Rishi Sunak and the ‘Chamber of Secrets’

Fiscal squeeze

Date: 23 March 2022

Memo Security Grade: TOP SECRET {not to be shared with Cabinet or the PM}

From: Agent R, senior risk analyst, MI6

To: The Rt. Hon. Rishi Sunak MP, Chancellor of the Exchequer

When the Chancellor rises in the House to deliver the Spring Statement today, it will already to be too late in the day to make any meaningful difference to the adverse direction of public finances, whatever measures he advances. The Right Honourable gentleman’s main task will therefore be to reassure the nation and the financial markets that the Treasury is abreast of events and in control of the nation’s finances – whatever the underlying reality.

As the Chancellor will be aware, the national debt is still rising at a moment when interest rates are about to rise sharply. Quite soon, the cost of servicing the national debt will exceed that of the education budget. We are still in the late stages of the pandemic, with infection rates rising again, although the virus seems to be less virulent than previously. There are increased structural frictions in our trade with the EU, and indeed within Great Britain-Northern Ireland trade too. Inflation has hit 6.2 percent – a 30-year high (albeit lower than US inflation and about the same as in the eurozone) − and is becoming entrenched. Inflation is expected to rise to over seven percent by the second half of the year.

The international situation is dire, with Russia’s aggressive war likely to escalate before it is assuaged. The cost of hydrocarbons will rise further before it abates, as Europe attempts to pivot away from Russian markets. The prospect of stagflation is now highly likely in the short term. Living standards are under pressure as never before since WWII – possibly since the Great Depression of the 1930s. Industrial relations are deteriorating and strike action is likely in numerous key sectors, from shipping to online food delivery, with its growing army of drivers. Labour unions across the world have become more militant during the pandemic. The climate catastrophists and other extremists are set to resume their programmes of scattergun disruption soon.

Against this backdrop, the Chancellor has relatively few levers that he can pull. It is now too late to reverse the planned increase in national insurance contributions (NICs) – even though the paltry £12bn to be raised from this has already been spent several times over. The government has balked at any fundamental reforms of the NHS which would halt the trajectory of its spending ambitions. There is pressure to increase defence expenditure, given the deteriorating geopolitical situation (which will get worse before it gets better). The debt-to-GDP ratio may now have peaked, but the fiscal deficit for 2022-23 is likely to be greater than in the current year. Therefore, the Chancellor’s main task will be to disguise the negative trends in national finances, if possible, by judicious creative accounting and much aspirational language about the government’s fervent desire to cut taxes in the future.

The nature of contemporary democratic politics is that all spending ministries promote costly initiatives; but very few politicians have the courage to propose taxes which will pay for those initiatives, lest they become “unpopular”.

The prime minister, unlike the Chancellor, appears blithely unconcerned about the fiscal deficit or the national debt. The 1.5 percent hike in NICs was the prime minister’s idea (though he has wavered on this since September). But no one in Whitehall believes that it will find its way into social care, which was its original purpose − and it is the Chancellor who will have to take the blame for this raid on pay packets. We are aware that the Chancellor never believed that lifetime, residential, care-home costs should be capped for the wealthy so that their children’s inheritances would remain intact.

The British public is dimly aware that the two-year pandemic has cost the state about £400bn, for furlough payments, the test-and-trace architecture (which didn’t work), protective equipment, the UK vaccination programme (which was an international benchmark) and a paralysed hospitality industry. All that £400bn was borrowed. There is some degree of popular understanding that this bill will have to be paid – and that that means more taxes.

The challenge is, of course, that everybody believes that someone else should be paying higher taxes. The impact of the rise in NICs could be attenuated by raising the income threshold above which workers pay NICs (the primary threshold of £9,568 in 2021-22) to nearer to the threshold above which workers pay income tax (the personal allowance of £12,570 per year in 2021-22). Why these two thresholds should be different is now an anomaly.

On the plus side, the surge in inflation has served to boost the tax take by about £12bn more than forecast in the current fiscal year; and by freezing income-tax bands the Treasury will receive an extra £12.5bn in tax revenues next year. Hence the talk about “headroom”. This affords the Chancellor the opportunity to make a grand – if somewhat futile – gesture, such as cutting fuel duty to slow the inevitable increase in petrol and diesel prices.

At present, about 58 pence of the cost of a litre of petrol is fuel duty – and another 26 pence is VAT. In the medium term, the Chancellor knows that revenues from fuel duty will plummet as the electrification of vehicular transport accelerates: therefore, it is likely to be replaced over time by some regime of road pricing. However, the motoring public will not remember this largesse once prices start to rise further. Similarly, scrapping the current level of five percent VAT on domestic energy bills would largely go unnoticed.

Also positive is that unemployment has fallen back to pre-Covid levels, at 3.9 percent. Indeed, there are 600,000 more people in work than before the pandemic. There is roughly one jobseeker per vacancy. The great British labour market continues to astound.

We understand that the prime minister’s political focus – when he can spare time from international affairs – is on the local elections to be held on 5 May. These will include elections for all 32 London boroughs as well as for all local authorities in Scotland and Wales. These elections are expected to coincide with the Northern Ireland Assembly elections in which Sinn Féin could emerge as the largest party for the first time. That would create political ructions.

The left-leaning think tank, the Resolution Foundation, recommends that Income Support be raised by 8.1 percent this year rather than the 3.1 percent envisaged last September. But that would cost far more than a rise in NICs would yield. Moreover, each one percent rise in inflation will cost the government £5.5bn in additional interest costs, as about one quarter of outstanding gilts are index-linked. And each additional rise of one percent in interest rates will cost the government at least £10bn a year.

But fiscal policy is not just about people; it must also address the concerns of businesses which generate the wealth and pay the wages and salaries of taxpayers. Energy-intensive sectors such as chemicals, cement, metals and paper – which also tend to be highly indebted – are now struggling. If they collapse, unemployment will soar. While the Spring Statement is not the Budget, which the Chancellor will deliver in the autumn, it must set the direction of travel by sustaining confidence in the government’s fiscal policy.

Monetary conundrum

Date: 23 March 2022

Memo Security Status: SECRET (FYEO – for your eyes only)

From: Threadneedle (code name), undercover economist

To: Andrew Bailey, Governor of the Bank of England

It is likely that the Chancellor’s package of proposals to be announced in the Spring Statement later today will attempt to shift the weight of blame for the “cost of living crisis” from the Treasury to the Bank of England. The Chancellor and his allies have been insinuating that sustained, loose monetary policy – effectively in place since the financial crisis of 2008-09 – was bound to have inflationary consequences at some stage. He will suggest that further rises in interest rates will be necessary before cost-push inflation can be tamed – ignoring the fact that most of the next wave of inflation will be triggered by the spike in the cost of hydrocarbons caused by geopolitical events beyond any central bank’s control.

The rise in the UK base rate agreed last week by the Monetary Policy Committee – from 0.5 percent to 0.75 percent – while modest, is likely to be succeeded by further incremental increases. Yet the impact on mortgage rates has already been profound. That will be seen to exacerbate the “cost of living crisis”.

Inflation, currently at 6.2 percent – the highest since 1991 − may well shortly reach double digits, while wages are rising by 3.8 percent (4.8 percent including bonuses), according to the ONS. The average UK domestic energy bill is set to double; the NIC tax hike will hit home in April, with income-tax bands frozen and council taxes on the rise.

But that is only the beginning. The prospect of stagflation – zero to negative growth with rising prices – presents a conundrum for central banks. If they raise rates, they risk choking demand; but if they maintain loose monetary policy, they risk stoking inflation. Comparisons have been made with the 1973 oil shock, but this time around, the oil-and-gas supply shock is layered on top of the global supply-chain disruption initiated by the pandemic (and all supply chains seem to originate in China). It is therefore of paramount importance that the leading central banks do not make a policy misstep which could trigger a full recession.

The Governor will be aware of a disturbing shift of opinion amongst the political elites in numerous western countries. By the 1990s, the idea that central banks should be independent of national ministries of finance became orthodoxy – though the UK was late to this consensus, as the Bank only became free from Treasury control in 1997. Before then, the Chancellor set interest rates at the stroke of a pen – even though, historically, few chancellors had any grasp of monetary policy. Most interest-rate decisions were inherently political rather than economic measures, often with poor outcomes.

But there is now a mood abroad that we central bankers (Master Investor calls us “the priestly caste”) have exceeded our remit and should be reined in – even that interest-rate decisions should be restored to finance ministers, especially since most central banks have so egregiously missed their inflation targets. If central banks are seen to stumble in the coming wave of stagflation, the political class will turn on us and use us as a shield against popular disaffection.

Further, we are advised that there will likely be a wave of sovereign defaults, some of which will severely impact the balance sheets of leading British banks (the list is attached as an addendum). There is currently a low-to-medium risk of a systemic banking failure in the short to medium term – though it is likely to begin in Europe. We are particularly concerned about the vulnerability of French and Italian banks to a general Russian default. This is likely to come at a moment when the eurozone is experiencing the first sustained bout of inflation in the history of the single currency…

Cost of living crisis

Date: 23 March 2022

Email status: Secure Conservative Network

From: Sir Percy Bunion, Conservative MP for Borchester & The Wolds

To: The Prime Minister, The Rt. Hon. Boris Johnson MP

Dear Prime Minister

When we met in late January to discuss the unfortunate ‘partygate’ affair, you assured me that, in your words, “everything would come out in the wash, and the economy would be purring again by late spring”. Well, this morning, I got a brick through the window of my Borchester constituency office, courtesy of a large and surly chap who shouted that he could no longer afford to fill up his white van. Lady B was present but was thankfully unharmed. The miscreant was marched away by Borsetshire Police and will no doubt receive anger-management counselling.

Rishi has got to do something immediately to mitigate the cost-of-living crisis for the least well off. A dozen or so of my constituents have had heating oil stolen from their tanks in the last two weeks. And most cannot afford to replenish what was taken – assuming they can get a delivery. Even lorries parked at Borchester Parkway have had their diesel emptied overnight.

The hospitality industry here also needs a shot in the arm after the devastation of the lockdowns. If restaurants will have to pay VAT at the standard rate of 20 percent, many have told me they will go under.

In the medium term, we must increase economic opportunity to reduce the demand for welfare. That means more and better-paid job opportunities. Welfare dependency seems to be the default position of the poorest 20 percent of the citizenry. We also need to profit from Brexit by removing poor regulation that stifles economic growth – GDPR, resulting from the EU data-protection directive, is a classic example of something European we could do without. Even the post-Brexiteers at the CBI, which now favours a “growth strategy”, are coming onside in this regard.

Overwhelmingly, the British people would support a policy of national resilience in a dangerous world. That entails military security, energy security and food security. And that means that the excesses of the so-called “decarbonisation” agenda – a dependence on windmills and using lush pasture for solar arrays – must be curtailed. A justifiable concern about climate change should not condemn my constituents to huddle in the dark.

As I learnt from a recent visit to the Museum of Borchester, the climate has always been changing. These islands became uninhabitable for about 100,000 years because they were inhospitably cold and could only support human life again at the end of the last Ice Age about 15,000 years ago.

The mood on the ground is dark. If traditionally blue seats like Borchester are turning pink, you can forget your famous “Red Wall”. Yours ever, Percy

Outcomes

Date: 23 March 2022

Security status: WhatsApp end-to-end encryption

From: Dr Narendra Gupta, economist, World Bank

To: Her Excellency Kristalina Georgieva, managing director, International Monetary Fund

Here is a quick update on the outlook for the UK economy. The figures released by the UK Treasury today in the Chancellor’s Spring Statement give a mixed message. Borrowing was £138.5bn in the first 10 months of this fiscal year – admittedly, about half of what it was in the previous year. The fiscal deficit will be about £18bn smaller than the figure estimated by the OBR last October. But total public debt has soared to 95 percent of GDP – the highest level since the early 1960s – though it is on course to fall to 79.8 percent in 2026-27, near its pre-pandemic level. The UK government’s growth forecast is bullish, though credible. The central bank expects price stability to be restored by 2024. So, the UK, like much of the developed world, is facing two years of significant inflation.

The finance minister announced three populist measures. The first was the cut in fuel duty by five pence per litre for the next 12 months, which was widely expected, given the spike in fuel prices. The second was to incentivise investment in home energy-efficiency measures such as insulation by exempting these from VAT (not before time). The third was to equalise the thresholds at which the UK’s two types of income tax are levied. It is not necessary to digress with regard to the arcane nature of the UK tax system which has evolved organically over more than two centuries. As you know, the British love tradition and shy away from structural change.

In a final flourish, the UK finance minister pledged to reduce the basic rate of income tax from 20 percent to 19 percent by 2024. He is going to announce reforms to the tax regime on capital expenditure and gains in the autumn. The UK equity markets hardly reacted to the Statement at all – which probably tells us all we need to know.

This was a political financial package, as expected. It was more about what was not said that what was proposed. But there are much bigger worries than the UK economy. I shall report tomorrow on the likely trajectory of impending sovereign defaults…