This article was first published on Conservative Home – 15th October 2022.
When you are in a hole, the solution is not to dig deeper. That, however, has been the hallmark of UK fiscal policy over the last decade, or so. A decade ago when growth was weak and the public finances were in poor shape, there was austerity. Then in recent years, it was a focus on tax increases. Now, because of the recent loss of market confidence, a combination of both is the approach the Chancellor feels obliged to take in the Autumn Statement.
Recent commentary has been dominated by a focus on the fiscal gap – the so-called black hole – in the public finances. Importantly, this is not a precise number. The managing of expectations in recent weeks points to the Chancellor unveiling a major tightening of fiscal policy, around £70 billion. Many tax hikes have been hinted at, but the bulk appear to be stealth taxes with allowances not rising in line with inflation.
Unfortunately, austerity and tax increases is not the policy mix that the economy needs. Ideally, with the UK already heading into recession the Chancellor should present a strong case to use fiscal policy to stabilise the economy. It would mean debt to GDP rising, temporarily, with increased government borrowing, alongside a clear path to reduce the future ratio of debt to GDP.
No-one should advocate ignoring fiscal sustainability, particularly given recent events. At the same time, because Kwarteng and Truss overdid it and spooked the markets, we must not throw the baby out with the bathwater and think fiscal policy can’t be used at all to help stabilise the economy going into a recession. The danger is a short-lived recession becomes a far deeper one, with long-lasting scarring.
Perhaps the best we can hope for is that the scale of tightening is less than indicated, and that presented in a credible way it will retain market confidence. Equally, given the concerns of business, it is important to be mindful that many of the supply-side aspects of the recent Growth Plan were well received by the likes of the CBI, Institute of Directors and the Federation of Small Business.
The premium attached to UK assets in the wake of the mini-Budget has gone – although this has largely been predicated on tough action to come. As expectations of tough fiscal action have risen, expectations of where UK interest rates and yields will peak have eased. Although there is an argument that the impression this Government has created has been an important factor.
Given recent events, Hunt will likely say he has no choice. Despite being warned, Kwarteng failed to address market concerns and show that fiscal easing was necessary, not inflationary and was affordable. As has been noted, the failure to use the OBR’s forecasts, given they were available, meant there was a further reason to stick with what the market had expected: namely, the energy cap, plus reversing the two major tax increases. Kwarteng also should have reassured the markets about his fiscal principles and addressed their concerns about institutions.
Because of this, we now have created a situation where the OBR is effectively setting the immediate stance of fiscal policy. The danger is a pro-cyclical policy. If economic expectations are poor, the finances look poor, so austerity or tax hikes follow – but these in turn make the economy and finances worse.
The economic environment has changed considerably since the OBR’s last projections made in March. Then, the OBR forecast growth of 1.8 per cent next year and 2.1 per cent in 2024. Now they are expected to predict recession. Inflation forecasts have deteriorated too, with interest rates expected to be higher. With a high level of debt to GDP, future debt projections are vulnerable to expectations of weaker growth or higher interest rates.
The danger is austerity is proven not to work. A decade ago, advocates said there was no other choice. I took the view then that it made more sense for the Government to take advantage of low borrowing rates to invest in public services. Meanwhile, while tax cuts alone do not guarantee economic growth, although incentives matter, tax hikes will squeeze take home pay and dampen consumer spending. It may trigger pressure for higher wages. While a tighter fiscal stance will slow the economy, the inflation outlook means further rate hikes are still possible.
Also, the difficulty of forecasting the budget deficit should make us think twice about the scale of tightening based on such forecasts. Consider the OBR’s forecasts, not because they are poor, but as they keep a record of them. The average forecast error of the budget deficit is 0.5 per cent of GDP in the current year – one per cent of GDP one-year ahead and 1.8 per cent of GDP two-years ahead. In terms of current GDP this equates to £11 billion, £21.5 billion and £38.6 billion, respectively. These are large numbers in the context of a £70 billion fiscal gap.
Sometimes, forecast errors have been sizeable, larger than 0.75 per cent of GDP: in three out of 23 cases for the year in which the forecast was made; in seven out of 21 cases for the one-year ahead forecast; and in eight out of 20 cases for the two-year ahead forecast error.
Of course, the OBR forecast error can also be low: 0.3 per cent of GDP and below in 14/23 cases for the current year, in 10/21 for one-year ahead and 9/20 for two-years ahead. In stable times, forecasts for the budget deficit can be accurate. But we are hardly in a stable environment now.
Some even blame austerity on Brexit, which shows how polarised some of the present economic debate has become. Tellingly, those who advocate this never talk about the role poor monetary policy has played in creating the perfect environment for inflation to take off. Compare the UK’s economic performance to the three major economies in Europe, namely Germany, France and Italy.
On the key economic indicators such as growth, jobs or inflation we compare favourably. Since June 2016, when the UK voted to leave the EU, we have grown faster than Germany and Italy though not as fast as France. We compare favourably on jobs too, with an unemployment rate around half the euro area average. On inflation, all are poor, although France’s inflation rate is lower.
The current deteriorating climate is also impacting Western Europe and the US. But our fiscal response will be very different. In the absence of economic growth, governments can borrow, tax or curb spending, or a combination of these. Yet, while the US has already eased fiscal policy and projections suggest the EU will, collectively, ease too in coming years it is important that, in keeping the financial markets onside, we limit the immediate scale of fiscal tightening. In future, a lesson is to address the relationship between spending and tax, between public sector reform and investment and to get the balance right between monetary and fiscal policy.