Friday 14 October 2022

A Decade of Bizarre UK Economic Policy

If you want to beat the markets, the old adage of "buy low, sell high" is not a bad place to start. To sum up a decade of Conservative economic thinking, they appear to have gone for "sell low, buy high".

The conservative party under Cameron ran the 2010 election on the idea that Labour crashed the economy. The idea was that Labour had spent too much which led to unsustainable levels of debt. Although it was somewhat true that the debt to GDP ratio crept upwards during the New Labour years, the biggest jump occurred during the bail out of the banks as a result to a sub-prime mortgage crisis which started within the US.

"The spent too much" part is debateable and depends a lot on your politics, the "crashed the economy" part was a lie. Blaming the previous government for economic woes is nothing new. New Labour frequently referred to previous conservative government as "the boom and bust years".

Cameron's soundbite was appealing to responsible voters everywhere: we all know someone who is bad with money, gets into lots of debt and struggles to pay bills. I vaguely remember Sky news running a ticker of government debt writing it out in its full 1,500,0000,000 or whatever. 

There was a view at time that the UK could end up like Greece, which was going through a crisis of its own due to lying about the levels of government debt. In reality, this was an existential crisis of the Eurozone: why should Germany bail out the Greeks? Eventually the European central bank would step in to help Greece. But the idea that the Bank of England would not immediately be the lender of last resort to the UK was as absurd then as it is now.

In normal times, the economy is "managed" by the Bank of England who set interest rates. For example, increasing rates when inflation is high, decreases demand in the economy which should help lower prices. 

The huge recession that followed the financial crisis led to rates at extremely low levels to try and increase demand within the economy. The problem thought was that it is difficult to decrease rates lower than zero. There was, however, another way we could have increased demand in the economy...government spending.

Now many people will have certain moral and political views about austerity. From an economics point of view, austerity is simply a way for governments to reduce their budget deficits. It is now, for better or worse, associated with spending cuts. But tax rises would have the same effect. Either way, you are taking money out of the economy which will reduce demand.

So at time when demand was very low, the Cameron government decided to pursue austerity which took demand out of the economy. The rate at which the government could borrow at was extremely cheap and economic orthodoxy* would say it would have been a good time for the government to spend. Now, this "spending" didn't have to come through investment. It could have been tax cuts!

Then there was Brexit.

Brexit is a tricky one because in terms of the economic impact of Brexit, the consensus was clearly it would make the UK poorer. But economics is not just about incomes, it's also about preferences. If people were willing to trade-off sovereignty for income then so be it.

Fast forward to the present day and we are faced with a different situation. Inflation is high and the Bank of England has raised rates at the fastest we have seen for 30 years. Interest rates are no longer at zero and the debt to GDP is near 100%. 

Whether the high levels of government debt is a concern or not all depends on whether lenders think the path of debt is sustainable. There is no optimal level of debt as such but the general consensus is that it should come down. How fast this process needs to be is again something up for debate.

Truss has argued that the only way out of this mess is growth. In order to repay back the debt we need the economy to grow so we get more tax receipts and pay down the debt. This requires a bit more steps in logic from voter. It is also a complete shift in what they were told by the Cameron government 10 years earlier. It does, however, happen to be true.

Truss has gone about seeking this growth through tax cuts. Now one would think that tax cuts would simply add to demand and thus add to inflationary pressures that the UK is already seeing. But her argument is that these tax cuts increase supply. These supply-side measures are meant not only to grow the economy but also reduce the price. If you magically found a way to increase the amount of apples that would grow on trees, we would have more apples at lower prices.

The difficult here is that not many people actually believe these tax cuts will increase growth as the evidence for them is weak. Even if you an ardent supply-side supporter, will these tax cuts translate into the large increases of growth needed? I very much doubt it.

This is possibly why the markets have reacted badly to the budget - the tax cuts will do little and lead the government on an unsustainable path of debt. 

There is a case (from an economic management perspective) that it would have been much better if Cameron and Truss would have swapped places. Rather than "buy high, sell low" it would have been a lot better if we "bought low and sold high". Which is why I find the whole thing utterly bizarre. 

*I know there is some debate here over economic "orthodoxy" as some economists in the profession were concerned about debt levels. 

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