Recession Inevitable − and If So, Who is to Blame?

15 mins. to read
Recession Inevitable − and If So, Who is to Blame?

Blame the Bank of England

On Monday (16 May), Andrew Bailey, the governor of the Bank of England (BoE) told MPs on the Treasury Select Committee that policymakers had been left “helpless” in the face of surging inflation. Fellow Monetary Policy Committee (MPC) members Dave Ramsden and Michael Saunders said that external factors had contributed around 80 percent of the recent inflationary surge. The other 20 percent arose from constrictions in the labour market.

Even if the BoE had raised interest rates earlier and more aggressively, they insisted, it is unlikely that inflation would have been contained within its official two-percent target (which is set by the Treasury). In fact, as we learnt on Wednesday, the rate of inflation in the UK is now running at nine percent.

This exercise in self exculpation followed reports in last weekend’s newspapers that unnamed cabinet ministers were blaming the BoE for allowing the inflationary ‘cat out of the bag’. Why had they not raised rates in the early autumn of last year when Russian machinations were already forcing gas prices to surge? And why did they continue to print more money with a programme of quantitative easing (QE) until the end of last year, by which time we already knew that inflation was gaining pace? Moreover, why did the BoE – and indeed the Federal Reserve in the US – continue to insist that inflation would be “transitory” when there were good grounds to believe it might be sustained?

Nobody blames the central banks for the coronavirus pandemic; the freezing of the economy resulting from periodic lockdowns; and the consequent disruption to global supply chains – which persist as China continues to pursue a “zero-Covid” policy. Nor does anyone blame the central bankers for the war in Ukraine which has put a bomb under energy and food prices. But it is not unreasonable to ask why our central bank did not act with more celerity to forestall the current tsunami of inflation.

The economist Gerard Lyons, whom some readers may have heard speak at this year’s Master Investor Show, thinks that the senior management of the BoE is guilty of groupthink – as is the Treasury. It is interesting that the one MPC member who consistently warned about the inflationary surge, Andy Haldane, quit the BoE last summer and now runs the RSA.

Indeed, while the BoE is independent, the Treasury and the BoE have exhibited a strange codependency. The BoE’s high command thought that the age of near-zero inflation (and therefore near-zero interest rates) would continue to persist indefinitely; while the Treasury mandarins believed that new government debt was sustainable, given rock-bottom interest rates. During the pandemic – roughly from March 2020 to March this year – public expenditure increased by about £450bn, and the amount of QE initiated by the BoE amounted to exactly the same.

Bailey also said that the outlook for food prices was “apocalyptic” – something I foresaw two weeks ago. He was at least honest. Normally, in the face of an economic downturn, the central bank’s reflex is to cut rates. This time is different: the BoE will have to raise rates to attenuate inflation. And inflation will accelerate in the UK when the energy price cap is raised in October for the second time this year. Monetary contraction will coincide with fiscal tightening. No wonder he feels “helpless”.

Blame the Treasury

It was the Treasury, after all, which gaily borrowed in the gilts markets, knowing that friends at the BoE would wade in and buy much of the new paper – thus effectively raising finance ‘for free’. I explained recently why such financial conjuring has its downside.

It seems that there was also a consensus among senior mandarins that taxes would have to be hiked at some point to pay for the Covid shock. Boris Johnson and Rishi Sunak then came up with the ruse that a national-insurance rate hike could be passed off as a “social-care levy”, which sounds like an act of kindness – but everyone knows that any new funding thus raised will just be poured into the bottomless pit that is the NHS.

Other European countries, notably France, have intervened directly in the energy markets to moderate hikes in the cost of energy – basically by transferring the pain from the consumer to the energy companies. EDF’s share price was hammered – though it has recovered somewhat over the last month. Call it populism, if you will.

In the UK, however, Sunak responded by reducing fuel duty by five pence a litre in the Spring Statement (24 March) – a futile gesture, since nobody noticed the impact, given perturbations in petrol prices. And now we know that many forecourt operators did not pass the cut in duty on. Also, Sunak had already decided to hike corporation tax just as it is coming down in competitor countries.

It’s all very well raising the primary threshold for national-insurance contributions to the level of the personal allowance for income tax – but the latter has been frozen for four years. So that, in inflationary times, many low-paid workers will be dragged into taxation (not to mention higher-rate taxpayers who will be paying 40 percent income tax on middle-class incomes). The promise to lower the basic rate of income tax to 19 percent by 2024 without raising tax thresholds is a gimmick.

But the problem goes deeper than who happens to be chancellor. The Treasury is a ‘super tanker’ which does not change course, no matter who is on the bridge. If you look at the evolution of public spending in the UK over the last 40 years you might suppose that Michael Foot won the 1983 general election, not Margaret Thatcher. Spending on defence as a percentage of GDP has declined remorselessly, while spending on welfare has grown exponentially. In recent years, the NHS plus social security and pensions account for 45 percent of all state expenditure. With an ageing population that figure will only climb.

In his resignation speech as a Treasury minister in January, Lord Agnew described the oversight of the coronavirus loans scheme as “woeful”. He accused Treasury officials of making “schoolboy errors” by giving loans to at least 1,000 companies which were not trading. He said: “a combination of arrogance, indolence and ignorance” was “freezing the government machine”. Since Lord Agnew’s departure, no one has sought to recover the estimated £4.3bn that was lost in loan fraud during the pandemic.

The IMF thinks that the UK will be the laggard in terms of growth in the G7 next year. Growth was negative 0.1 percent in March. The chancellor cast himself as a Thatcherite when he came to office; he now looks like a disciple of Gordon Brown – though not quite as canny at politics.

Blame Boris and “those Tories”

During the general-election campaign of 2019, Johnson extolled the Tory Party as one wedded to the ideal of low taxes. How hollow that sounds now. The talk then was of lowering corporation tax from 19 percent to 17 percent. Instead, it has been raised to 25 percent. The tax take as a proportion of GDP is at its highest level for 70 years.

The government is accused of having little sense of urgency; it is perceived to react to events. When roused, its reflex is to throw money at problems, hoping they will go away. The civil service continues to grow. In 2015, the Cabinet Office employed 2,154 people: now it is 9,225. The Tory government talks a lot about “green investment” but can’t articulate policies to stimulate growth or productivity.

What is the Tory government’s economic ideology? I wrote an essay three years ago which was reprinted in The Independent. It began with the question: “What is the Tory Party for”? I’m still thinking about the answer.

Blame the civil service – and the NHS

The endgame of the pandemic in the UK has shown the civil service and public services across all parts of the UK to be dysfunctional. Civil servants seem to be extremely reluctant to come back to the office – “work is not a place” is the new mantra. Even BoE employees, we learnt this week, are only required to turn up one day a week.

People are unable to obtain driving licences, renew their passports or regularise their immigration status. Asylum seekers wait years to learn their fate – and then if they are refused there is no one to deport them, so they just disappear, knowing that no one will pursue them. The police do not even respond to reports of burglaries anymore, although they get very exercised about “non-crime hate incidents” of which they recorded more than 25,000 last year.

And in our much-vaunted NHS the waiting lists are longer than ever before − 6.4 million at the last count. Ambulance response times have lengthened beyond reason. An elderly man who fell and broke his hip at a concert in Bath last month waited 12 hours for the ambulance to arrive. People presenting themselves at A&E must be prepared to wait for up to 12 hours to be examined.

The number of NHS bureaucrats, many of whom earn more than the prime minister, has doubled in the last two years. Yet the number of frontline nurses has risen by just seven percent. We spend about the same percentage of GDP as the French on healthcare, yet our health outcomes (for example, recovery rates from cancer) are inferior to theirs. Everybody agrees that the NHS is a bureaucratic nightmare, but the only politically acceptable remedy is always the same – spend more money and employ more equality and diversity managers.

Blame the foreign-exchange markets

Since the beginning of the year the pound has depreciated against the dollar from 1.35 on 1 January to 1.25 this morning. There are numerous reasons why sterling has gone down.

First and foremost, in times of geopolitical crisis and with the oil price (which is priced in dollars) surging, the dollar has become the ‘safe haven’ currency − hence all major currencies have retreated. Last week the Swiss franc fell to parity with the dollar. And the dollar could reach parity with the euro any day now. The single European currency has not looked this weak since it was first launched in 2001. The Japanese yen is down about 13 percent on the dollar year to date.

Second, interest rates are rising faster in the US than elsewhere; thus, funds are buying dollar assets. Third, the US is perceived to be self-sufficient in hydrocarbons (not least because fracking is widely practiced there) at a moment when they are rocketing in price. That means its trade-deficit outlook is positive.

In contrast, the terms of trade are deteriorating for the UK, and its growth outlook has worsened too. The markets are responding accordingly. The UK will have to import expensive hydrocarbons because it has wilfully refused to invest in its North-Sea oil and gas reserves – and it will pay for them (as well as foreign food) with a weaker currency, thus stimulating domestic inflation further. It may have to finance its twin deficits – its worsening current-account (trade) balance and its enduring fiscal deficit – by borrowing from abroad.

Blame the labour market

Two years ago, we thought that the pandemic would result in higher unemployment – but that did not happen. Then it was supposed that the cessation of the furlough scheme would result in a spike in unemployment. Yet figures out on Tuesday morning (17 May) showed that the UK’s unemployment rate fell to its lowest level since 1974 – nearly a half century ago − at 3.7 percent in Q1. Moreover, there are more advertised job vacancies (1.3 million) than there are people looking for work (1.24 million). That is what economists call a ‘tight’ labour market.

The Covid pandemic persuaded many more older workers, especially self-employed people, to cash in their pensions and retire (though many who did that may well regret it, since the value of their pensions will now be dwindling). Thus, the labour market shrank by about 600,000; and because of Brexit (and Ukraine), the slack is not being taken up by a steady flow of labour from eastern Europe. Some Ukrainian farm workers have even headed in the opposite direction.

There are, interestingly, 7.1 million economically inactive people aged between 16 and 64 who do not have a job and who do not want one. Surely, more could be done to entice these people back into the labour market. And there must be some people with skills amongst the 125,000 asylum claimants still waiting for their cases to be adjudged; but, alas, they are obliged to watch television 24/7 at countless Ibises and Premier Inns.

The trades unions are becoming more activist since wages, although trending upwards at a clip of 4.2 percent, are not keeping pace with inflation. A Tube strike is promised in London for the Platinum Jubilee weekend and there could well be a paralysing rail strike across the UK over the summer.

Apocalypse now?

It is a perfect storm. China’s zero-Covid policy is now pushing the world’s number-two economy into recession – as well as amplifying the supply-side disruptions already in process. Uncertainty about how long Putin’s war in Ukraine will last, and what will be its outcome, continues to cloud the policy outlook.

There is very little that the government can do about rapidly rising food and energy prices. And inflation is likely to get even worse as producer prices are passed down the manufacturing supply chain. The Ofgem energy price cap could rise to £2,800 in October, according to the BoE. The British people are going to get poorer, at least in the short term – but no government minister can say that. Even the well-off are likely to be hit by a fall in property prices as interest rates rise.

There are, however, actions that the government could take, to forestall recession. They could remove tariffs on certain imported goods; they could suspend the various green levies on energy, end the moratorium on fracking and speed up exploration of new oil and gas reserves in the North Sea. Instead, they are likely to impose a “windfall tax” on the oil majors because it is popular – even though oil companies already pay a higher rate of corporation tax. BP and Shell are oil companies – but they are, more correctly, “diversified energy companies” which need to generate profits to finance investment.

The government could deregulate further and faster. Here is one small example: contact lenses are far more expensive here than in the US because you can’t buy them over the counter or online here – instead, you must have an up-to-date prescription from an optician. Is that really necessary?

Or the government could cut taxes. But to do that today, considering that the cost of servicing the national debt is likely to cost £83bn this year, would necessitate cutting spending. I would raise the personal allowance well above inflation to release more lower-paid workers from the Tax Man’s clutches altogether. I would also raise the threshold for higher-rate taxes – teachers should not be paying 40 percent income tax on each extra pound they earn.

Janus Henderson puts the risk of recession in the UK (that’s at least two consecutive quarters of negative growth) by the end of this year at 70 percent. The money supply is already contracting as the rate of credit expansion (lending by banks) falls below zero – a key indicator of hard times ahead, as is the sporadic inversion of yield curves.

The stock markets have begun to sag in America, suggesting that sentiment may have turned. Tech stocks especially have fared poorly. The S&P 500 fell by four percent on Wednesday, its biggest drop since June 2020 and its fourth decline of more than three percent in less than a month. On Thursday it edged further into bear-market territory. The S&P 500 is now down about 18 percent year to date. Here, the FTSE100 is still bearing up, but equity investors are getting nervous.

Who is to blame? All of the above. But a YouGov opinion poll showed that almost three quarters of voters think the government is handling the economy badly, including more than half of Conservative voters. In the end, governments take the blame; and it will be difficult for the Tories to re-establish a credible reputation for good economic management before the next general election, which will most likely take place around May 2024.

Long before then, there might be civil disorder beyond the capacity of the police to control. The real question is whether the British people will take it on the chin and tighten their belts, as they have done in the past. If so, living standards will fall, but recession will not be inevitable. If, on the other hand, widespread strikes prompt above-inflation wage rises which are not justified by productivity gains, then interest rates will have to rise more rapidly, and recession will become the most likely outcome.

Regular readers will know that I have been saying for some time that the era of near-zero interest rates with mass money creation is historically anomalous. There was always going to be a moment when interest rates would start to regress back to the historical mean – that’s roughly the three to six percent band in the UK. Investment managers and policymakers who didn’t grasp that were fooling themselves. That snapback was always likely to be painful and disruptive and would depress asset prices, just as QE had inflated them.

But this is also now happening at a time of deglobalisation when companies and nations are re-shoring their supply chains for geopolitical reasons. Europe’s re-orientation away from dependence on Russian gas is one aspect of that. The deflationary impact of globalisation – what I call the “Primark Effect” (one could buy a fleece or a pair of socks there for £1 in the noughties) – is now in reverse. Taking these two significant trends together, we are probably looking at a period of two-three years of inflation, low-to-zero growth and severe supply- chain disruption. Call that stagflation if you will.

Remember the four horsemen of the Apocalypse, as foretold in the Book of Revelation. First came plague, then war, followed by hunger and lastly by death. The first horse has charged; the second is running wild; the silhouette of the third can be seen on the horizon.

As for the fourth one – let’s not go there.

Comments (1)

  • Paul says:

    Blame the SUN.
    some people think we are approaching a grand solar minimum,
    A 400 year cyclical event.
    This causes electromagnetic disruptions and affects the weather amongst other things.
    The Chinese being an ancient culture know ALL about these events,
    Is this why they have been stockpiling supplies like there is no tommorrow ?
    As no Chinese ruling dynasty has survived these grand solar minimums.
    For more info see you tube channel ADAPT 2030

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