Weathering the storm
Liz Truss will have been told by the Whitehall mandarins on Tuesday evening that the UK economy is in a bad way – and getting worse. The country is cursed with the G7’s highest inflation rate, which is expected to accelerate further, the steepest decline in real wages and the biggest fiscal and trade deficits as a percentage of GDP.
The pound has been in freefall this year. Back in mid-January one pound bought $1.37; on Wednesday afternoon one pound was buying $1.14. That’s a devaluation of nearly 17 percent. The hydrocarbons that we import are priced in dollars, so that is boosting the inflationary surge already underway and further weakening our balance of payments. The terms of trade – especially with regard to energy and foodstuffs – have worsened dramatically.
Meanwhile, borrowing costs for the government are rising faster than anyone expected. The yield on a 10-year gilt has now exceeded three percent for the first time in years – to be precise, it is at 3.153 percent this morning. The proximate cause of the spike in gilt yields was a sell-off by institutional investors; but interest rates are going to rise anyway. The Bank of England has already raised rates six times since last December, from 0.1 percent then to 1.75 percent now. The next rate rise could be in the order of 0.75 percent.
That means that all new government-debt issues will have to carry higher coupons; hence the UK government’s outstanding debt pile of £2.383trn will be more expensive to service this year than last, and the absolute size of the debt pile is likely to rise given the new prime minister’s spending plans. The UK is about to acquire the dubious honour of joining the “One Hundred Club” – that’s the elite group of rich but profligate countries which boast a debt-to-GDP ratio of more than 100 percent.
The labour market is as tight as anyone can remember given that many people (the exact figure is disputed) appear to have left the labour market during the coronavirus pandemic and are now “economically inactive” (as I discussed here recently). There are more job vacancies than there are people looking for work. That is putting upward pressure on wages which could exacerbate the inflation problem. Boris Johnson, in his valedictory address before returning, like Cincinnatus, to his plough, hailed record low unemployment (at 3.8 percent) as one of his many achievements. But that is to ignore the ‘elephant in the room’ which is that British workers are less productive than those in competitor countries and skills shortages are legion.
Downside risks are high. Hundreds of thousands of small businesses face massive increases in their energy costs which they cannot fully pass on to their customers. There is talk of thousands of pubs – which hung on in there during the pandemic lockdowns – closing their doors for good. If that happens then the knock-on effect in terms of new unemployment could be profound. Loan default rates will spike, and banks will have to include higher risk premiums on new loans to their remaining clients. On Wednesday (7 September) the Governor of the Bank of England, Andrew Bailey, told a committee of MPs that recession was now inevitable.
Cut tax and spend more
Against this backdrop, the new prime minister, as she has asserted in almost every address since she became leader of the Conservative Party on Monday afternoon, proposes to cut taxes to stimulate the economy. First off, she is set to reverse Rishi Sunak’s planned, phased hike in corporation tax from 19 percent to 25 percent. Less definitely, she aspires to reverse the 1.25 increase in national-insurance contributions (NICs) for both employers and employees, which has already taken effect. The question then is: if the hike in NICs is to be reversed, how will the proposed expansion of social care, which is itself critical for the smoother running of our hospitals, be financed?
Truss has talked about “a low tax economy”; in contrast, Labour talks about “trickle-down economics” – an idea associated with Ronald Reagan in the 1980s – which they deem to have been discredited. (I shall investigate that argument another time). On Monday, she committed to return to the 2019 Tory manifesto which, let us remember, included a pledge not to increase income tax, VAT or NICs.
Further, she proposes to roll out a massive programme of energy subsidies and to boost defence spending from around two percent of GDP to three percent. It seems that the new Chancellor of the Exchequer, Kwasi Kwarteng MP, who is a longstanding friend of the prime minister, is on the same page. (Incidentally, Mr Kwarteng is the first Chancellor who has a PhD in economics, awarded by the University of Cambridge in 2000). The obvious implication of this cocktail of policies is that state borrowing will explode, at least in the short term, thus testing the goodwill of the gilts markets, which is already under strain. At some point, there will have to be spending cuts – the state spending “triple lock” may be the first target.
Deutsche Bank has warned that that the UK risks a 1970s-style currency crisis if the Truss government unleashes a programme of unfunded and poorly targeted tax cuts. Nouriel Roubini of Roubini Macro Associates predicted last week at the Ambrosetti Forum a “severe downturn”, especially in the UK which “has shot itself in the foot” with Brexit. He thinks the UK will experience the worst stagflation of any advanced economy.
Orthodox economic thinking suggests that to go for a full-blown fiscal stimulus at a time when inflation is high and rising is certainly risky and potentially calamitous. The risk is that a stimulus will aggravate inflation further; the potential calamity is that gilt yields could be driven so high that the government is effectively bankrupted.
The counterargument to the orthodox approach is that we should distinguish between demand-pull inflation and cost-push inflation.
What we face now is cost-push inflation. Vladimir Putin has incrementally pushed up the cost of gas as part of his hybrid war against the west (and anyone else who threatens his ambitions). Supplies of Russian gas to Europe began to be disrupted as early as last autumn; now, de facto, the Nord Stream 1 gas pipeline has been closed – and Europe faces a challenging winter. Gas prices have soared as a result of a lack of supply; and all kinds of other inputs, from carbon dioxide and fertiliser – on which farmers depend – have followed suit. The inflationary wave that besets the west was ultimately manufactured in the Kremlin.
A fiscal stimulus in an environment of demand-pull inflation (“too much money facing too few goods”) is straightforwardly ill-judged. A fiscal stimulus in the case of exogenous forces – geopolitics, the ‘shadow war’ we are fighting against Putin – is another matter. The immediate impact of rising energy and food prices is to suck demand out of the economy because people have less disposable income to spend on such things as clothes, meals out and entertainment. Therefore, the risk of cost-push inflation is that the economy tips into a state of stagflation – rising prices with falling output – as happened in the 1970s, further to the oil-price shock of 1973.
If energy prices in the primary market can be capped, that itself will be anti-inflationary, even if there will be a long-term cost to the taxpayer. Inflation in France has been consistently below the EU average because early on Emmanuel Macron decided to make EDF pay for higher energy prices. Having crippled the company, he then nationalised it. But there is no doubt that the headline rate of inflation can be attenuated by government intervention – whatever its ultimate cost.
Similarly, the negative impact on real wages could be compensated for, to some extent by targeted tax cuts. That might also do something to restrain militant unions from agitating for strike action to secure real-terms wage rises – something that both stimulates inflation and restricts output. Collectively, Trussonomics might just be able to avert a sustained recession without making inflation worse than it would have been anyway.
Let’s be clear that Trussonomics, in so far as we understand what it is yet, is not Thatcherism. Margaret Thatcher spent her first government combatting inflation by a policy of fiscal retrenchment. Those of my vintage will remember: “We shall not reflate”. The tax cuts and the fiscal stimulus under Nigel Lawson only came after the inflationary ‘beast’ had been slain and the British economy had returned to growth. Trussonomics, in contrast, is something closer to the economic policies of Ronald Reagan and Donald Trump.
Kwarteng, who is more of an economic historian than a quantitative economist, will be aware of this. He is unintimidated by economic orthodoxy. He also knows that at a time of inflation, the real value of debt declines so that it becomes less burdensome.
The entire ‘Baby Boomer’ generation (that’s people born between 1946 and about 1962 – this writer being at the tail end of that demographic) acquired houses by borrowing against the value of property which was pretty much certain to appreciate. Economic historians know that while inflation is highly disruptive to social cohesion, its opposite − deflation (sometimes called disinflation) − is even worse.
One thing we do understand about Trussonomics is that the prime minister wants to create the conditions to stimulate growth over the medium term. She thinks that the focus has erroneously been on redistribution when it should have been on wealth creation. That will involve supply-side reforms including but not limited to deregulation. But again, the devil is in the detail – and in week one of the Truss premiership we are short on detail. The fact is that, as Roubini has pointed out, it is difficult to effect supply-side reforms in a high-welfare economy.
The cost of an energy-price freeze
On Thursday (8 September), before the news came through about the Queen’s condition, the new prime minister rose in the House of Commons to announce a package that involved the scrapping of green-energy levies and a price cap of £2,500 from October for two years. Small businesses will receive “equivalent support”. There will be support for people who run their central heating on oil and for people living in park homes. New drilling licences will be issued for exploration in the North Sea. A new fund worth up to £40bn will attempt to smoothen fluctuations in energy prices. The moratorium on fracking will be suspended. Truss also said that she will end the UK’s “short-term approach to energy supply” once and for all, and indicated a new focus on energy security – and issue I have written about extensively in these pages.
A report out earlier this week from the Centre for Policy Studies (CPS) attempts to quantify the cost of some of the measures under consideration by the new government to soften the impact of energy-price hikes on households and small businesses.
Entitled The Bleak Midwinter, the report by Karl Williams examines the measures brought in across Europe and how they compare to the UK, and evaluates the government’s potential options. According to the CPS, holding energy bills at the April price cap will cost at least £44bn for households alone, even if energy prices rise no further. An energy price cap at the £2,500 level, as announced on Thursday, would cost at least £29bn – again for households only. If energy prices reach the £6,616 level, which Cornwall Insight has warned could be the case by next April, a household price cap would effectively double the current fiscal deficit of £115bn – all with borrowed money.
Contrary to what many critics of the Conservative government have claimed, the UK’s packages of support thus far have been broadly comparable to what other European countries have offered. However, we are notable for having done nothing specifically until now to help small businesses or to reduce demand for energy. UK households are also more vulnerable to higher energy costs because British houses are not as well insulated as their German and Scandinavian counterparts.
As Truss has said, as well as acting now to help households and businesses, the government needs to increase energy supply and reduce energy demand ahead of next winter, including more support for onshore wind and solar power and fracking, and improved tax incentives for oil and gas firms operating in the North Sea.
For Labour, any package to subsidise households’ energy bills should be (partially) paid for by a windfall tax on the “supra-normal” profits of the oil majors and other energy companies which are profiting from high gas and oil prices. That turned out to be the main topic of Prime Minister’s Questions (PMQs) on Wednesday. Truss held out against windfall taxes, though in fact the windfall-tax package initiated by Sunak is still ongoing and has not been reversed. In any case, the oil majors already pay corporation tax at a higher rate so government revenues will benefit from their so called supra-normal profits. But the real point is that such windfall taxes will raise less than £10bn when the government needs to find up to £100bn to cover the costs of freezing energy prices.
Looking beyond the storm
A few things strike me at the end of this unforgettable and deeply sad week.
First, it is to the prime minister’s advantage that, such is the pessimistic torpor of the British people, expectations about her premiership are low. There is a mood abroad that, since Thatcher, each successive prime minister has been worse than his or her predecessor. But that is not the whole story. Her performance at PMQs on Wednesday was wooden, halting and obscure – and was hailed as a triumph. The prevailing sense is that we have had our fill of Oxford classicists quoting Horace and that a slightly gawky woman from Leeds with socialist, academic parents cannot be all bad. No one can deny (except, possibly, Angela Rayner) that the Tories have a keen instinct for survival.
Second, although gas prices will remain high until there is some resolution of the war in Ukraine (which will not happen soon), the rate of increase in gas prices will moderate or fall as demand reduction is implemented out of necessity. The price of oil is already falling – Brent Crude is down to under $90 this morning. That’s where it was in January. While there is likely to be further inflation in food prices for reasons I would like to discuss soon, I think that Jim Mellon is right that we are now roughly at or near peak inflation.
Third, the British people are much more resilient than the Islington-based commentariat imagines. People are getting thriftier, like their grandparents and great-grandparents. At last, insulation and ‘grow-your-own’ are becoming popular discussion topics. True, the food banks are busy, but these are as much about intelligent recycling as social indigence.
The most successful investors I have ever met – and Jim Mellon is way up there – are brilliant risk analysts and can smell a rat from 50 paces; but they are also essentially optimists who believe that human beings are rational (except when sometimes they are not) and that, over millennia, we have built a culture that is good at problem-solving. I suspect that Truss would agree.
The new prime minister is not an intellectual, thankfully; but she has sound instincts. She is a disciple of Hayek and Popper without knowing it. Call it common sense if you will. The British philosopher, Bertrand Russel, said that “common sense is the witchcraft of the civilised”. We need a little witchcraft right now.