14 November 2022

Is now really the time for fiscal tightening?

By Laurie Laird

Despite her truncated spell at Number 10 Downing Street, Liz Truss won’t fade from the public consciousness any time soon. And that’s not just because she had swiftly become the nation’s favourite political punch line – at least until Matt Hancock made his way to the Australian jungle. 

Give the UK’s shortest-serving premier her due. If nothing else, she provided us all with a crash course in entry-level economics. Over 45 hair-raising days, the British public absorbed Lesson One in Economic Orthodoxy, that governments cannot indefinitely spend more money than they take in.

It’s a lesson that current Prime Minister Rishi Sunak tried to impart during his losing battle for the leadership over the summer, presenting himself as the only fit and proper steward of the nation’s finances. Although his reputation for fiscal probity was somewhat tarnished during his chancellorship, when he combined tight fiscal policy with a promise to cut income taxes in 2024, a date suspiciously close to the next general election.

But has Sunak abandoned a second tenet of economic orthodoxy? The one that cautions against fiscal tightening during an economic downturn? George Osborne was the last Chancellor to attempt such a manoeuvre, but his axe fell during a period of fiscal expansion starting from the recovery from the great financial crisis in 2010. 

Sunak and his Chancellor Jeremy Hunt are proposing to fill what they call a fiscal ‘black hole’ of as much as £55 billion, just as the economy has begun to contract. Gross domestic product slumped by 0.2% in the third quarter, and the Bank of England believes the downturn could stretch into 2024.

And about that gaping black hole, how has Hunt arrived at such an indisputably large figure?

A projected fiscal shortfall isn’t easy to measure; it relies heavily on estimates of future growth figures and resulting tax flows. The simplest definition is that a fiscal hole represents the difference between how much cash the Treasury expects to collect in years to come and how much the Treasury would like to spend, which involves a bit of guess work on the part of politicians. Hence the importance of independent economic projections, so let’s give Ms Truss another cheer for acquainting the nation with the importance of the work of the independent Office for Budget Responsibility.

Given the grim economic forecasts over the short term – and the dire state of many public services – there is a strong argument for the Government to re-test the borrowing waters. Remarkably, UK gilt yields of all maturities have fallen to well below the level of 22 September, the day before Kwasi Kwarteng delivered his not so ‘mini’ Budget.

Not only have bond yields retreated smartly, but investors have rather sportingly declined to place a political uncertainty premium on UK borrowing rates. Sunak’s government may appear a model of stability after 18 days in office, but the Conservatives are facing a general election in little more than two years, with a financially untested Labour party holding a commanding poll lead. Shadow Chancellor Rachel Reeves has made soothing noises to the City, but it’s not yet clear that she can bring her colleagues along with her. 

Currently, the UK can borrow for 10-years at an interest rate of 3.28%. It’s a far cry from the sub-1% rate of early 2021, but it’s also significantly less than the 3.80% interest rate carried by US bonds of the same maturity.

That’s not to say that the Government should eschew all fiscal tightening. The triple lock on pensions is ripe for reform, especially with inflation topping 10% in September. With many pensioners sitting on sizeable property and securities assets, the money saved by ditching the policy could be redirected to the most vulnerable pensioners and to those on benefits whose payments may face an uplift in line with slower-growing earnings, rather than inflation.

Then there are the things that this government could do to enhance growth prospects with little cost to the Exchequer.  Top of that list is to forge a stable trading regime with the big market on our doorstep.  Yes, Brexit remains an emotive issue, but it’s difficult to argue that the weakness in business investment since 2016 isn’t in some way related to uncertainty over trading with our biggest trading partner.

The UK was once — and still could be — a proud trading nation, with exports comprising almost a third of GDP. Goods exports to the European Union are triple those to the US, and a free trade agreement with an increasingly protectionist America is a distant prospect indeed.

And, finally, the incumbent government could – at long last – tackle the planning constraints that make it impossible to build in places where people want to live and work. But sorting out European trade and making it easier to build do not seem likely to be top of the Tory agenda any time soon.

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Laurie Laird is a financial journalist and commentator.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.