Ryan Bourne is Chair in Public Understanding of Economics at the Cato Institute.
Four weeks ago, I wrote here that Kwasi Kwarteng must acknowledge jittery markets by setting out a longer-term plan to bring down debt alongside his Growth Plan. This did not require offsetting tax cuts with immediate spending cuts. He merely needed to provide some evidence that the Tories took debt constraints seriously, perhaps through a new fiscal rule or some modest spending cuts as a downpayment to that end.
Explaining the full market reaction we saw to the mini-budget is difficult. Each tax measure had sound microeconomic grounding. The vast majority of borrowing impacts were trailed pre-statement. The UK is still enforcing a sharp tax rise (income tax thresholds being frozen) and a tough spending cut (cash totals for departments remain) in light of higher-than-expected inflation. While gilt yields and market interest rates were expected to go up with the large additional borrowing for tax cuts and the energy price guarantee, sterling’s plunge is difficult to explain through conventional macroeconomics.
I hypothesised initially that markets were worried the Bank of England would keep monetary policy too loose to help out the Government with its rising interest bill from higher borrowing. Given the pound’s rebound since, Ed Conway is probably right that the volatility instead reflected a “credibility” problem for the Government. The combination of spurning the usual budgetary processes, the febrile bond market, unwinding a decade of low interest rates, and a new leader pivoting to more borrowing were, together, a step too far. That might explain the pound’s smaller rise and gilt yields’ fall on abolition of the (small-fry) 45p rate cut – it’s “vibes” that orthodoxy is reasserting itself.
For that reason, setting out vast spending restraint won’t be perceived credible, and now that Tory MPs have forced a u-turn on the symbolic 45p rate, they will feel emboldened to resist it anyway. But Truss remains correct that more building, investment, and better tax incentives are crucial to raise the country’s GDP potential. This simple premise infuriates many commentators, but it is clearly more reasonable – working, as it does, with the grain of markets – than promising “green industrial revolutions,” or an overhaul of skills, or “levelling up,” or all the other state-centric routes to growth that have a long history of failing to deliver.
So the Government must hold the line on other tax cuts that, let’s not forget, the Institute for Fiscal Studies says would only keep the overall burden at 2021/22 levels. Credibility must be slowly rebuilt instead by respecting fiscal processes, by curbing uncertainty around the energy price guarantee’s costs, and by outlining longer-term fiscal and supply-side reforms.
Here is what I would recommend to Truss and Kwarteng.
First, emphasise the independence of the Bank of England in every discussion of bank rate and inflation. Respect the traditional fiscal event procedures, including the role for the Office for Budget Responsibility. If a forecast and analysis of your Medium-Term Fiscal Framework will be ready sooner than on November 23rd, incorporating your supply-side policies’ details, then go earlier with the statement, to avoid the risk of looking like you are buying time to dream up new policies.
Second, your Energy Price Guarantee is a mammoth, unbounded commitment that adds huge uncertainty to borrowing. The Government’s support as a percentage of GDP dwarfs other European countries (it’s more than double Germany’s) and we now face a very cold winter. The benefit of the scheme was it could be adopted quickly. But subsidising the gap between the capped and market price for all households not only diminishes the incentive to economise on fuel use, but subsidises the richest massively in cash terms.
Committing to it for two years for households off the bat was a mistake. Given Tory MPs’ evident concern for the optics of borrowing from future taxpayers to fund supposed “giveaways” to the rich, the Government should rethink how next year’s relief is structured. The aim should be to protect the vast majority of households’ normal use but avoid subsidising mansions and heated swimming pools with borrowed money.
Third, given the scale of the energy price intervention, and the sensitivity of its cost to households’ use, the Government should remind people that energy costs remain historically high and gas is still scarce. Truss wants to avoid nannying people to use less power. But a public information campaign to inform people of how they might save on their own financial outlays during a war-induced energy crisis is not anti-liberty, and could reduce the needed subsidy substantially.
Fourth, given the energy relief and the fact that the gas price is a “real” shock that makes the country poorer, it would be imprudent to raise working age benefits, public sector pay, and the state pension by CPI, as if all the uplift were a pure monetary phenomenon. Real earnings in the private sector have fallen and there’s little evidence this energy shock will unwind any time soon. All these benefits and payments should therefore be upgraded by average earnings growth plus maybe one per cent (around six or seven per cent overall). Again, remember that the Government has frozen income tax thresholds entirely – compared to that, this is a generous settlement.
Sixth, the Government should remind people that our true, long-term fiscal challenge is driven by an ageing population and our pay-as-you-go welfare state. The Government could pass legislation now that improves the long-term debt outlook, without making anyone today “worse off.” Two ideas might be for an accelerated timeline for state pension age rises and for phasing out the pension income tax-free lump sum. These would both be controversial. But they would be right and signal a willingness for revenue-raising tax reform, rather than just tax and spending cuts.
Finally, the Government must flesh out its supply-side plans for growth, which have always been more important than the modest net tax cuts. Given the political mood, these reforms must be realistic. As I noted in my Times column last week, that requires finding mechanisms that assuage fears, bring sceptics along, or compensate those who lose out (for example, cheaper energy for those affected by fracking projects or onshore wind).
Truss is correct that liberalisations of land-use planning, infrastructure, energy, and childcare rules are crucial to improve economic mobility, deepen our domestic market, and raise productivity and GDP. Yet those working around Westminster often say, “well, these supply-side reforms won’t make much difference because they will be watered down or rejected politically,” as if MPs have no agency in the matter!
The growth plan’s long-term success now largely hinges on these supply reforms. Whether meaningful reforms pass depends on MPs. Truss and Kwarteng need to rebuild economic credibility, yes, but Tory MPs must decide whether they want to even try for growth.