Tag: UK economic policy

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.

The Tories must choose between lower taxes or the NHS

Discontent in the British Conservative party goes beyond frustration with the erratic leadership style of Boris Johnson, and his low poll ratings. Many feel that the government is failing to deliver on a distinctly Tory vision of how to run the country – one that is business-friendly with light regulation and low taxes. Shadow leadership contenders, the Chancellor Rishi Sunak, and Foreign Secretary Liz Truss are both trying to capitalise on this discontent. But there is no way out, which is why Mr Johnson may yet limp on until the next election.

Item One in this discontent is the government’s covid strategy. Many Tories feel that it is too heavy-handed and too beholden to cautious experts. Leave the public to make up its on mind on precautions and take the consequences, they suggest. Their thinking is plainly muddled, and out of touch with most voters, but at least as the virus morphs into something a bit less deadly, so policy can move on in their direction.

Item Two is Brexit. In Tory eyes this was meant to be a great liberation from bureaucracy, which would allow “buccaneering” British business to achieve its full potential. And yes, one prominent Tory did use that word, referring to licensed pirates on the high seas back in the 17th and 18th centuries, at whose modern equivalent the Russians’ advantage is surely unassailable. In fact businesses have been mired in even more form-filling, associated with imports and exports to the European Union, which surrounds the country, and is thus its readiest partner for both. Some remember that it was much simpler back in the 1960s before Britain entered the Common Market – failing to understand how the world has moved on. Meanwhile rolling back regulations has been happening at a snails’ pace, as the regulations were more than a bureaucratic whim, and aimed to achieve a public good – which has to be achieved in an alternative way. Downing Street has resorted to pointing to crowns printed on beer glasses and the changed colour of passports as among the main achievements of Brexit. And that is before the insoluble problem of Ireland is brought into the picture, ever capable of exploding with dire consequences. In fact most Brexit voters, including the former Labour-voting ones that Mr Johnson so successfully courted in the 2019 election, never much cared for deregulation as a reason for Brexit. They wanted to see more restrictive immigration policies – which the Tories have indeed delivered. But that has brought more bureaucracy, and snarl-ups due to labour shortages. Tory MPs’ business friends are not particularly happy, even as Tory voters are now a lot less worried about the issue.

And Item Three is taxes. They are going up, both corporate taxes and national insurance, levied on people in work and their employers. This is nominally to pay for grasping the nettle on the emerging social care crisis, but in fact the money will disappear into the National Health Service, which has been completely disrupted by the covid crisis, and now has massive backlogs for routine care. The Tory discontents say that above all they should be a party of lower taxes (especially on businesses and the rich, sotto voce) – and that this is a betrayal. Mr Sunak hints that if it was left to him, he would be cutting taxes soon. Most people outside the Conservative Party wonder if he can possibly be serious. With little room for manoeuvre on the budget deficit and national debt (and if you don’t think such things are relevant, high inflation suggests fiscal excess) the only way this vision can be delivered is by cutting government spending.

At the heart of this is rising spending on the NHS. Since the party regained power (in coalition) in 2010, the government has attempted to cap NHS spending so that it just about kept pace with inflation. But as the baby boomers age, and skew the ratio of older people, demand has been rising at a higher rate. The financial pressure has caused system resilience to be reduced, and this is one of the causes of the now alarming backlogs. Tory hopes that NHS costs are containable are based on two fallacies and a misconception. Fallacy One is that demand can be met through making the service more efficient. Any user of the service can point to inefficiencies in this massive, bureaucratic behemoth of an organisation. But that comes with the necessary scale and complexity of what the healthcare sector is trying to do – international comparisons show that Britain’s health services are amongst the world’s most efficient. But these same comparisons also show that in many areas Britain’s health services less effective. We are, to quote The Times columnist Matthew Parris, “getting a second-rate service for the cost of third-rate one.” This is not what the public wants, and further cost restraint is liable to mean the service becoming third-rate all round.

Fallacy Two is that faster economic growth can allow spending to keep up with demand. Alas the headwinds against growth in a modern, developed economy are many, and I have written about these many times. That demographic problem that is stoking up demand is not least among them. Besides there is plenty of evidence to suggest that the wealthier people become the more demand there is for health services. Which leads me to the misconception: which is that excess demand for the NHS arises because it is free. That suggests that there should be ways of persuading the public to make do. But the problem is that the effective NHS monopoly on health care limits supply. Other systems are much better at mobilising private money – and where they do, demand is higher, not lower. A large and growing healthcare sector is one of the features of any modern, developed economy, however it is financed. Resisting it will breed discontent.

That points to an answer. If Britain could move healthcare to a public insurance model, such as the Netherlands or Australia have, the public would both get a guarantee that their basic needs will be met, and the mobilisation of private money to pay for a world-class service. I have been to Australia quite a bit over the years – and one thing I hear very little of is discontent with its health system. And Aussies know how to be discontented. But such a shift, as surely almost all Tories know, is an impossibility. For all its faults, the public has become attached to the system. And trying to mix more private money into it would be seen as a betrayal of its ethos. Doing this as a open public policy is clearly suicidal. But doing so by stealth, by restraining the public service while allowing the private sector to grow, is problematic too – although exactly this has happened to dentistry and optometry already. If wealthier people are paying big taxes for a service they don’t use, it will create discontent, and reducing their taxes will starve the public service, making it even worse. Neglect of the NHS under the Conservative governments of 1979 to 1997 was one of the reasons that support for the party collapsed in the 1990s. And one of the reasons that Mr Johnson did so well in 2019 was by promising to invest a lot of public money in the NHS, amongst other public services.

But people can pay more tax. Taxation in Britain is not especially high by European standards. If the system is well-designed the harms can be limited. Tories will have to embrace this, unless they want to challenge the public shibboleth of the NHS. Instinctively many Conservative MPs understand this, and they may realise that Mr Johnson represents the best way of postponing this awkward choice, and they may well let him muddle on.

What Conservatives should be doing is developing a new vision for the 21st Century that embraces higher taxes and a well-funded NHS at the heart of a flourishing health economy, based on world-leading health research and development. This is perfectly credible, unlike world leadership in buccaneering.

Now is the time for austerity

Contrary to some of the headlines, yesterday’s British Budget was an austerity budget. Its aim was to bring current spending and taxes into balance in three years, with a capital deficit restricted to 3% of GDP. With the current budget deficit at around 11% of GDP, that is a sharp contraction. The Institute of Fiscal Studies points out that most households will be worse off next year. The ratio of tax to GDP is widely projected to be the highest since the years of postwar austerity. Austerity is what current economic conditions demand. The main risk is that it will not be enough, and that it will precipitate a recession in the run up to the next general election.

That the Budget felt the opposite is down mainly to brazen but effective news management by the Chancellor of the Exchequer, Rishi Sunak, and also to a stroke of good fortune. The main bad news was the substantial rise in National Insurance, alongside the withdrawal of most of the emergency support for Covid, notably an uplift in Universal Credit and the furlough scheme. This news had been broken weeks ago, and presented as in the former case a bold stroke to deal with the growing crisis in social care, and in the latter as the coming to an end of the pandemic nightmare. The stroke of good luck was that the independent Office for Budget Responsibility that produces the economic forecasts on which the Budget is base offered a more optimistic picture of the years ahead than hitherto. It charted a rapid recovery from the pandemic with a reduced level of long-term damage. The country is indeed rapidly recovering from the shutdowns that disrupted the economy, making the furlough scheme in particular redundant, and this does improve the economic statistics – but beyond that this all chaff. The tax rises have little to do with the social care crisis; rising prices mean that the Universal Credit cut is causing hardship; economic forecasts have a paradoxically backward looking methodology which makes them very unreliable. Mr Sunak has navigated these treacherous waters cleverly, but what does this all mean in the cold light of day?

Austerity, by which I mean the squeezing of the government deficit by raising taxes or cutting spending or both together, has a bad name at the moment. In this country it is attached to the policies of the Conservative/Liberal Democrat coalition of 2010 to 2015, after the Great Financial Crisis (GFC), and to the following Conservative-only government. The crisis had shredded government finances, but its aftermath left economic demand weak. Economists pointed out that in these circumstances it was usually wise to loosen government finances, not tighten them. Years of hardship and lacklustre growth bore this analysis out. The defenders of austerity stuck to economically illiterate but intuitively appealing arguments, making an analogy with prudent household budgeting and the idea of protecting future generations from debt. There was a literate defence of government policy to be made, at least up to 2015, but practically nobody made it – I was a lonely voice (Lib Dem Business Secretary Vince Cable also made a valiant attempt). This put the blame on the unbalanced nature of the economy before the crisis and the need to restructure it. But even I (and surely Vince) thought the austerity was overdone, especially with regard to public investment. Meanwhile the literate economic critique gave the left their opening to demonise “Austerity” as vicious crime against humanity. Loose fiscal policy and economic growth came to be seen as two sides of the same coin.

Given that experience, it was natural to respond very differently to the next economic crisis, brought on by Covid-19. Government coffers were immediately opened up with a number of very generous schemes to support individuals and businesses. These were successful in alleviating a lot of hardship – though economists making comparisons between different countries have struggled to draw a connection between fiscal generosity and the scale of economic damage. Britain’s government was one of the most generous, but many others suffered less economic damage. That, though, is more a reflection of poor management of public health than the economic policies. Also Britain was coping with a further disruption: dropping out of the European Single Market and customs union, and the implementation of tighter immigration controls – which collectively I will call “Brexit”. All the same it points towards a greater truth: this crisis is very different from the previous one, and that affects the economic response.

In retrospect the remarkable thing about the GFC is that it affected the demand side of the economy more than supply. Important though it may be to the functioning of the economy, the financial sector at the centre of the crisis did not have such a big impact on the “real” economy – relatively few jobs were directly impacted, and a lot of those were saved by narrow but generous government intervention. What it did was to increase the level of net saving by making it harder for people to borrow, while at the same time the shock stopped businesses from investing. Increased saving paired with reduced investment is the very definition of a Keynesian recession, to which the public policy response should be to loosen fiscal policy.

But the problem this time is very different. Demand is alive and well; the impact of the crisis on jobs has been muted, while the lockdowns have allowed many people to accumulate savings that are now available to spend. Supply, however, and especially in Brexit Britain, has been hit hard. This is particularly evident in trade and logistics, and also in energy. The problems are global, but Brexit has added an extra dimension in Britain, especially as many foreign workers went home as the lockdowns took effect. This was what the economy demanded at the time, but these workers are reluctant to come back, partly, but not only, because of immigration controls. In the last two decades Britain has relied on two safety valves to regulate its economy: imports and immigration. Mismatches in supply and demand have been met through both – and in particular the fact that the supply side of the British economy is relatively weak. Now neither is working properly – or rather they are only working in one direction – to accommodate reduced demand, as in the early stages of the pandemic, but not its increase. The result is visible: inflation.

Government politicians and economic forecasters shrug the problem off. The problems are temporary, they insist. Once more ships are back plying the seas and containers located in the right places, and businesses have adapted to the changed environment, then it will be business as usual. But this is complacent, and especially so in Britain. It reminds me of the early stages of the GFC (and has resonances with what I read of the oil shocks of the early 1970s); the crisis was evident by mid 2007 when the uncertainties arising from complex derivatives linked to the US housing market caused international interbank markets to freeze up. At the time (alas before I had started blogging) this was scary enough for me to sell all shares in my pension plan and invest in index-linked gilts. But most people were in denial, supported by the usual backward-looking economic data, which showed th problems to be limited. The metaphor I used at the time was of a ship holed beneath the waterline desperately sailing for safety. That metaphor works less well this time, but the problems with supply look deeper than most people are allowing. And in Britain the changes following from Brexit are long-term. The Prime Minister, Boris Johnson, cheerfully talks about the economy responding to the difficulties by restructuring to become a high-skill high-wage one; he is even encouraging people to push for wage rises. But such changes take time and investment – and meanwhile all putting wages up does is encourage a wage-price spiral. We have thrown away the stabilisers on our bicycle without having learnt to ride it unaided. These are exactly the conditions where governments should reduce overall demand by applying austerity.

What happens if the austerity is not enough? This was the topic of my last post. Inflation gets stuck at a high level; interest rates go up; hardship spreads across Middle England (and Scotland and Wales) and property prices dive; the costs of government spending go up. Recession follows. Most Government supporters seem to be in denial. The smarter ones (and I suspect that Mr Sunak is among them) hope that with clever footwork they can time the next election in a sweet spot while people are feeling good from inflationary payrises before the devastation strikes, perhaps supported by a (reckless) tax cut. But at least there is some appreciation that austerity needs to be the direction of travel. Alas the left have not caught up with this fact, ever unwilling to acknowledge that economic policy depends on context.

The government’s choice: higher taxes or higher interest rates?

Britain’s Conservative government is approaching two years in office. Depending on how it amends the legislation on fixed-term parliaments, it will seek re-election in as little as a year and half (May 2023), or, more likely, in two to two and half years (later in 2023 or May 2024). The endgame of this parliament’s existence is now in sight. Tory thoughts turn to the question of how to secure a further term in office.

The 2019 election was fought largely on the question of “Getting Brexit done”, as the Conservatives successfully framed it. But they also set out a broader agenda: “levelling up” – tackling inequality by securing a better deal for the less well-off regions and groups rather than by punishing the better-off; improving public services – mainly the NHS and police; curbing immigration – the big dividend from Brexit; and keeping the country on the path to carbon neutrality. This is pretty popular and the government shows no sign of backing down on any of it. But with the possible exception of immigration, these aims aren’t notably different from the opposition’s. The Tories are further distinguished by putting more faith in the enterprise and initiative of private individuals and businesses, rather than a bossy government and government-sponsored mega-projects (even if Boris Johnson, the prime minister, has a weakness for the latter). To many observers this agenda looks impossible to reconcile – a question of “have your cake and eat it”, but it is not entirely vacuous. The left tends to underestimate the importance of setting the zeitgeist so that private initiative sets society on the right path.

Nevertheless the shallowness of most Conservative thinking is breathtaking. One example of this is the idea, popular in the party, of announcing a cut in income tax before the next election. The idea is that this would show the benefits of Tory stewardship of the economy, and drive a wedge between Labour and many of its potential supporters. It would also straighten up the record a bit after the party was forced to raise National Insurance, which it had promised not to do. It is a truly terrible idea. Basic Rate Income Tax, alongside VAT, is the the most broadly based tax the government raises, and it is therefore a valuable economic tool. And yet raising it has become a politically toxic idea, ever since Labour under Tony Blair and Gordon Brown promised not to do so in the mid-1990s. They preferred to raise National Insurance instead, even though this tax is narrower, and the employer-levied version adds friction to job creation. One of Mr Brown’s biggest mistakes was cutting the tax to 20% in 2007. The Great Financial Crisis soon after showed how much the government was relying on volatile capital taxes, and the income tax cut contributed to a dire budget deficit that panicked the subsequent coalition government into drastic spending cuts. Cutting the Basic Rate adds a level of instability to the country’s economic management.

Still, that line of argument is unlikely to appeal to Tory MPs, who seem to have a blind faith in muddling through. The bigger problem for the party is that supply and demand is out of kilter in the UK economy, and cutting taxes will add fuel to the flames. As demand recovers from the shock of the Covid pandemic, it has revealed weaknesses in the supply side of the economy, which can’t keep up. Some of the problem is worldwide, with the global trading system put under stress by problems in container shipping, for example, or the production of microchips. But Brexit, or more precisely the country’s rapid departure from the Single Market and customs union, has made the problem much worse. On top of that there is the government’s hostile attitude to immigration, especially of people on lower rates of pay. Many immigrant workers have left the country, and don’t want to come back, even if the government would let them. These problems have hit the distribution of goods particularly hard, and imports especially. That matters a lot, because the usual way for the British economy to handle excess demand is to import more. With that option closed, unless the public starts to save more, the consequence is inflation. And sure enough, inflation has risen already. The government is even encouraging it by urging businesses to pay people more.

This is bad news for the government. Inflation is a corrosive economic disease that attacks savings, and usually hits the less well-off, and those reliant on pensions the worst. These are critical parts of the Conservative base (i.e. savers and pensioners). Under the widely accepted understanding of economic policy the way to counter inflation is to increase interest rates, preferably so that they exceed the rate of inflation itself. Right now official interest rates, which drive commercial rates, are very low, and less than inflation. This has enabled many people to afford very high levels of borrowing, usually to buy houses. It also means that the high level of government debt is not actually all that expensive to service (this may not impress followers of Modern Monetary Theory very much, but it matters to the government’s political credibility). Any rise to nominal interest rates will cause widespread pain, which will create a sense of economic crisis. One thing that tends to characterise Conservative voters is ownership of property. Rising property values gives them a sense of wellbeing (even if they have paid off the mortgage), and declining values makes them thing the world is going to pot. If mortgages become more expensive, property prices are bound to fall.

To head this off the government needs to reduce demand. The best way of doing this is to increase one of the broadly based taxes: Basic Rate Income Tax, Employee National Insurance or VAT. Taxes that hit the rich, such as Higher Rate Income Tax, are much less efficient for this purpose, as the rich save more – though they would help with the national debt. The government is, in fact, increasing Employee NI (as well as Employer NI), which will help. It also also trying to cut government spending. It has made a start by withdrawing Covid emergency measures, such as the furlough scheme and Universal Credit. But the politics of large additional spending cuts is awful. Maybe this will all be enough – but I doubt it.

Doubtless the Conservatives hope that within a year the inflation scare will have blown over, and that would give them the wriggle-room they need. And yet many of the supply-side problems that drive it will take years to solve, and may only be solved with a permanent cut to consumption levels. Responding to the problems with pay rises, as the government is encouraging, will also lengthen the time it takes for any settling down.

The chances are that there will be no room to cut income tax before the end of this parliament. Tory party managers should be thinking of other ways of trying to securing political advantage.

How will Britain’s economic chaos pan out?

Britain is suffering mounting economic chaos as supply chains break down. The government shrugs – these are just teething problems, the Prime Minister, Boris Johnson, suggests, as Britain finds a new normal as a high-wage high-productivity economy. Is this the nonsense it seems to be at first sight?

It doesn’t help that reporting on the emerging problems is very superficial – simply the regurgitation of statements put out by interested parties with no attempt being made get to the bottom of things. The government chooses to dissemble rather than inform. The current petrol crisis, running into its second week here in Sussex, even if it is easing elsewhere, is a case in point.

The government blames it on consumers – or a surge in demand caused by “panic-buying”. After the first few days this was clearly nonsense. People were running out of petrol. Such evidence as we had from the queues outside petrol stations, admittedly anecdotal, was that most people had delayed filling up, and were now desperate. And yet nobody seems interested in trying to understand what was really happening. The government kept on repeating the tangential but irrelevant fact (if it is the case) that there was plenty of petrol at the depots, followed by the non-sequitur that if people simply behaved normally the situation would right itself quickly. This morning the BBC Today programme interviewed a forecourt manager in Kent – and suddenly things started to make a bit more sense. Instead of the normal four fuel deliveries in the last week he had received just two. The current situation had come about because supply problems over the summer meant that forecourt stocks had run low, so that the slightest blip was enough to knock the whole system out of kilter. He didn’t say, but it was easy to infer, that a continuing shortage of deliveries meant that the system couldn’t right itself. This is fundamentally a problem of supply, not demand. The government’s tactic of increasing the number of tanker drivers, including by the use of the army, starts to make sense. It wasn’t simply a confidence-building measure, as ministers seemed to be suggesting, but an attempt to fix a broken system.

And what is happening to motor fuel is being repeated across many other sectors. A lethal combination of a hard Brexit, restrictive immigration rules and the covid-19 pandemic is delivering a series of critical labour shortages. The most notable is that for heavy goods vehicle (HGV) drivers, which is behind the fuel crisis. But it is far from just this – there is an emerging crisis on the slaughtering of pigs, for example. Problems emerged in the summer, or before; businesses did what they could to manage, but at the cost of resilience; as difficulties arise, the system breaks down. A small uptick in motor fuel demand broke the distribution system and it requires an influx of additional resources to fix it; the large, seasonal uptick called Christmas is approaching, covering all manner of goods (though hopefully not motor fuel). Muddling through could easily tip into breakdown in many parts of the economy.

The government’s problems are both in ideology and competence. Ideologically the government wants to move to a different sort of economy, less reliant on cheap, imported labour. Its leaders also believe in the problem-solving capabilities of free markets and private enterprise, and the need for government to step back. They fully expected teething problems following Brexit and the roll back of immigration, but they expected that businesses would adapt and solve these problems without the need for government intervention. So they shrugged off the early warning signs. And for the most part ministers lacked the competence to see how problems could become unmanageable, and what the best interventions might be. It doesn’t help that the public appears unwilling to hold the government to account, and seems happy to accept that “stuff happens” and that it is all somebody else’s fault. So we have strategy but no tactics.

Does this strategy make sense? I always felt that the strongest case for Brexit was what I called “the hair shirt” one – that Britain had it too easy in the EU, and was relying on cheap imports of both goods and labour. Brexit could force the country to raise its game, and move to higher productivity. Living standards would fall in the short-term, but the result would be more sustainable. What other countries have succeeded in reaching this high-wage high-productivity model? Not the US, where high levels of inequality make cheap labour plentiful in many places, and where the currency can be kept at a high level to make imports cheaper. The most obvious examples of the are in Scandinavia, and Denmark and Sweden in particular. These are obviously not such good exemplars for Conservatives, as they have achieved this within the European Union. Switzerland may be a more a congenial example, though it has opted for a higher level of European integration than Britain has. However there are also the examples of Canada, Australia and New Zealand – which are doubtless more acceptable. Japan, perhaps, is another case. But all these countries have built their success on strong exports, in agriculture, manufacturing and mining. Britain no longer has the potential for agriculture or mining exports on the scale needed; its manufacturing has been hollowed out. There may be alternatives, perhaps based on the country’s world-class university sector. Various aspects of health technology seem to me to be the most promising – especially since the centralised structure of the NHS provides opportunities for data mining (if that’s the right word). There could be a path through to the sort of wealthier and more equal society that the government seeks, or says it does.

But it is hard to see how the country can get there without serious investment, led by government. The education system is an obvious case in point. Universities look to be in relatively good health, so long as the supply of foreign students can be maintained, which means allowing successful graduates to stay in the country if they wish. The obvious gap is in technical education, to fulfil the many mid-level jobs that a high-productivity economy needs, as well as making the best use of the country’s Human Resources. Clusters of technical excellence also need to be developed across the country – this is best led regionally by empowering regional and local government. I also think that a better-resourced health service is required, both to supply the quality of service a country of Britain’s income level should expect, and to be the anchor for an expanding private health economy, developing new treatments and technologies that can be applied worldwide. These investments would need to be financed. If a government had the courage of its convictions, it would do a lot of this through borrowing – as the investment should yield a bigger money economy to tax in future. But doubtless more tax income would be needed too.

And yet the government has no such clarity. Rishi Sunack, the Chancellor of the Exchequer, talks of fiscal prudence and even future tax cuts. Unless he means to do the opposite of what he says (a possibility that this government is quite capable of), this is a bad place to start. A period of cuts to areas that need more money is beckoning. Meanwhile the government urges businesses to overcome labour shortages by raising wages. This at a time when one of the government’s key policies is a public sector pay freeze. Wage rises may be a good thing, but they are also liable to lead to price rises for the goods that people buy – a process that could lead to intolerable pressure through the economy. It is all very well to hope for higher productivity, but this is hardly feasible in many of the areas under stress – such as HGV drivers.

Where is this heading? The government has already been forced to “temporarily” relax immigration rules for HGV drivers and some others. Much more of this is likely – the government will try to tackle the shortages of “low-skilled” workers though temporary immigration visas. This is a strategy that many countries have followed, and it rarely goes well. It either fails because the jobs aren’t attractive enough, or more likely, it will simply draw in an underclass of highly exploitable workers from poorer countries, which could form the basis of poorly-integrated immigrant communities of the future, as the idea of “temporary” gets ever more stretched. To its credit, the government is clearly alive to the dangers, but it may find it has little choice. Another safety valve for the economy is increasing imports – though this won’t reduce the dependence on HGVs – as the country proves too small to sustain productive supply chains by itself, it can make use of those from abroad. That can be financed by the sale of ever more assets such as property and businesses to foreigners – perhaps the real meaning of “Global Britain”. This will be no more appealing to patriots.

And meanwhile in one part of the country an interesting economic experiment is taking place. Northern Ireland has one foot in the EU single market, and an open border with the Union. This has created supply chain problems with the mainland and empty supermarket shelves. But they didn’t suffer from petrol shortages (or not to the same critical extent). As the province’s supply chains become more integrated with the Irish Republic, and thence the wider EU, perhaps it will find things easier than its compatriots over the water.

I shouldn’t underestimate the resilience of Britain’s economy. Perhaps the stresses will indeed push the country towards a more modern economy – electric cars certainly look more appealing now. But for once I’m not optimistic.

Should we be worrying about inflation?

Now is a very interesting time to be a macro-economist. The shock arising from the covid-19 pandemic is unprecedented in its extent (barring world wars, maybe) and its economic effects. Government responses, with very loose monetary policy combined with generous fiscal measures, is similarly unprecedented. The latter is remarkable in that its generosity is far greater than that shown by governments following the Great Financial Crisis that started in 2007. Economic conservatives have been routed and are grasping for evidence that their once confident assertions about the public debt and deficits have a basis in fact. These generally turn on the question of inflation.

Inflation plays a critical role in macro-economics. In theory it is what happens when supply fails to meet demand across an economy. There a number of reasons that this can happen but the most important, to macroeconomic commentators, is when a when aggregate demand is boosted by a government spending too much or taxing too little. Or, putting the same idea in a slightly different way, when too much money is being put into circulation by government policy. It is one of the points of agreement between orthodox conservatives, whose narrative is that bad things happen when governments intervene, and advocates on the left for Modern Monetary Theory (MMT), whose narrative is that governments can and should spend freely so long as inflation is kept at bay. Things get more complicated when you try to apply the theory to an open economy – one that trades substantially with others – that issues its own currency, but this is usually glossed over.

The theory of inflation had to be redeveloped after the 1970s, when inflation (excess demand) and high unemployment (inadequate demand) co-existed in so-called stagflation. The new theory, working its way through such ideas as monetarism, a craze of the 1980s, to the Neo-Keynesian consensus of the 1990s, built on the idea of inflation expectations. This suggested that inflation could happen simply as a function of the zeitgeist. The standard theory was that therefore it was essential that inflation expectations were “anchored”, and that it was the central bank’s job to do this. This theory has become so embedded that organs such as The Economist, who should know better, report it as fact.

In the first two decades of the 21st Century inflation in the developed world has been stable and quite low (around 2% per annum and often less). This has been hailed as a great success for central banks, who have firmly anchored those expectations. It has also been taken up by MMT enthusiasts as evidence that reticence over government spending and national debt, and especially the demon “austerity”, is vastly overdone.

And so here we are now. Many developed world governments, led by the United States, have thrown caution to the wind in response to the pandemic. This appears to have been remarkably successful in in that the economic impact of the calamity has been relatively limited. But now inflation seems to be breaking out everywhere. Optimists say that this is just the result of temporary supply bottlenecks, pessimists say that over generous economic policies are coming home to roost. Commentators pore over the available data and argue like mad.

If you find all this rather perplexing, you should. Macro-economists inevitably deal in simplified models that represent the actual world but imperfectly. The statistics they deal with, such as income and, indeed, inflation, are similarly imperfect representations of a complex reality. They all know this, but instead of taking on an air of humility, they find it easier to gloss over the difficulties and wallow in the vicarious power of dealing in the fate of millions. In the process most of them have become completely detached from reality.

Inflation is a case in point. What most economists seem to mean by the term is a devaluation of money: the price of everything going up without anything deeper going on. One of the 1980s economists suggested that “Inflation is everywhere and always a monetary phenomenon,” because it couldn’t happen in that favourite fiction of conservative economists, a barter economy. But a general rise in consumer prices may simply be part of a widespread balancing out of things across different markets. In the 19th Century, according to statisticians who estimate these things, there were many surges in prices, but compensated by falls at other times, so that there was no overall rise over the long term. Not coincidentally, money was closely linked to gold at the time, though that is incomplete as an explanation. A more recent example is the inflation that accompanied the economic boom in Ireland after it joined the Euro. This rise in prices was the only way an open economy could respond to a surge in productivity without a now-impossible currency revaluation. That didn’t stop the European Central Bank ticking the Irish government off. Another example came during the austerity years of the British Coalition government after 2010. There was persistent (though not especially high) consumer price inflation. But this wasn’t matched by wages, and it was simply the economy reflecting the reality of lower living standards. I remember one commentator suggesting that the inflation would make debt easier to pay off; nonsense because you pay debts out of income. Inflation then was not reflecting a devaluation of currency.

So what is happening now? Prices rises genuinely seem to reflect shortages in supply relative to demand, both in goods markets and labour markets. These may well reflect temporary bottlenecks. We can expect this to go on for some time as the pandemic has had far-reaching impacts on many supply chains and labour markets. Yesterday our local picture framer was complaining on behalf of his glass supplier that the cost of hiring a container from China had risen from £500 to £8,000 (or something like that), because all the containers are in the wrong places, not to mention the disruption to the Suez Canal. In Britain we have the added complication of Brexit disrupting both goods and labour markets; in that case when the dust settles most people are bound to end up a bit poorer. But the pessimists have a point too. The entrenched inflation of the 1970s started with similar temporary shocks, to the oil market in particular. If it really is all about expectations, this is how it starts. But there is so much noise in the statistics that it is really very hard to see what is going on.

Personally I am less concerned about inflation that many. I think the 1970s-style inflation was mainly a product of unionised labour markets and less flexible supply chains, which gave labour much more power. This certainly had a good side in ensuring a fairer distribution of wealth, but it prevented adjustment to economic realities. In today’s much more open world economy there are other ways than inflation for unsustainable excess demand to play out, in the most developed economies anyway. In the 1990s it may have been right to talk about inflation expectations being anchored by the central bank, but the world has moved a long way since then. Inflation is held in check by the forces of global trade. The stress is taken in the financial system through higher levels of debt and international capital flows. This is likely to end in financial busts rather than 1970s stagflation.

So if there’s trouble ahead we are looking in the wrong place. Is there trouble? Financial asset markets certainly look as if they are in a bubble, but the banking system looks a lot healthier than it was in 2007, when the last great financial crisis started to gather momentum. In Britain I think things are going to get much bumpier as the government tries to bring its budget deficit (currently an eye-watering 11.5% of GDP, though less than America’s 13.9%) back to a new normal. But there are so many uncertainties as to what a sustainable new normal will look like, that this very hard to predict. This is going to dominate politics from 2022 on as there is no coherence to the government’s message on this.

Interesting times indeed.