They crashed the pound, but mustn’t crash the economy

They crashed the pound, but mustn’t crash the economy

David Smith

Sunday October 02 2022, 12.01am BST, The Sunday Times

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You have to hand it to Liz Truss and Kwasi Kwarteng. In less than a month in office they have crashed the pound to a record low against the dollar, destroyed the credibility of UK fiscal policy, brought widespread predictions of a house-price crash and forced the Bank of England to step in with a big market intervention to head off a financial stability crisis that was threatening something that Tory members and voters hold dear: their pension funds and the assets they hold.

These are world-class levels of ineptitude. In the same month that people across the world saw Britain at its best, with a superbly organised state funeral for the Queen, brilliantly filmed and broadcast by the BBC, we have seen a new administration revealed as a bunch of bungling amateurs. One was soft power. The other is daft power.

Before the chancellor’s “fiscal event” nine days ago, I wrote that what the government saw as shock and awe could well turn out to be shockingly awful. As the economist Jonathan Portes put it, with the classic line from The Italian Job: “You were only supposed to blow the bloody doors off.” Another economist, John Hawksworth, likened it to teenagers breaking into a nuclear power plant to have fun with the fuel rods.

How do we get out of this confidence-destroying made-in-Downing Street mess? The first priority is to admit the errors. While the government and a minority of frankly weird commentators want to blame everybody else, it is crystal clear what has happened.

A government that thought it could ride roughshod over basic fiscal convention, having sacked the senior Treasury official who cut his teeth fighting crises, and refusing to call on the services of its own economic watchdog, the Office for Budget Responsibility (OBR), has been punished by the markets — and we are all suffering the consequences. Promising further tax cuts, as Kwarteng did last weekend, was pouring petrol on the fire.

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So it is essential to restore some fiscal credibility. Even an OBR forecast, which will eventually be published on November 23, may not do the trick if predicated on unrealistic projections for public spending. Already the talk is of “Austerity II” in which departmental budgets are not adjusted for the high inflation we are seeing and pensions and other benefits are not uprated in line with inflation next April. Let us see how that goes down if it coincides with the reduction in the 45 per cent top income tax rate, also next April.

The government is looking for efficiency savings to reduce public spending, always wheeled out at times of difficulty, but usually with little effect.

On the tax side, I suspect that as long as Truss is prime minister any reversal will be regarded by her as “over my dead body”. Stealth tax increases might be another matter. She may not last long as prime minister, and we have learned — again — that leaving the choice to a small number of Tory Party members is dangerous, but another change of leader would hardly reinforce the UK’s reputation for stability. A change of government might.

Under this government, the best hope is outside its control. Gas prices have been volatile, falling from their highs in response to Europe’s success in filling reserves to see countries through the winter months and falling consumption. If they were to fall decisively, it would significantly reduce the cost of the energy price freeze announced by Truss on September 8.

She told local radio listeners on Thursday that the freeze meant that nobody would pay more than £2,500 a year for the next two years, though the amount, which in some cases will be much more than £2,500, depends on the type and size of property. Even so, the high cost of the package, and its equivalent for businesses, could come down from the estimated £150 billion or so — estimated by independent forecasters, not the government — if prices were to fall.

That would still leave the permanent tax cuts announced by Kwarteng on September 23 and the hole in the public finances caused by the abandonment of the fiscal repair job that was being undertaken by his predecessor but one, Rishi Sunak. The consequences of them will not be stronger growth but higher government borrowing costs and, closely related to them, mortgage rates.

The question then arises of how much the Bank has to raise interest rates to deal with an inflation problem exacerbated, both in its direct effects and through the weaker pound, by the actions of the government.

One route to bearing down on inflation, reversing quantitative easing (QE) through quantitative tightening (QT) has been made more difficult by last week’s emergency moves to settle the market. That large-scale bond-buying was not, technically, more QE, but the difference is technical. Selling bonds back to the markets, QT, is harder in this environment.

That puts the onus on interest rates. Before the chancellor’s fiscal event, markets thought the Bank rate would peak at 4 per cent or so. Expectations have since shifted to a more rapid rise, with expectations of a bumper 1.5 percentage point increase on November 3, with further increases taking the Bank to a peak of close to 6 per cent next year. Some are predicting that a 7 per cent rate could be needed.

I don’t think that can, or will, happen. The Bank’s intervention last week was all about heading off a “material” threat to financial stability. Pushing up rates to those levels would not only crash the economy into recession but it would crash the property market, both of which would represent material threats to financial stability. Yes, the Bank needs to be part of restoring credibility into UK economic policy, which has been so casually damaged, but it is not clear that credibility would be restored by unnecessarily punitive interest rates.

It is necessary, too, to look at the Bank’s motivation for raising interest rates, which is to bring down inflation. In its last set of projections, in early August, conditioned on a rise in the Bank rate to about 3 per cent, inflation was predicted to fall to the 2 per cent target in two years’ time and to 0.8 per cent in three years.

And, while the weak pound and the unfunded giveaways will add to inflation, they will not do so by enough to warrant a Bank rate above 5 per cent, or probably anywhere near it, That would produce not just low inflation but deflation, falling prices, and the Bank has no mandate for that, suggesting that the peak for rates should be well below 6 per cent, perhaps 4 per cent, compared with 2.25 per cent now.

Calmer heads need to prevail, and we can only hope they will. The government, far from going for growth, has increased the risk that it will crash the economy. Such an outcome can be avoided, as long as the government does not keep getting it so badly wrong.

PS

After all that, some good news. When, a few weeks ago, I was looking for the figures to see what was really happening during the “summer of discontent” of strikes, I discovered that the Office for National Statistics (ONS) suspended the collection of the figures for industrial disputes on the outbreak of the Covid-19 pandemic, with no plans for reinstatement.

This was, as I put it at the time, an act of statistical vandalism. Official data for industrial disputes goes back to 1891 and monthly data is available from 1931, also a time of economic crisis. To stop producing the statistics on a permanent basis would have been terrible.

Fortunately, I can report that the ONS has brought back the figures, and they will be published on a monthly basis from next month, which is great. In the meantime, the statisticians have given us the figures for June and July to chew on. They show that there were 70,500 working days lost to strikes in June and 87,600 in July, mainly in what it says is the transport and storage sector.

That is quite a lot of disruption. June and July taken together suggest days lost to disputes ran at roughly four times the 2019 monthly average of 19,500 — still tiny compared with the past. During the miners’ strike in 1984, days lost peaked at three million a month, while shortly after Margaret Thatcher took office in May 1979, there were 11.7 million working days lost in the September — bigger than in any month in the 1978-79 winter of discontent. We will probably never see those numbers again.

david.smith@sunday-times.co.uk