Autumn Statement: A Growth plan in disguise?

Budgets are often Highly Political and Not What They Seem

When economists analyse Budgets they tend to underestimate how they are about politics as much as economics. Budgets have major economic implications, with significant technocratic input, but are delivered by politicians who have elections to win. A classic example was the Thatcher government’s 1981 Budget, which increased taxes in the teeth of a recession, prompting a furious protest letter to The Times from 364 economists. The Budget defied conventional economics because it was really a statement of political intent showing that the government was deadly serious about squashing embedded high inflation. Businesses and investors were convinced, the economists were wrong, and a strong economic recovery began.

The Sunak/Hunt Budget is seen as Treasury Austerity combined with Socialist Tax and Spend

I name it the Sunak/Hunt Budget because it is the PM that is driving economic policy – not surprising from a recent Chancellor. The Labour Party’s attacks on the Budget lack bite as it is unclear how Labour could follow markedly different policies given current debt and deficit constraints. The vociferous criticism coming from Tory Party free marketeers and conservative commentators – some appearing close to self-combustion – is precisely that the government’s tax and spend policies are essentially socialist. They complain that the tax burden is to be the highest for 70 years, and that the tax increases responsible are mainly aimed at businesses, entrepreneurs, and savers – the very people that create economic growth. They deplore the reversal of the Truss policy of using tax incentives and tax reform to promote higher growth, the watering down of supply side reforms and cuts in capital spending. They argue that Sunak and Hunt have been badgered into Austerity 2.0 by the OBR (Office of Budget Responsibility), an institution with an appalling forecasting record. The Chancellor blames global factors for the high inflation rate, seemingly absolving the BoE (Bank of England) even though control of inflation is its primary responsibility.

My previous article “Trussonomics will work if supply side reforms are delivered” supported the Truss programme. After Liz Truss was deposed the emerging economic policy outlines were alarming, undermining optimism that the UK could achieve relative economic outperformance over the next few years. First impressions of the Budget were not encouraging. However, looking at the Budget closely, and with a political hat on, a different conclusion is possible.

This Budget is less Austerity 2.0 and more a Growth Plan in Disguise

The two key policymakers are unlikely socialists. Rishi Sunak worked for Goldman Sachs. His political heroes are Margaret Thatcher and Nigel Lawson. He was deeply alarmed by the implications of lockdown for the economy and personal liberty. Jeremy Hunt was a successful entrepreneur before entering politics. In his leadership campaign he proposed reducing the company tax rate to 15%. It is said that they know they can’t win the next election and are just aiming to limit the electoral damage by following centrist policies. Rishi Sunak is a young and ambitious politician, showing great tenacity in securing the top spot at the second attempt. Jeremy Hunt has been given another chance at power after two failed leadership bids. And they are not planning to win the next election?

Why knowingly attract such opprobrium from their own side?  Firstly, they needed to present a credible plan to reduce debt as a % of GDP over time, which Truss and Kwarteng failed to do, in order to stabilise markets. This required working with key institutions – the OBR and BoE – no matter how flawed their previous performance. Sunak and Hunt will be aware of the failings of these two bodies but have chosen not to attack or side-line them while in a weak position. Given the governments deep unpopularity major additional spending cuts – real public spending was already set to fall significantly because of higher-than-expected inflation – was just not practical politics. Neither were tax increases on consumption or on lower income groups. Tax rises on business and higher income groups were the remaining options. These choices got the OBR on side and enabled the BoE to moderate increases in Bank Rate that would have deepened the recession. The Budget has achieved the shorter-term objective of market stabilisation. When a company in crisis appoints new management, they often dump all possible bad news into the first set of results, blame previous management and set the company up to outperform deliberately lowered expectations. Sunak and Hunt might following this template – under promising and over delivering.

It is implausible that they intend to fight the next election promising the punishing tax increases and spending cuts currently pencilled in post-2024. These are there to reassure the markets and confuse the Labour Party. The OBR forecasts UK GDP to fall by 1.4% in 2023 followed by a weak bounce of 1.3% in 2024. Since GDP has flatlined from Q4 21 and will decline in Q4 22 this implies that by end-2024 the UK economy will have shown no net growth for more than three years. The government is electorally sunk if this forecast is correct, but I don’t think it is and doubt that Sunak and Hunt do either.

Why the OBR forecasts are too Pessimistic

Sunak and Hunt’s plan to win the next election must be based on their belief that the economy will perform significantly better than forecast by the OBR. These are the key reasons why they could be right:

• The OBR assumes that Bank Rate will increase to 5% by H2 2023, ignoring clear signals that the BoE have no intention of raising rates that much. A lower peak in Bank Rate will moderate the projected downturn and lower government debt interest costs. Leading indicators signal that inflation may fall very sharply next year. Key commodity prices, including energy and food, have fallen by between 25% and 40% recently. Shipping costs have fallen by 70% since the start of 2022. UK money supply growth has been slow for 18 months. The OBR’s forecast of 7.4% inflation for 2023 looks far too pessimistic, a mirror image of their previous absurd optimism on inflation. A return to low inflation would be a major boost to business and consumer confidence.
• The OBR’s model assumes higher interest rates to be an unmitigated negative for economic growth, but the ultra-low rates of the last decade are a key contributor to low productivity because they facilitate malinvestment and enable weak companies to survive. The return of more normal interest rates will help raise the economy’s sustainable growth rate.
• The OBR’s estimates of the costs of the EPG assume a Q1 23 gas price that is 25% higher than gas futures prices for that quarter. If gas prices remain where they are or move lower the costs of the EPG will turn out much lower.
• Most of the Budget’s tax rises and spending cuts are back loaded to post-2024 – of the total of £55bn “savings” made in the Budget only a net £14bn take place before the election. This is electorally convenient but also avoids a major fiscal retrenchment just as the economy enters a downturn.
• The Johnson government aimed to reverse decades of neglect by increasing infrastructure spending to a globally competitive level of 3% of GDP. Liz Truss retained this investment programme in her Growth Plan. The Budget confounded fears that this programme would be axed by maintaining planned spending levels for the next two years (£114bn in 2023 and £115bn in 2024), including the ‘core’ Northern Powerhouse railway and continued rapid rollout of 5G and digital broadband. Capital spending thereafter will remain at the same level rather than increase, “saving” £14bn, but public investment projects will help counteract the current downturn. This is a welcome contrast to Osborne’s Austerity 1.0 which severely cut public capital spending. The OBR’s model understates the likely positive impact of public sector investment, which is vital in raising the sustainable growth rate.
• The Budget retains other key elements of the Truss Growth Plan, a little noticed development that is crucial to a full understanding of economic policy and prospects. Rishi Sunak’s leadership campaign created the impression that he was uninterested in strategies for growth. Sunak’s Mais lecture in February this year disabuses that notion, as it is full of ideas to raise productivity and growth and references Adam Smith, Margaret Thatcher, Nigel Lawson, his experiences of working in Silicon Valley, and recent academic studies of the roles of innovation, ideas, and technology in promoting growth. Hence the Chief Scientific Adviser is to urgently review post-Brexit science regulation “to better support safe and fast introduction of new emerging technologies”, public Research and Development funding is to be raised to £20bn by 2024/25 (2.4% of GDP), and the promised review of all EU regulations prioritises the growth sectors of digital technology, life sciences, green industries, financial services, and advanced manufacturing.
• As part of this deregulatory push the Government has overruled the BoE and will overhaul the Solvency 2 rule book – inherited from the EU – freeing up about £50bn of capital held by UK insurers that can be invested in the real economy. Over time this will raise business investment and thus productivity. To boost the City’s competitiveness the bank profits tax surcharge was reduced from 8% to 3%, while there was a boost to industry competitiveness from the unilateral abolition of more than 100 tariffs on imported manufacturing components. All these measures are only possible post-Brexit.
• The drive for free trade agreements (FTA’s) and global partnerships will continue apace. An FTA with the Biden administration has long been ruled out, but media sources indicate that a new “Energy and Security Partnership” with the USA will be announced soon. Negotiations on trade and investment agreements with individual US states continue, along the lines of those recently concluded with Indiana and N. Carolina. Die-hard Remainers who scoff at such deals should note that the GDP of these two states combined is equal to Netherlands, the EU’s 5^th largest economy. The PM’s indicated in his G20 report back that rapid progress is being made in the UK’s application to join the giant Asian trading bloc CPTPPT. He was more circumspect on the ongoing but advanced FTA negotiations with India, stressing the need for “quality rather than speed”, but will the first British PM of Indian heritage fail to conclude a ground-breaking deal with India? I doubt it. Negotiations on an improved trade deal with Switzerland are to begin in the New Year, following a new three-year visa free deal for financial service workers between the two countries.
• Brexiteers who are alarmed about talk of the UK re-joining the single market or coming to a Swiss-style arrangement with the EU should relax. By end-2023 we are set to have irreversibly diverged from the EU regulatory regime and made major global trade and security agreements that will finally consign such talk to the dustbin of history.
• This is entirely consistent with the UK simultaneously improving relations with the EU. Once the EU accepts the irreversibility of Brexit the absurdity of its antagonism towards a major trade and security partner becomes all the starker. One beneficial side-effect of the Ukraine war, and the increasing belligerence of China, has been to greatly accentuate the need for Western unity. The UK’s leading role in supporting Ukraine has been appreciated in a number of EU states in the Baltic and E. Europe, while the EU’s already stagnating economy has been greatly damaged by the after-effects of the war. All this suggests improved UK/EU relations are likely. Progress is already being made on the illegal migrant issue, and the probability of a deal on the N. Ireland Protocol has increased. Absent any possibility of re-joining the single market UK/EU trade barriers could still in time be reduced.

In summary, a plausible scenario can be constructed in which the UK suffers only a mild downturn, as interest rates soon reach their peak, the inflation rate falls sharply, and confidence is boosted by major global trade and security agreements and improved relations with the EU. A recovery begins towards the end of 2023 and into 2024, further assisted by strong public sector investment and well targeted deregulation. UK public finances are highly geared to economic growth so the OBR will be obliged to radically modify their pessimistic fiscal outlook. The government will then be able to cancel much of the post-2024 increase in the tax burden and cuts in capital spending. A fantasy? Maybe so, but Messrs Sunak and Hunt will be exerting every sinew to make it happen!

Robert Lee November 22^nd, 2022