Sunday, October 02, 2022
They crashed the pound, but mustn't crash the economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

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 major 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 some 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 tiny 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, as was inevitable, and we are all suffering the consequences. Promising further tax cuts, as Kwarteng did last weekend, was pouring petrol on the fire.

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 it is predicated on unrealistic projections for government 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 when it coincides with the reduction in the 45 per cent top rate of income tax, also next April.

The government is said to be looking for efficiency savings to reduce public spending, an ambition 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 highly volatile in recent weeks, 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 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 long-term 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 desal 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 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 though Bank Rate would peak at 4 per cent or so. Since it, expectations 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 Banks 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 rate levels.

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 Bank Rate to about 3 per cent, inflation was predicted to fall to the 2 per cent target in two years’ time and below 1 per cent, 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 my 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. But such an outcome can be avoided, as long as the government does not keep getting it so badly wrong.