Fiscal Event: Chancellor Kwarteng’s New Era

“A new approach for a new era”

In a curious twist of fate in which Mistress Fortune excels, we have seen or heard little of the prime minister and her finance minister since they entered Downing Street (Numbers 10 and 11 respectively) more than two weeks ago. That is, of course, because an unimpeachable monarch who had reigned for over 70 years died on Day Three of Liz Truss’s premiership. The nation has been in mourning and distracted by the obsequies of Her late Majesty until early this week. Unsurprising then that an Australian TV pundit struggled to identify the woman who delivered the Gospel reading (John 14:1-9) at the Queen’s funeral in Westminster Abbey on Monday (19 September).

One thing that we did learn during the period of national mourning was that Mr Kwarteng’s first act was to fire the Treasury’s supreme mandarin, Sir Tom Scholar. This was considered, predictably, highly improper behaviour by retired mandarins Lord Butler (who was cabinet secretary to Margaret Thatcher, Sir John Major and Sir Tony Blair) and Lord O’Donnell (cabinet secretary to Blair, Gordon Brown and David Cameron). Sir Tim’s rumoured successor is Antonia Romeo, who served as Permanent Secretary at the Department for International Trade when Liz Truss was Trade Secretary.

Sir Tom’s departure reflects the Truss-Kwarteng worldview that the Treasury has become too focussed on redistribution and crisis management and too little concerned with fostering growth; and that it is overly cautious on fiscal policy. It has presided over “a vicious circle of stagnation”, Mr Kwarteng opined. Many Tories who backed Liz Truss for PM also think that Sir Tom and his underlings were behind “Project Fear” which rendered the process of negotiating Brexit so much more painful.

Under the Johnson government, it was the Treasury which blocked initiatives to profit from Britain’s departure from the EU. The accusation is that the Treasury, like much of the civil service, is “declinist” and therefore pro-EU because it believes that we much cling to our European partners (even though they too are evidently in relative decline). And the massive losses to criminal fraudsters under the various Covid support schemes cannot entirely be blamed on Mr Sunak. If the “Treasury View” is essentially conservative (with a small “c”), the Truss-Kwarteng worldview promises to be radical. It involves an “entrepreneurial and shareholder democracy” in which the tax code is much simplified. The government now has a target growth rate of 2.5 percent. The question is how that can be achieved.

The fact is, however, that inflation is messing up the public finances. The Institute of Fiscal Studies (IFS) reckons that last November’s Spending Review will require a £44 billion top-up over the next three years to make good its spending pledges. About half of that is related to the health and social care budget. £44 billion is more than the cost of cancelling the Johnson-Sunak hike in national insurance contributions (NICs) – which Mr Kwarteng confirmed yesterday, to take effect on 06 November.

On Thursday (22 September), the Bank of England raised the base rate by 50 basis points to 2.25 percent at a Monetary Policy Committee (MPC) meeting that had been delayed by a week because of the period of national mourning. This was pursuant to a 75 basis point hike by the Fed on Wednesday. The pound rallied slightly – though this morning it is down further to $1.12.

The package, already announced, to cap household – and now businesses’ and institutions such as schools’ – energy bills at £2,500 could cost up to £200 billion over two years. Mr Kwarteng put a figure of £60 billion in the first six months this morning. The final cost will depend on how quickly gas prices begin to fall after the European winter. The Energy Price Guarantee is effectively a government subsidy for all households, regardless of need. Few incentives have been offered to induce households to lower their energy consumption. And how will the £100 billion or more this year be financed? By new borrowing, it seems.

The challenge will be aggravated by the prospect that the Bank of England may not be able to continue its role hitherto acknowledged as official “magic money tree” to the state. In Andrew Bailey’s first week as Governor of the Bank in March 2020, he injected £200 billion of new cash into the economy. He was accused of bankrolling the Covid-stricken state – which is not within the Bank’s mandate. But now, instead of buying bonds with invented money and lodging them on the balance sheet of the central bank, the Bank is selling them. A new era indeed: quantitative easing has given way to monetary tightening.

If Truss-Kwarteng can put the lid on inflation by subsiding household and small business energy costs as the French and others have done, then the financial markets may cease to regard Britain as in deep distress – which it is not. (The real reason why the pound is falling in my opinion is that the money men think that the Tories will lose the next election). But to issue new government debt at a moment when the central bank is also selling off its existing stock of government and corporate bonds implies that bond yields will spike further as demand exceeds supply. The yield on 10-year gilts has spiked to over 3.5 percent this morning. That means that borrowing costs will rise further – and that is set to become one of the key challenges for the Truss government.

Despite the gloom, 30 years on from “Black Wednesday” (16 September 1992) when sterling was ejected from the (European) Exchange Rate Mechanism (ERM), Barclays thinks that talk of a 1970s-style currency and balance of payments crisis is “scaremongering”. Barclays is projecting that the pound will end the year around the $1.22 level. That said, the current account deficit (that is, the difference between exports and imports) stood at a record 8.3 percent of GDP in the first quarter of this year. That is a small part due to additional trade “frictions” arising from the post-Brexit dispensation, and a large part due to the increasing cost of imported hydrocarbons.

Inflation may have peaked overall but food and drink prices were up by over 13 percent in August relative to the year before. Some dairy products are up by 40 percent and meat by 20 percent – no wonder the food banks are busy. The inflation rate overall has fallen thanks to an easing in petrol prices. Retail sales fell by 1.6 percent in August as shoppers tightened their belts. The only sectors which enjoyed increased sales were newsagents and off licenses (liquor stores) which were up by 6.3 percent – suggesting that people, if not drowning their sorrows, are not cutting back on the booze even as it gets more expensive. Good news this morning then that planned increases in duties on alcoholic drinks are to be cancelled.

Increasing spending – Defence

During her leadership campaign, Liz Truss expressed the aspiration to lift defence spending from 2.2 percent of GDP to three percent of GDP. The Royal United Services Institute (RUSI) estimates that that would require an additional £157 billion in defence spending over the next eight years.

That would come on top of the massive energy support package. But one should see this in the context of history. In 1955-56, in the early years of Her late Majesty’s reign, 21 percent of government expenditure was dedicated to defence and just eight percent to healthcare. In recent years it has been 18 percent on healthcare and five percent on defence.

Cutting taxes – corporation tax, stamp duty and income tax

This morning Kwasi Kwarteng cancelled Rishi Sunak’s proposed rise in corporation tax from 19 to 25 percent. Britain will continue have the lowest level of corporation tax in the G-20. New modelling by the Washington-based Tax Foundation and the Centre for Policy Studies (CPS) shows that in the long term this could increase GDP by 1.2 percent by avoiding the hit to GDP that would otherwise have taken place.

The modelling shows that if the government were to go further, and incentivise business investment, he could increase long-run GDP growth. The two think tanks have modelled the impact of various scenarios proposed by the Sunak Treasury, as well as the costs, and considered further policy scenarios which extend capital relief to buildings as well as plant and machinery. As I have written in these pages before, the headline rate of corporation tax is less important than the prevailing regime of capital allowances – that is, what kinds of capital expenditure can be offset against tax.

According to the Tax Foundation, between 1995 and 2015, Britain had one of the lowest levels of business investment in the OECD, suggesting that the UK tax system has been hostile to investment. The Tax Foundation’s 2021 International Tax Competitiveness Index ranked the UK 33 out of 37 OECD countries for “capital cost recovery” – a measure of how well a corporate tax system treats investment. The UK is also falling behind its European neighbours. In 2021, gross fixed capital formation in the UK was just 17.1 percent of GDP, compared to 22 percent in Germany and 24.4 percent in France.

Rishi Sunak’s temporary provisions for “super-deduction” are set to expire next April. The two think tanks have therefore modelled a wide range of alternatives to replace the “super-deductions”. The research shows that the more ambitious and generous the government is in terms of business investment, the greater the economic benefit.

Rumours that Kwasi Kwarteng would cut stamp duty were confirmed this morning. There will be no stamp duty applied of the purchase of homes worth less than £250,000 (in England and Northern Ireland). Many will say that, given that house prices have risen by 15 percent or so over the last year, the housing sector does not need a tonic. But this will be good news for people contemplating moving home, especially first-time buyers who will only pay stamp duty on houses worth over £425,000.

Income tax was the anticipated rabbit out of the magician’s top hat. The higher rate of income tax (currently 45 percent) is to be scrapped and the standard rate will be cut from 20 pence in the pound to 19 next year – something to which Mr Sunak aspired by the end of this parliament. That means a tax cut for 31 million people.

What spending can they cut?

Cutting the NHS budget without major reorganisation would be politically calamitous. The increases in spending earmarked for social care will be kept in place. With huge backlogs in courts and junior barristers on sporadic strikes, it is unlikely that HMG could cut expenditure on the Ministry of Justice. Local government will also resist further cuts as it already funds much of the spill-over social care budget. Transport might be squeezed – further roadbuilding in an era of transition to net zero carbon looks questionable to me. But something will have to give.

It will be awkward to cut welfare during a cost-of-living crisis. It is pensioners who are going to have to take the wrap. The so-called “triple lock” is likely to be scrapped – something that Mr Sunak opposed.

Deregulation: Bonfire of the quangos?

There is talk that Truss-Kwarteng will seek to reduce the huge number of state-funded watchdogs and regulatory agencies – what the British call “quangos” and the Americans call “parastatals”.

Once a quango is created, however, it engenders an eco-system of clients who have a vested interest in its continuation. And quangos which are abolished tend to pop up in new forms elsewhere – consider how the hopeless Public Health England was replaced by the UK Health Security Agency and Office for Health Improvement and Disparities. Both of these are no doubt worthy bodies administered by serious people – but how are we supposed to evaluate their success?

In short, it is much easier to extend bureaucracies than to curtail them. That is why the impulse to create “arms-length” regulatory bodies which are accountable to, but not controlled by, the state – which started under Mrs Thatcher in the 1980s – should be checked.

In his statement this morning Mr Kwarteng also signalled the abolition of the EU-inspired cap on bankers’ bonuses. As Dan Hannan has pointed out, Brussels has always loathed “Anglo-Saxon capitalism”: yet two and a half years after Brexit, ministers are only now getting round to unpicking its laws. We accrued a lot of anti-competitive legislation under the EU including Solvency II and MIFID II, the Alternative Investment Fund Managers Directive and so on. Since the EU has made it clear that it will not offer “equivalence” to British financial institutions even if our regulatory regime is identical to theirs, we have nothing to lose.

Mr Kwarteng said this morning that our planning system is “too slow and fragmented”. A new bill will be forthcoming soon to “unpick the complex patchwork of planning restrictions”, particularly in so far as infrastructure investment is concerned. New land will be released for development. New residential and commercial developments will be exempt from stamp duty.

Another initiative might be to lower childcare staff ratios to cut the cost of day nurseries.

The dash for gas

On Thursday (22 September) the Truss government announced that the moratorium on fracking in England was to be rescinded. The National Grid thinks that fracking’s contribution to Britain’s energy mix could equal North Sea oil by 2037 – but it is unlikely to come onstream until 2026. The UK currently has two shale gas wells ready for gas production, both operated by Cuadrilla Resources. British energy explorer IGas said in March that it could heat up to 125,000 homes in Nottinghamshire with shale gas by the end of the year if the moratorium were lifted.

The new government’s ministers are courting the oil and gas majors in an effort to accelerate exploration projects in the North Sea. A government taskforce is in discussions with Norway’s Equinor to about a potential £4.5 billion investment in the Rosebank oil and gas field which lies about 80 miles north-east of the Shetland Isles. Equinor took over Rosebank from Chevron in 2019. The Cambo field – about 20 miles south-west of Rosebank – is also in play. Ithaca Energy has a 70 percent stake in Cambo, which could pump up to 180 million barrels oil a year. Shell is committed to the Jackdaw field, which is 150 miles east of Aberdeen.

Ms Truss will need the goodwill of the French to achieve Mr Johnson’s nuclear ambitions. Recently, French media reported that EDF (now fully state-owned) will delay the delivery of Sizewell C in Sussex due to extreme perturbations in the French nuclear energy sector. With exquisitely poor timing, about six French nuclear reactors have been out if service over the summer.

Last week, Business Secretary Jacob Rees-Mogg said that the energy crisis had “exposed the need to strengthen Britain’s energy security for the good of the nation”. Since I have been writing on that theme in these pages for several years – may I be allowed an Alleluia?

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The transition from one monarch to her heir has been seamless. King Charles is to make his first state visit to France. That will be significant in many ways. We love the French, and – as we have been reminded – they love us. We are inextricably intertwined.

Hereditary monarchy makes perfect sense to me. King Charles is the 34^th grandson of Kenneth Mac Alpin, first King of Alba (Scotland); and he is the 33^rd great-grandson of Alfred the Great, King of the Anglo-Saxons and, arguably, the founder of England. According to some genealogists, he is the 41^st great-grandson of the Holy Prophet, Mohammed. I vote for lineage.

Grief should not be sustained too long. Life goes on with vibrant expectancy.

Listed entities cited in this article which merit analysis

• IGas (LON:IGas)
• Equinor (ASA:EQNR)
• Ithaca Energy (LON:IAE)