Liz Truss’s economic policy was actually very clear. It had three components.
The first was to allow monetary policy to reduce inflation and, by increasing nominal interest rates, allow real interest rates to become positive again – which they have not been since the Global Financial Crisis. (Negative long-run real interest rates are not sustainable as a long run equilibrium – they discourage savings which are the only source of long-term investment and inefficient zombie companies are kept in business through low-interest bank loans when the resources they utilise should be reallocated to more productive uses.)
The second was to allow fiscal policy to stabilise the economy, prevent a recession, and ensure that the ratio of government debt to GDP was on a falling trajectory over the medium term.
The third was to introduce supply-side reforms to increase investment, build infrastructure, promote innovation, and provide appropriate incentives through lower taxes and smart regulation – the outcome would be higher real incomes because of the resulting improvements in productivity. This was Truss’s Growth Plan.
It was also the economic policy that supporters of Brexit had wanted since the UK left the European Union. However, the Remainer elite both at home and abroad was determined that Brexit would not be a success and has done everything in its power to trash it.
Kwasi Kwarteng, the Chancellor of the Exchequer who announced the supply-side reforms in the ‘mini-Budget’ on 23 September, did not help himself by explaining how the tax cuts were going to be funded at a time of heightened financial uncertainty caused by the global energy crisis and the war in Ukraine. Then there was the sacking the Treasury Permanent Secretary on Kwarteng’s first day in office and the refusal to get projections from the Office for Budget Responsibility (OBR) on the impact of the tax cuts on the public finances. There were understandable reasons for this – explained below – but it came across as hubris.
The bond and currency markets reacted badly to the announcement and, scenting blood, anti-Brexit media outlets like the BBC went into overdrive in an attempt to force the Chancellor and Prime Minister to resign – as they had successfully done with Dominic Cummings and Boris Johnson.
The International Monetary Fund soon joined the fray. Maurice Obstfeld, a former chief economist of the IMF, said ‘Fears over fiscal dominance are real given the way the British government has conducted itself in this episode. A lot of damage has been done. It was reckless to roll out tax cuts without the requisite analysis or respect for institutions. The message was that ideology trumps all else. It is the wrong historical moment for neo-Thatcherism’.
This was immediately followed by IMF Managing Director Kristalina Georgieva wilfully misunderstanding the first two components of Truss’s economic policy by announcing that ‘fiscal policy should not undermine monetary policy because, if it does, the task of monetary policy only becomes harder and it translates into the necessity of even further increases of [interest] rates and tightening of financial conditions. When monetary policy puts a foot on the brakes, fiscal policy should not step on the accelerator because if it does, we are in for a very dangerous ride’.
We should not forget that this is the same IMF that in 2016 cut its forecasts for global economic growth following the Brexit vote: ‘The Brexit vote implies a substantial increase in economic, political, and institutional uncertainty, which is projected to have negative macroeconomic consequences, especially in advanced European economies’. Obstfeld, who was IMF chief economist at the time, said ‘Brexit has thrown a spanner in the works’ and forecast that the UK would experience the biggest reduction in growth among advanced economies.
This view was in line with HM Treasury (HMT)’s predictions at the time. You will remember that it was the HMT model that predicted that the ‘extreme shock’ of the UK leaving the EU in 2016 would cause a recession, with GDP falling by 6% and unemployment rising by 520,000.
However, there was no recession after the Brexit vote. In fact, the economy grew by 6% between 2016 and 2019 (the last year before the Covid pandemic) and unemployment fell to 3.8%. The UK government’s budget deficit declined between 2016 and 2019 ‒ from 3.3% of GDP to 2.4%. I heavily criticised the HMT model in ‘Making Astrology Look Respectable: On the Extraordinary Abuse of Economic Models in the EU Referendum Debate’.
The real concern now is that the OBR model will be used to trash Truss’s economic policy and return government economic policy to Treasury oversight and approval. Economists who follow the model closely say that the main forecast is overriden by a productivity assumption (which just reflects recent poor experience) and the forecast of company investment is adjusted to make everything add up. The OBR’s forecasting record is not particularly accurate. This may have been why Kwarteng did not want to use the OBR model.
Jeremy Hunt who has replaced Kwarteng as Chancellor ‒ the rumour is that the Treasury advised that Kwarteng be fired ‒ said that the mini-Budget went ‘too far, too fast’. He has announced that most of the tax cuts will be reversed and public spending will be reduced – and he will rely on the OBR forecasts to ensure that the government’s economic policy is sustainable.
Yet no serious scientific discipline would rely on the output from a single model. Scientists understand the concept of ‘model risk’ ‒ no single model can capture all the nuances of the real world that is being modelled ‒ so good scientists always look at the results from a variety of models.
The Chancellor should ideally look at the predictions from other macroeconomic models as well as the OBR model. But this is not going to happen.
And this is exactly what the Remainers at HMT want. They now have the Chancellor entirely in their hands. He has also become a captive of the Bank of England. Andrew Bailey, the Bank’s Governor, has warned of a significant increase in interest rates: ‘We will not hesitate to raise interest rates to meet the inflation target. As things stand today, my best guess is that inflationary pressures will require a stronger response than we perhaps thought in August’.
So, in the last few weeks, the whole of UK fiscal and monetary policy has come under the control of Treasury and Bank of England orthodoxy – just look at the membership of Hunt’s new economic council ‒ and the Growth Plan has been effectively abandoned. In fact, the opposite could happen: the combination of tight monetary and fiscal policy is more likely to cause a recession.
The so-called ‘anti-growth coalition’ are delighted ‒ including President Biden with his ice cream, faithfully reported on BBC News. The Labour Party said at the time of the mini-Budget that tax cuts benefit the rich more than the poor. The clear implication is that we can never cut taxes again ‒ since the rich will always benefit relatively more from lower tax rates and we can’t have this when the poor are left queuing at food banks. From now on, taxes will only ever increase – and that will do nothing for productivity or growth. Anyone who makes a profit, can now expect a windfall tax.
So, we face a future of no productivity improvements and no real growth – productivity and real wages have barely increased since the GFC. Instead, the future will be one of redistribution. Obstfeld again: ‘The whole Covid experience has strained social cohesion and people are going through very tough times. Economists are now more alert to the distributional effects of crises’.
The implication of this is very clear. In future, there will only be an illusion of growth with ever increasing taxes on the better off paying for higher in-work benefits for the less well off. And if the Greens or Lib Dems get into power, they will impose a 1% per annum tax on people’s houses – effectively confiscating private sector wealth over the next 100 years.
The real risks to the UK economy now come from the Remainer elite both at home and abroad. It won’t be long before they start suggesting that, since we are so useless at running our own economy, we should join the Single Market, the Customs Union, Schengen, the European Army and the euro.
Professor David Blake
Bayes Business School
PS – See Narayana Kocherlakota’s piece on Bloomberg, ‘Markets Didn’t Oust Truss. The Bank of England Did. The way the UK government fell should worry all who support democracy’; https://www.bloomberg.com/opinion/articles/2022-10-26/liz-truss-s-ouster-wasn-t-the-markets-doing