days. No clear national narrative is emerging from the party. But it is too early for that. They need to understand how resentment at failing house prices and a stagnant economy translates into specific demands. But for the first time in a long time, the period the party spent in coalition with the Conservatives in 2010-15 might be an asset. From the vantage point of 2022, with some selective memory, many Tory voters might remember this as a golden age.

Levelling up from a government that won’t let go of centralised power

Last week Michael Gove, Britain’s cabinet minister for “levelling up”, published a white paper to set out government strategy, building on what had hitherto been not much more than a slogan. It attracted predictable howls of derision, not all of which were deserved. If it is disappointing it is because it presents no real sign of challenge to Britain’s highly centralised political culture.

The good points about the strategy are its ambition, and is aim to make levelling up, or equalising geographic opportunities, a central priority across all government departments. There are two main areas of public criticism. Firstly that there is not much public money attached to the transformation process. Secondly that it advances the idea of political devolution within England only a fraction. I have some sympathy with the government on the first count. It is clear that the problem of regional inequalities has deep causes, and it is not just a question spreading public investment more equally. And yet this all most people want to talk about. We need to move the conversation on. The second criticism is much more pertinent. The Economist suggests that the policy is reminiscent of the Labour government led by Tony Blair and Gordon Brown from 1997 to 2010: the introduction of regional mayors to provide a new, more local focus for policy coordination, combined with a lot of centrally designed targets and centrally controlled pots of money for local bodies to bid for. Serious devolution would entail local revenue-raising powers, something that is clearly still as much anathema to Whitehall now as it was back then.

I will come back to why I think that matters. But first I want to take issue with the way that government policymakers, and many of those that critique them, like the journalists at The Economist, are thinking about regional development. And that centres around productivity. To them the central problem is low productivity in English regions outside the South East, and Wales – the picture is a bit more complicated in Scotland. By this they mean a concentration of better-paid jobs and profitable businesses in the South East. That is fine as far as it goes, but their suggestion is that this needs to be corrected by making regional businesses more efficient and productive. But what if the main problem is that more productive businesses (i.e. the most profitable ones, or those with best-paid employees) are attracted to the South East. If you improve the productivity of a business in Yorkshire, say, you may find that all that happens is that it moves to near London, or outside the UK altogether, or at least the more profitable elements of it. Often this happens through the business selling out, especially hi-tech businesses.

Regular readers of this blog will know that I have huge reservations about the way most economists think about productivity. They are guilty of a fallacy of composition, by assuming that the way you manage an individual business is analogous to the way you run the whole productive side of an economy. This is ironic because economists love to complain that the public suffer from a similar fallacy about household budgets and the national budget. An economy contains a wide variety of businesses with different rates of productivity, as economists measure it. Some are more susceptible to productivity improvement than others. Some are positively inimical to productivity (consider status goods, for example). As productive businesses become yet more productive the resources released tend to move to less productive businesses. This is well-known to economists as the Baumol Effect (or Baumol’s Cost Disease), which doesn’t stop them from ignoring it.

So the key question to me is not why regional businesses are relatively unproductive, but why well-paid jobs tend to gravitate to London and its environs. Political connections are surely part of the answer. Decisions over the allocation of vast public resources are made there, to say nothing of decisions on laws and regulations, and taxes. Physical proximity makes a big difference to the political influence you can wield. That is why countries with more devolved decision-making (my favourite example is Switzerland – but the same applies to Germany) have more equal regional productivity, and why small, independent countries often perform better than non-central regions in large countries. Yorkshire isn’t physically or culturally very far from Denmark or the Netherlands after all, but income per head does not bear comparison. The Irish Republic has overtaken the initially more developed Northern Ireland. The government’s proposed reforms will do very little to change London’s gravitational pull. Regional politicians still will have to travel there to bid for the new funds on offer, employing London consultants to hone their bids to match the fashionable ideas and buzz words that hold sway there.

Still, that can’t be everything. The British regions have suffered enormously from the collapse of old industries, devastated by the march of technology and globalisation. There may be interventions that can push back against this tide. Universities are amongst the few bright spots of regional development. The South East has very strong universities, especially if you include Oxford and Cambridge, which are on the edge of the Midlands, but no monopoly. Perhaps more regional centres can be established for medical research, surely a promising avenue for the country, based on these universities and local NHS institutions. Better intra-regional transport would surely help. Better transport links to London, on the other hand, are more ambiguous in their impact. But such initiatives would be easier to get off the ground if local leaders were not constantly having to appeal to London for permission to proceed, but something could still be done.

An interesting question is whether the green economy can be used to promote regional development. Renewable energy has a strong regional element, but its impact on jobs looks quite limited, especially compared to the old fossil fuel industries. Can a change in focus in agriculture, to turn the land into a carbon sink, generate a healthier rural economy? This must surely be a critical part of any zero carbon strategy. This is interesting because it might entail a reversal of agricultural productivity, as conventionally measured anyway, as some of the interventions could be more labour intensive. Agricultural productivity has always been a prime driver of economic development, as workers are released from the land to work in factories. But we are now appreciating its huge hidden costs. There would be a rather wonderful symmetry if the development of a more sustainable post-industrial economy involved reducing nominal agricultural productivity. It is not incompatible with improving wellbeing, though attitudes to the consumption of “stuff” and, indeed, meat, would have to change. It entails placing a financial value on environmental assets.

Such ideas seem far away from current government thinking, though some ideas on agricultural finance are starting to move in that direction, and have also been promoted by Mr Gove. It is one of the few positive possibilities arising from Brexit, as agricultural reform in the EU proceeds at a snail’s pace.

Meanwhile some good-old fashioned “levelling-down” should not be ruled out. This means taxing excess wealth and high incomes harder, and using this to make investments in regional infrastructure. That, at least, is something Britain’s highly centralised government infrastructure is well-designed for.