The UK economy has been pushed to the brink by austerity, now Brexit has it rocking on the edge. We find out today what the Bank of England will do on interest rates, but the new Chancellor Philip Hammond must help the Bank to stave off recession by changing tack on government investment.
Financial markets reacted strongly to the vote to leave the European Union, and although we have seen some signs of stabilisation, the pound is still down by around 10 per cent against the dollar compared with before the referendum, and shares in UK banks, airlines and homebuilders in particular have all fallen sharply.
The UK is now facing the possibility of a sustained stagnation or recession, and as with all downturns, it is the worst off who will be hit the hardest. IPPR analysis has already shown that the impact of higher inflation one year on from a Leave vote could hit those at the bottom of the income distribution twice as hard as those at the top.
The Bank of England has been hamstrung by austerity
The immediate response from the Bank of England was to emphasise its commitment to £250 billion in extra funds, as well as ‘additional measures’, to shore up the financial system. More recently, commercial bank capital requirements have been reduced to increase lending. But in reality, the Bank’s anti-recession tool kit has been hamstrung by six years of austerity, both from the current government and the coalition before it.
The tried and tested intervention when faced with a possible recession is to lower interest rates. Commentators expect today will bring the first change in interest rates this decade, with a small further cut looking likely. But with rates already so close to what economists describe as the effective zero lower bound – the point beyond which further cuts provide little additional stimulus – the Bank will be unable to provide an adequate response through conventional policy alone.
In order to make possible an effective stimulus today, interest rates would need to have risen in the medium term following the financial crisis. But the Bank was forced to keep rates at record lows as a direct result of a painfully slow economic recovery. In part this slow recovery is down to the magnitude of the shock that caused it and the severity of the Eurozone crisis that followed. But independent analysis, both at home and abroad, now agrees that the UK government actively made things worse by deliberately starving the economy of public investment to a degree that is without international comparison.
The Bank could expand its experiment with quantitative easing (QE) – buying up more government debt to pump money into the financial markets, effectively lowering interest rates indirectly, among other things. But standard QE can prove regressive and poorly targeted, and in any case relies on market mechanisms that work less predictably during economic stagnation or recession.
Government needs to change direction on fiscal policy
The most effective means of countering a downturn in this situation is increased government spending, in order to raise the overall level of demand in the economy. And with UK government borrowing costs falling as investors move their money into safer assets in view of the turmoil, there could be no better time for government to borrow in order to provide this injection of demand.
Theresa May has already acknowledged the need to abandon the government’s surplus target, but in many ways this was a fait accompli – any kind of surplus would have proven extremely challenging even before a Leave vote, now it has become impossible. But simply moving down one gear on austerity is not enough: there needs to be a deliberate change in direction if Brexit induced damage is to be contained.
If the OBR confirms that the UK economy has experienced a shock, which would trigger suspension of the existing fiscal rules and a vote in parliament, Hammond should set out plans to remove public investment from deficit targets and target debt reduction over a longer time horizon.
Extra spending should be targeted at both digital and physical infrastructure projects, and the government should launch a review to explore the best way of accounting for investment in human capital. Those areas of expenditure – such as some elements within education, skills, employment programmes and health – that pass a tight set of criteria such that they can be shown to boost the productivity of our workforce should be treated as a form of investment spending.
Instead of ruling out tax rises at this early stage, as May has done, Hammond should also set out a review of the entire UK tax system. Revenue streams from wealth should be expanded. And regressive and inefficient tax reliefs – such as those on buy-to-let mortgages, some elements of capital gains and pension contributions for high earners – should be revisited to avoid further cuts. Where appropriate, the Treasury should also consider new mandates for the Bank of England that allow for more innovative forms of QE that find their way quickly into the real economy.
Committing to new public investment would represent a more effective response to the threat of recession than the Bank working in isolation, and with the few tools left at its disposal. If done in the right way, it could also begin to tackle the longer, and far harder, task of addressing the underlying economic disconnect and disempowerment that led to the Brexit vote in the first place.
