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Conservative Home op-ed: Pro-growth is replaced by stability, and a recession will be the result

Oct 18, 2022

This article was first published on Conservative Home – 18th October 2022.

The economy is heading for a deep recession and a number of years of weak economic growth. Unemployment, currently low, will rise. Living standards will stagnate.

The era of cheap money, which has lasted excessively since 2008 and created a host of serious issues, is now being replaced with both a tighter monetary and fiscal policy.

Many of the supply-side reforms unveiled in the recent Growth Plan that could help deliver growth, such as planning reform, are unlikely to get through Parliament.

For now, this has been overshadowed by the risk premium that has been added to UK assets because of concerns about economic credibility. Once lost, credibility takes time to restore.

Because of the avoidable mistakes made, UK economic policy, now led by Jeremy Hunt, the new Chancellor, will be dominated by austerity and tax increases. It was wise to have a fiscal update yesterday to reassure the markets, but more painful decisions on public spending are to come.

Despite recent happenings in the financial markets and the many policy U-turns, the case ahead of the mini-Budget for some fiscal loosening to stabilise the economy and prevent a deep recession was the right one. Raising taxes into a downturn was unwise.

The Growth Plan, too, was constructive and something I endorsed at the time – as did the major business groups like the CBI, IoD and FSB.

But the mini-Budget, which announced far more than what was trailed on the campaign, has caused irrevocable damage that triggered the current policy response. Ironically, there could not be a worse combination for trying to deliver growth. More pertinently, it will make the recession far deeper than it might have been.

While the announcement of a tighter fiscal policy has reduced some of the risk premium in UK assets, it will not prevent the Bank of England’s policy rates from rising.

As I’ve argued elsewhere, if the mini-Budget had stuck to what was expected and priced in – namely the energy package and reversing the national insurance increase plus cancelling the planned corporation tax rise – then the adverse financial market reaction would have likely been avoided and, politically, the landscape would be very different.

Instead, it fed the idea that ‘Trussonomics’ was merely about cutting taxes to achieve growth, with no concern for fiscal prudence. In short, if the Government was not having its homework marked it should have stuck to what was expected.

It also fed the misplaced idea that this was a dash for growth, like the Barber Boom, and not a plan for growth aimed at boosting investment.

Unnecessarily removing the top rate of income tax meant the whole agenda could be mischaracterised as trickle-down economics, something few believe works. The markets were not convinced the Government’s plans were necessary, non-inflationary, and affordable.

Regular readers of this column will know back in February I warned of a sterling devaluation and the week before the mini-Budget I expressed concern about the febrile state of the markets – and how this should be top of the then Chancellor’s thinking.

A fair analysis should be able to be critical of both the Government’s mini-Budget and the Bank for being behind the curve in curbing inflation. The Bank’s decision, too, to start quantitative tightening the day before the mini-Budget, even though the market had enough gilts to absorb, was also a factor.

While the Bank appears now in a much stronger position, many of its same issues remain, including its poor communication. If reports are also to be believed that the Governor and the then Chancellor spoke every day before the mini-Budget, I wonder what they spoke about – obviously not the markets.

There is now also the related issue of why pension funds were so exposed to changes in interest rate expectations through leveraged positions, something the regulators and the Bank appeared aware of.

There was also misplaced market concern about institutions, notably the Bank and Treasury. Truss always said the Bank would remain independent and her stance that the mandate should be reviewed (commonplace in Canada) is hardly radical. Certain criticisms of the Treasury, too, were valid such as its institutional focus on tax and not growth.

It is more likely that those who cite this as a factor simply don’t like the idea of people being critical or trying to hold these institutions to account. Often when valid criticisms are raised, the response is that the integrity of the Bank is undermined. Independence while important, should not mean the absence of scrutiny.

Bringing it back to where we are now, Hunt’s actions are to show the Government’s fiscal sums add up, to calm the markets, and reduce peak interest rate expectations.

Hunt has ripped up the mini-Budget and announced net fiscal tightening of around £32 billion per year. The full costings will be unveiled at the end of October, with the release of a medium-term fiscal plan that will be fully costed by the OBR. There is likely to be a further spending squeeze too.

While UK debt to GDP is high, it is manageable, as it was before the mini-Budget. Higher inflation will reduce the ratio of debt to GDP. But the high level of debt makes it very sensitive to the relationship between growth and interest rates.

For instance, expectations of low growth make the fiscal outlook look poor. Before the mini-Budget it always looked likely that debt to GDP would rise in the next couple of years, either because of a deep recession or fiscal measures to prevent it.

Last week the IFS said there would be a black hole of around £60 billion per year, based on Citi’s U.K. growth forecasts. For next year they expect -0.7 per cent. In contrast, the IMF last week forecast 0.3 per cent growth, but they had not taken into account the mini-Budget – which they thought would boost growth (while making the inflation picture more complex). The NIESR though had raised their growth forecast to 2 per cent for next year on the back of the mini-Budget. Higher growth forecasts would have removed the black hole.

‘Trussonomics’, which was never really defined and was yet to evolve, is now dead. The events in recent weeks that led to its downfall were avoidable. The only positive, if any can be taken, is that it tried to embed growth as central to policy making. We need a greater focus on how to break out of the low growth, low pay, low productivity environment that the UK finds itself in.

Before her entry into Downing Street it appeared that it was becoming more broader based: using fiscal policy to stabilise the economy as opposed to always relying upon cheap money (thus reversing the two major tax hikes plus the energy levy), boosting investment (hence the supply side), borrowing when necessary as opposed to austerity or tax hikes (hence the criticism of orthodoxy), fiscal discipline (hence reducing debt to GDP), addressing downside risks so the Bank could act to tackle inflation, and boosting the competitiveness of the City to help deliver growth for the real economy.

By the Party Conference, Kwarteng was saying it was supply-side change, curbing public spending and tax cuts. While tax cuts are critical for incentives, they do not by themselves deliver growth. And the plans for public spending were never outlined during his time in Number 11.

Going forward, for economic policy to succeed, the UK needs a three arrowed approach: monetary and financial stability, a pro-active fiscal policy while reducing debt to GDP; and a supply-side agenda, encompassing all the “I’s” of innovation, infrastructure, incentives and investment.