The financial and political world is agog at the scale and radicalism of the Truss administration’s new economic policy. It is portrayed by critics as a “reckless gamble”. It is certainly a sharp departure from the prevailing orthodoxy, but this article argues that it is a well-considered and necessary one. There are three main reasons for this belief.
The Previous Policy Approach was Failing
The previous policy approach – ultra-low interest rates, money printing through QE, excessive regulation, higher and more complex taxes – has resulted in an ever more anaemic growth rate and currently much higher inflation. UK GDP growth since 2010 has only averaged 1%, and the Bank of England (BoE) claims the economy is now in recession. Without higher economic growth none of the UK’s structural challenges – such as excessive regional inequality, a chronic housing shortage, a failing NHS and social care system, the need to increase defence spending and achieve net zero– can be successfully tackled. The Johnson government started a free trade drive, began post-Brexit deregulation and increased infrastructure investment but more needs to be done and with more urgency.
The New Policies are Based on Classic Market-based Economic Principles
The new policies have not been plucked out of thin air nor do they result from panic but are based on classic economic principles. The UK is currently in a stagflation phase – stagnant economic growth and high inflation. The textbook macroeconomic policy response to stagflation is to promote growth through easier fiscal policy and to fight inflation by tightening monetary policy. Policy is currently being re-balanced in this way, with the BoE steadily raising interest rates. Market fears that the new policy stance is inflationary are wildly misplaced. The Bank’s independence of action is strengthened by the fact that decisive fiscal action has been taken to combat recession. Crucially, UK broad money growth has already fallen on a sustained basis to levels consistent with a return to inflation in the 2-3% range. The BoE is right to reject calls for an emergency rate rise, which would smack of panic, and should wait until the next meeting before raising rates again. The BoE is also right to take action to counteract threats to financial market stability caused by the recent sharp rise in bond yields but should resume its planned quantitative tightening when conditions allow. The bond market reaction to the mini-budget seems like an overreaction, which would naturally correct in due course even without intervention. It could also be though that markets are indicating that a more competitive exchange rate and interest rates in the 4-5% range are needed to be consistent with a higher growth economy. From a longer-term point of view the new interest rates represent a healthy return to more normal levels from the historic lows of the last decade and will assist in the required rebalancing of the economy. Current financial market “turmoil” reflects the necessary process of finding a new equilibrium in reaction to radical change.
Liz Truss and Kwasi Kwarteng are enacting policies, harnessing the power of the private sector and market forces, that they have advocated for many years and set out in a jointly written book Brittania Unchained. Key tax changes proposed so far – abolishing the 45% top marginal rate, cancelling increases in NI and Corporation Tax, cutting stamp duty – are deliberately aimed at increasing incentives for business to invest, to innovate, and to create jobs. They are also the start of a long process of simplifying the tax system. With the UK Tax code now running at a monstrous 24 000 pages there is a long way to go!
Clearly it is not ideal that these tax cuts take place while the fiscal deficit is already higher than is sustainable long term. Therefore, it is crucial that increased fiscal stimulus is not only accompanied by tighter monetary policy but major supply side reforms as well. The government has set a goal of raising the sustainable growth rate by 1%, from 1.5% to 2.5%. This is an ambitious but attainable target, but it will not be achieved by changes to the tax system alone. The government is making all the right noises about sweeping regulatory reforms across a range of industries and sectors – financial services, planning laws, child care, agriculture, immigration and oil and gas. All EU laws are to lapse by the end of 2023 unless specifically retained or amended. Surplus government land is to be sold. New investment zones are planned that are radical in scope.
It is vital that these reforms are delivered, and the quicker more detail is provided the quicker businesses and investors will respond. There will be stiff opposition from the civil service and from within the ranks of Tory MP’s. It is therefore encouraging that the government has already proved willing to take unpopular but growth promoting decisions such as lifting the cap on banker’s bonuses and ending the moratorium on fracking. Sacking the Treasury’s top civil servant (known to be an enthusiastic blocker of moves away from EU law) also sends a clear message to the bureaucracy. This administration seems to mean business.
Critics of the New Policies are Exaggerating the Risks
The main fear is that the new policy approach will be brought to an abrupt end by much higher interest rates caused by continued high inflation and an unsustainable rise in government debt. Comparisons are made with the “Barber Boom” of the early 1970’s, which eventually resulted in the UK going cap in hand to the IMF for a bailout in 1976. This comparison is ludicrous. The then Chancellor Tony Barber’s tax cuts were accompanied by 20% plus money supply growth but not by significant supply side reforms. The biggest tax changes in the current package are primarily cancellations of planned tax rises rather than genuine cuts, while UK money growth is now less than 5% and likely to decline further. Although Sterling is weak, the $ prices of key commodities are falling sharply. Over the last 3-4 months Copper is down 30%, Iron Ore 33%, Wheat 27%, Soybeans 16% and Lumber 70%. Even more important, energy prices are falling with oil prices down 30% from the peak earlier in 2022 and UK spot wholesale gas prices down by fully 62% from their late August peak. At that time the Institute of Fiscal Studies – arch critics of the new policy approach – warned that the government’s energy price cap would increase public debt by £150-200bn. The subsequent fall in gas prices has already reduced that figure to £60bn, with energy analysts and traders forecasting further sharp falls in gas prices early next year.
The Energy Price Guarantee (EPG) caps gas prices paid by consumers so that average household bills will be no more than £2500. Even at the recent much lower cost estimates this is certainly a major state intervention in markets, apparently at odds with the new approach, but Truss/Kwarteng rightly acknowledge that such interventions are necessary in extreme circumstances. The National Institute for Social and Economic Research (NIESR) estimates that primarily because of the EPG Kwarteng’s “mini-budget” will result in the economy escaping with only a very mild mid-year recession and resuming growth from Q4 onwards. A deeper recession would of course have itself increased the fiscal deficit by weakening tax revenues and increasing spending. Further savings will come from lower interest payments on index-linked government debt* as lower gas prices will reduce the headline inflation rate by as much as 5% below what it otherwise would have been. Components of public spending linked to inflation rates will also be lower than otherwise. In a splendid irony this state intervention by arch-marketeers may well turn out to be one of the most successful ever attempted by a UK government!
Those accusing Kwarteng of fiscal profligacy also seem to have failed to notice that he did not change the previous Chancellor’s policy of not indexing income tax thresholds for inflation, thus allowing “fiscal drag” to increase tax revenues. Furthermore, government departments are given cash limits on their budgets, and so far those cash amounts have not been increased even though inflation in this fiscal year is much higher than forecast a few months ago. A significant cut in real departmental public spending is therefore being carried out by stealth.
The IFS has secured many headlines and BBC interviews with its forecast that the new policy approach is unsustainable because it will result in the public debt to GDP ratio continuously rising. Although economic models are essential tools for certain purposes, I am a career long sceptic. The economic models used by the Treasury and high profile forecasting organisations today seems no more able to capture the dynamic changes generated by market systems, the power of the price mechanism, or household and business responses to incentives than the models around when I first worked as an economist nearly 50 years ago. The gloomy IFS view assumes that the economy’s sustainable growth rate will not be significantly raised by the announced tax cuts and planned supply side reforms. However, even the IFS calculates that if the potential growth rate can be raised by 0.7% the public debt ratio will stabilise. In contrast, although the NIESR also does not see the growth target being reached it nevertheless does forecast a moderate fall in the ratio over the next 5-years. The UK presently has the second lowest public debt to GDP ratio in the G7, and by a significant margin over top 5. Arch-Keynesian economist Paul Krugman has pointed out (as noted in B4B’s last newsletter) that the UK foreign liabilities are largely £ denominated while foreign assets are mainly $ denominated. A weaker £ exchange rate therefore actually improves the UK’s international balance sheet. The case for predicting a sustained UK fiscal or currency crisis is remarkably skimpy.
In my assessment, based on long observation rather than any economic model, the scale and scope of the planned supply side and tax reforms/cuts is enough to generate the kind of improved economic performance the government is seeking. The principal policy risk is that the bureaucracy and nervous/rebellious Tory backbenchers stymie the implementation of the required changes. If the reforms can be delivered in good measure, then the UK economy will soon start to recover and will steadily reach and sustain the desired 2.5% growth rate. I am even more confident than before that the UK will be the best performing G7 economy in the five-year period post-Covid. The US Fed looks far more likely than the BoE to commit monetary overkill, while the EU has been worst hit by the aftermath of the Ukraine war while still mired in structural stagnation and well behind the curve in tightening monetary policy.