15 September 2022

Truss is right to tear up the Treasury rule book

By Patrick Minford

The change of government has rightly produced a change of policy. We are now expecting a mini-Budget next week that will reverse the Treasury’s long-standing insistence on balancing the books and cut taxes by at least £30bn.

The Government is going for growth in the belief that boosting supply is the way to way to end the stagnation of recent years, tackle the cost-of-living crisis and ultimately generate the tax flows needed to protect public services.

Liz Truss’s policy agenda is bold, invigorating and right. But she and her Chancellor Kwasi Kwarteng can expect howls of criticism from establishment economists and their cheerleaders at The Financial Times when he stands up in the Commons and hits the accelerator pedal. Their argument is that a ‘sterling and bond market crisis’ is being provoked by the higher borrowing in prospect from the energy price freeze, reversing the National Insurance rises and scrapping the planned increase in Corporation Tax.

There is no such ‘crisis’, since neither sterling nor bond interest rates are objectives of policy. We have not had a fixed exchange rate since our foolishly mistaken episode inside the European Exchange Rate Mechanism came to its inevitable end in 1992. As for the long-term interest rates we have been paying on government bonds, they are still remarkably low in real terms, reflecting real rates close to zero in world markets. In fact our ten-year real rates on index-linked bonds are still negative.

Both sterling and real interest rates are market prices that reflect policies set to maximise the welfare of UK citizens. These are therefore aiming to maximise growth, subject first to the inflation target to which monetary policy is committed and second to the only valid constraint on the government budget, which is the long-term one of solvency. In practical terms, that means our debt/GDP ratio should be tending downwards to a sustainable level over the long term.

We can reasonably ask what market outcomes we might expect these policies to produce for sterling and interest rates. We will come to that in a moment. But first let us verify that the Truss agenda satisfies solvency, a point seemingly queried by the critics above.

Begin with the extra borrowing in prospect in a worst-case scenario. The price freeze on current gas price projections could cost up to £150bn over two years, or £75bn a year. Then add in the rollback of tax increases and allow for the extra effects of inflation on debt interest minus its effects on income tax (for which the price freeze is some compensation). All this could push public borrowing as high as 5% of GDP over this fiscal year and next – driving up debt by 10% of GDP.

However, on our forecasts inflation by the end of 2023/24 will have totalled about 15%, and this will independently reduce the real value of debt by about 12% of GDP – a key inflation effect never mentioned by these critics. That means by the end of fiscal 2023 the debt/GDP ratio (defined as usual to exclude Bank and publicly owned banks’ balance sheets) would actually have fallen slightly from its current level of 82% to around 80%, illustrating the powerful effect of inflation in reducing real debt.

If we can then restore growth even just to its 2% trend from 1990 to 2010, long-term projections based on our modelling research show that on current spending plans the ratio should fall steadily to around 50% by 2035.

So, solvency looks assured on current plans. Of course, there is a big margin of error around all this arithmetic, which is why if the numbers turn out to be worse the Government is committed to trimming its spending to maintain a downward debt ratio trend.

Meanwhile, we are seeing the start of supply-side tax and regulation reforms raising growth and a fiscal easing that should stop recession.

Now, we turn to the outlook and those market prices. First, how will the Bank manage its task of reducing inflation?

It is now clear that most commodity prices other than gas are falling back from their peaks; supply bottlenecks have eased and world growth is slowing sharply, especially in China. If the Ukraine war ends soon, as looks more probable by the day, gas and key food prices will fall sharply; besides lowering inflation, that will dramatically cut the cost of the price freeze.

The Bank needs to finish the job and restore inflation to its 2% target; it has raised interest rates to nearly 2% and now has little recession excuse not to raise them further, with fiscal policy supporting the economy and increasing supply potential.

Its credibility is therefore stronger, with hawks dominating doves. This will reduce expected inflation and so also bring inflation down faster. This reveals that by influencing expectations fiscal policy can help, not hinder, the effort to get inflation down – contrary to what some economists might say.

Indeed, the effects of borrowing on inflation are not merely via increased demand, as in their simplistic account. Besides this expectations channel, fiscal policy can also reduce inflation via the increased supply and reduced wage pressures produced by tax cuts and income transfers like the price freeze. On balance, therefore, the Government’s fiscal policy should help drive inflation down.

Monetary conditions are likely to stay as tight as they already are. Our forecasts are that 3% remains the rate peak, likely to be held until end 2024. Inflation should fall to about 5% next year, dropping further to about 3% in 2024. The latest forecast consensus is similar. With this expected profile for interest rates, long-term gilt rates will match it and are therefore likely to stay around the 3% mark.

As for the exchange rate, two forces are at work. Short-term market arbitrage will move it to compensate for interest differentials against the dollar and the euro. So if the Fed and the ECB raise rates more than the Bank, as seems likely, it will fall against both. The long-term factor is growth: the more growth we achieve, the more competitiveness we will need to sell our higher GDP as exports abroad to match rising imports. This will push sterling lower, as part of the necessary market process.

None of this is remotely alarming. Market forces must be allowed to work to support the objectives of the new government’s policies.

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Patrick Minford is a former adviser to Margaret Thatcher and Professor of Applied Economics at Cardiff University.

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