Are the Tories on course to crash the economy?

Liz Truss and Kwasi Kwarreng are betting the farm on cutting taxes to stimulate growth to pay for the aforementioned tax cuts (and win the next election).

Three comments from leading economists:

“Unsubstantiated hogwash – ideological faith triumphing over evidence and reason.” Will Hutton

“Just wishing for 2.5% growth won’t make it happen” David Smith

“The energy price freeze must be replaced by “something better next winter” because it will cost up to £150bn” Paul Johnson, Institute for Fiscal Studies.

Pulling the economy around before the next election is very unlikely. Owl fears this will all end in tears.

Here is a summary of the context:

  1. TheTories have just squandered six weeks gazing at their navels whilst a serious economic crisis developed. Economic crises require speedy and decisive action or they get worse. Events beyond the Government’s control have now taken over and the Government is on the back foot.
  2. On appointment to be Chancellor Kwasi Kwarteng summarily sacked the perm sec to the Treasury, Sir Tom Scholar. He represented Treasury orthodoxy, which right wingers blame for lack of economic growth. Scholar was the man devising a set of economic support options that could be implemented quickly whilst the Tories were asleep at the wheel. So bang goes any continuity of experience at the top of the Treasury and civil servants will now find it difficult to “speak truth to power” at a time when it is most needed. In economic crises stability matters.
  3. Events have caused the Bank of England to postpone interest rate rises.
  4. The pound has been falling.
  5. Because of her unpreparedness, “No Handouts” Liz Truss has been forced to announce the biggest open ended handout in history for individual energy consumers. Businesses only have vague promises. In the short term this will reduce inflation because the taxpayer is picking up the bill, However, as this support is untargeted it is almost certainly unsustainable (see 8 below). 
  6. What Liz Truss and Kwasi Kwarteng are betting the farm on is that by cutting taxes they can stimulate growth to the extent they are keen on borrowing another £30bn to do so. 
  7. Latest ONS growth figures are lower than expected. Recession seems certain. The questions are how deep will it be and how long will it last?
  8. Truss and Kwarteng have refused to put a figure on the support package they will announce. Their “fiscal event” will avoid OBR scrutiny. It will, therefore, be free of analysis, costings and forecasts.  Paul Johnson, director of the Institute of Fiscal Studies reckons the first year may cost £150bn and, at that level, would be unstainable beyond.

Here are two recent comments from economists:

“Unsubstantiated Hogwash” Will Hutton on cutting taxes to stimulate growth

“Bold action,” he [Kwarsi Kwarteng] suggested, was an imperative to relieve this “toxic combination”: “Cutting taxes, putting money back into people’s pockets and unshackling our businesses from burdensome taxes and unsuitable regulations.” Only thus could investment and growth be unlocked. Better that, he added, than “burying our heads in a redistributive fight over what is left”.

It is unsubstantiated hogwash – ideological faith triumphing over evidence and reason. In these terms, Scholar, exemplar of the alleged old economic managerialism, had to go. We are on an economic fairground ride led by fairies and fools.

Of course, the two-year £2,500 price cap is welcome. It will lift from millions of people the threat of desperate choices over warmth or food. It will also lower the peak inflation rate by up to 4% and so lower debt service costs in a full year by around £20bn – a quarter of our national debt is represented by bonds indexed to the level of inflation. It will also partially avert the risk of a dangerous wage price spiral. But those were the reasons Labour first advocated a price cap. The libertarians only changed tack when they realised that resisting and sticking to their preferred response of tax cuts and minimalist rebates risked them being politically overwhelmed.

But you don’t win wars and reset economies with daffy libertarianism. Europe is in a de facto war with Russia over Ukraine, as it threatens a price cap on Russian gas. Putin responded by saying in Vladivostok that at the limit Russia will export nothing – no gas, no oil, no food – to Europe. This is economic rather than battlefield war, but it is war nonetheless. Britain’s energy policy is not serious, it betrays the cause.

Energy policy in a time of potentially prolonged supply disruption has to be designed for the long term; has to protect business as much as consumers; has to be financially sustainable and avoid the risk of blackouts. The government plan fails on all counts.

Crucially, it is not financially sustainable: Britain’s national debt, as the Trussians continually say, is the lowest in the G7 bar Germany so there is scope to borrow. But the dollar, yen and the euro are the world’s reserve currencies and Canada runs a balance of payments surplus. Britain is alone, outside any of the major trade blocs, with a weak, legacy economy and a chronic international payments deficit. It cannot sell at least £100bn of extra public debt a year to protect living standards rather than raising investment without the threat of further sterling weakness or an enforced jump in interest rates.

Financial sustainability could have been addressed in a number of ways. A further windfall tax could have been imposed on the extraordinary profits in the energy sector. In addition, for the duration of the Ukraine war, all gas and oil from British fields should be required to be sold to the government on a cost-plus basis rather than distorted international prices. Consumers could have been told to tighten their belts with ministers giving a lead and a rationing system rolled out if needed. There should be a state-led crash programme of building onshore and offshore windfarms, – the fastest and lowest cost route to boosting energy supplies – along with accelerating the home insulation programme.

For libertarians, every such measure sticks in their craws. Thus they propose untargeted, if generous, help for households but, because even they recognise the near open-ended costs, they have limited the help to business to six months. Scared of what may follow, business will batten down the hatches so that Kwarteng cancelling the proposed corporation tax rise will have zero effect on investment. It is also aware of the risk of blackouts this winter, unrelieved by the uncertain prospect of fracked gas on stream in a decade.

Just wishing for 2.5% growth won’t make it happen David Smith

In the meantime, let me turn to another issue, the new administration’s ambition to get the economy to 2.5 per cent trend growth, which the new chancellor, Kwasi Kwarteng, reiterated at a meeting with business leaders.

It is an ambition that sounds a bit geeky but is very important. The economy’s trend growth rate is what determines our prosperity, and 2.5 per cent is an interesting number. It is, in fact, exactly the average growth rate for the UK economy since 1949.

That 2.5 per cent average, however, reflects different experiences in different periods. Growth was strong in the second half of the 20th century, and the UK outperformed most rivals after joining the European Economic Community in 1973. But growth this century has been slower, averaging 1.8 per cent, and particularly weak since the financial crisis at an average of 1 per cent.

Apart from last year’s bounce-back from the pandemic, which followed an even bigger fall in 2020, the only two years of 2.5 per cent-plus growth were 2014 and 2015, as the economy was getting into its stride after the crisis but before the EU referendum.

Pre-crisis, in the 2000s, 2.5 per cent was a very modest ambition for the economy’s trend growth rate. In fact, the Treasury — these days thought of by new cabinet ministers to be some kind of malevolent growth-destroyer — used 2.5 per cent as its “cautious” assumption for meeting the government’s fiscal rules, believing then that the true trend growth rate was 2.75 or 3 per cent.

When 2.5 per cent trend growth was thought to be the (cautious) norm, it was easily described. Simply put, it consisted of 2 per cent annual growth in productivity, the long-term norm, and 0.5 per cent workforce growth.

Now, 2.5 per cent trend growth is harder. The Office for Budget Responsibility (OBR) always takes a relatively optimistic view on the prospects for productivity recovery, assuming its growth will get back to 1.5 per cent a year after over a decade of near stagnation. But the OBR also expects the workforce to shrink by 0.1 per cent a year, and its estimate of long-run trend growth, in its “Fiscal risks and sustainability” report in July, is only 1.4 per cent a year. If productivity does not perk up, that might be optimistic.

The trend has been undone by four growth-damaging events: the financial crisis, Brexit, the pandemic and now the cost of living crisis. We are back to the age-old question of whether it is possible to waken productivity out of its slumber.

Kwarteng, meeting business leaders, was right to focus on “unlocking” business investment as one of the keys to doing this. Rishi Sunak, having identified the problem, was working on this when chancellor. Perhaps the new chancellor will bring forward some of his ideas.

But the challenge of boosting business investment is considerable. Despite a small second-quarter rise, it remains below pre-pandemic levels and, indeed, is at pre-referendum levels — despite a large incentive to invest now because of the super-deduction tax allowance.

An excellent new Institute for Government paper by Giles Wilkes, “Business investment: not just one big problem”, outlines the difficulty. There are no easy levers for the government to pull to stimulate investment. Merely cancelling next April’s planned increase in corporation tax will not do the trick. “Policymakers once hoped that steadying the macro economy would create the conditions needed for a rise in business investment,” Wilkes writes. “But such stability is often elusive — for reasons both within and beyond the control of politicians … And while macro-economic stability is a necessary condition for growing investment, it may not be sufficient. Nor are the standard recourses of chancellors in the past: financial help for investment, lower interest rates, targeted subsidies or the perennial call for tax cuts. All can make a difference, but given the ‘lumpy’ nature of investment, none is able to drive new projects when conditions are not otherwise encouraging.”The policy debate is thus in danger of becoming a bit circular. Business investment would pick up strongly if firms were more confident about UK growth, but long-term growth will not recover without a rise in business investment. It is a bit of a catch-22. Merely talking about growth will not ensure that it happens.