It has never been truer to say that a week is a long time in politics. As sterling has plummeted and long-term gilt yields soared, the market chaos has forced an unprecedented intervention by the Bank of England to shore up the gilt market; mortgages have been withdrawn in swathes leaving many would-be buyers in the lurch, and the IMF has waded in to call for a reversal of some of the recent economic measures. The Prime Minister herself has been forced today into an emergency meeting with the Office for Budget Responsibility. It is hard to imagine a less propitious start to a new Government.
And yet — bar the cuts in taxation — many of the measures announced just a week ago were heavily trailed and widely accepted as necessary. While the tax reductions announced in this budget are substantial, their impact is only forecast to return the UK tax burden to 2021-22 levels — reflecting the large increases in the tax burden previously forecast for the coming years. The mantra of growth, growth, growth is also one widely accepted as the only way through the current impasse of tight labour markets, increasing inflationary pressures and a high burden of taxation.
So why the reaction?
Arguably, the new Government’s problem was not so much in the ambition to grow the economy at the same time as cushioning the impact of energy prices on households and businesses, but in the delivery. First, they represented only one part of the overall economic measures in the pipeline (the ones which bore heavily on the public finances) and second, they not only showed a complete disregard for process, economic institutions and the markets, they almost seemed to revel in that disregard. Having served at the highest levels of government, I am well aware that the sequencing of announcements is critical. A case needs to be made for reform, before the action is taken. Stakeholders need to be convinced that the system needs to change if there is to be a positive reaction. At the Treasury, this ‘buying in to the narrative’ is even more important, as an adverse reaction from the markets could risk derailing the very object of the reforms.
It is worth taking a brief look at the state of the economy before considering what moves the Government should make next.
It is undeniable that in the decade between the financial crisis and advent of Covid the UK’s underlying economic performance has been dire, masked only by more and more people of working age joining the labour market — mainly migrants from the EU — which drove up GDP per head.
Scratch beneath the surface and we see that during this time the UK’s productivity was stagnant, its worst performance over a ten-year period since 1860. And stagnant productivity has meant stagnant wages. Between 2007 and 2018, real median household disposable incomes fell by 2 per cent in the UK. Over the same period, they rose 34 percent in France and 27 per cent in Germany.
The Government’s ambition is to reverse the decline in the trend rate of growth, doubling it to 2.5% a year in line with the pre-financial crisis performance — ambitious perhaps, but necessary. The challenge of low growth has been made significantly harder to redress, however, given the hundreds of thousands of people of working age withdrawing from the labour market over the last years in the ‘Great Resignation’, possibly as a result of long Covid, increased caring responsibilities or a change in preferences about their work/life balance.
Alongside this poor underlying economic performance, the UK’s population are highly exposed to international energy prices largely because the vast majority of homes are heated with gas, and about 40 per cent of electricity is generated by gas-fired power stations — a higher proportion than most European countries.
The result of the Great Resignation and the high exposure to international energy markets meant that the UK has suffered the unique combination of the tight labour markets of the US and the inflationary shock catapulting across Europe.
The response therefore needed to be two-pronged.
First, it was clear that households needed to be protected from the unprecedented spike in energy prices. To do otherwise would be to risk destitution and misery on a large scale. And while, some, including Policy Exchange have argued for a more targeted approach than the one delivered by the Government, or one that kept a clearer link between behaviour and price signals, a large spending package was clearly needed.
Second, the government rightly recognised that a supply-side revolution is needed to raise the level of productivity growth and increase the trend rate of growth to more normal levels.
Of course, there will be debates about the best way to increase productivity and the trend rate of growth. Some obvious productivity boosts would have included additional funding for research and skills. These have been a hole in the Government’s narrative so far.
But arguably even more important than investment in research and skills is addressing some of the major constraints on the operation of the market. The Government has promised future announcements in a series of areas. Planning reform, for example, particularly to unleash greater housing supply, is one area which could make a real difference to future growth rates. And other parts of the economy, such as childcare, as Policy Exchange has argued recently are broken and needed fundamental reform to allow people to have reasonable choices between work and caring responsibilities. Together with other supply-side measures to accompany the fiscal boost, these could have amounted to a reasonable, if contested, economic agenda.
As it was, the mini-budget (if ever there has been a misnomer for a fiscal event, this was one), combined all the fiscal measures needed to cushion the rise of energy prices, with none of the measures needed to reassure markets and opinion-formers that the increased borrowing would pay for itself over the longer term. And on top of that, it added in unfunded tax cuts by not only cutting the basic rate of income tax but abolishing the top rate of income tax too. The result was to set government borrowing — in the absence of other measures — on an unsustainable path. We were all expected to take the Government’s measures on faith.
And taking measures on faith is hard without the plans being part of a well-defined system of checks and balances, without the Office for Budget Responsibility, the Treasury and the Bank of England all singing from the same hymn sheet.
But this time, we had no economic forecast from the OBR. The most senior official in the Treasury had been summarily dismissed on the Government’s first day in Office, and there was vague talk of future reform of the Bank of England’s mandate. There was little talk of the fiscal rules being observed, merely a future plan to set out how fiscal discipline would be maintained in the medium term.
Regardless of the fiscal measures themselves, the process the government has followed and the disregard it has displayed for the UK’s economic institutions have undermined the Government’s economic and fiscal credibility. It is certainly the case that the Office for Budget Responsibility, the Treasury and the Bank of England are not perfect. While Policy Exchange was the first to promote the idea of an ‘independent fiscal committee” back in 2007, which was later adopted by the Coalition Government and renamed the OBR, some of its assumptions may need to be challenged. Officials at the Treasury may need to be changed. The Bank’s mandate should probably be the subject of a periodic review. But it was a mistake to allow obvious suspicion of these institutions by the Prime Minister and the Chancellor to make it look like they were economic buccaneers, rather than level-headed stewards of the nation’s finances.
Mel Stride, chairman of the Treasury committee, said the OBR would demand a “rethink” of ministers’ plans for £45 billion in tax cuts because “this circle cannot be squared”. There are, however, some things that can be done alongside the raft of supply side measures we are expecting over the next few weeks. For a start, the Government has no time to lose in underlining its commitment to working with the economic institutions we have. The Bank’s independence should be reinforced at every opportunity. The OBR should be involved in assessing the impact of the supply-side agenda on economic growth. A commitment should be made to due process and ongoing scrutiny of all economic plans.
Then there needs to be an intense focus on productivity in public services. During the last decade or so, there has been little to say on how to make public services more efficient and more responsive to the consumer, yet they make up around a fifth of GDP and are essential to delivering the services that make the economy function well.
Lastly, we need to see real devolution to towns, counties and cities. If productivity is to increase, then cities outside London will need to grow fast. That may mean a degree of devolution of taxes as well as regulatory powers.
It is not clear that these will do the trick. The concern is that if credibility is not restored, then we will yet again the burden of adjustment yet again falling on those at the bottom of the income scale, those on benefits and those who rely on our public services. A new era of austerity in all but name.
Rt Hon Ruth Kelly is a Senior Fellow at Policy Exchange. She served as MP for Bolton West from 1997 until she stood down in 2010. During this period, she served as Secretary of State for Transport, Secretary of State for Communities and Local Government, Secretary of State for Education and Skills and Minister for Women and Equalities, as well as holding ministerial roles in HM Treasury. Since leaving Parliament, she has held roles at HSBC Global Asset Management and St Mary’s University. She is Chair of Thames Freeport.
