Austerity is back.
The Government this week announced £55bn of tax rises and spending cuts. Some of the pain has been deferred to after the next General Election, but pain nonetheless. This was the 5th major announcement by a Chancellor this year, from our 4th different Chancellor.
Once again the British economy is facing an extended period of austerity, with some Conservative commentators arguing that this proves George Osborne was right all along.
I have my doubts.
To understand how we got in the mess we need to ask how we ended up wth such a big hole in our finances just a few years after the age of austerity, which was supposed to put public finances on a stable footing permanently. Boris Johnson won a General Election only 3 years ago on a manifesto with no mention of cuts, only levelling up and spending increases.
The basic answer is growth – the economy isn’t growing fast enough to meet our spending commitments – the NHS is in crisis and needs more funds, poverty is rising and the benefit bill is rising with it, commitments to the pensions triple lock cost a lot more if inflation is 11%. If the economy is growing at 2.5-3% per year then finding more money for these priorities is tough, but achievable – if the economy is growing at 1% per year or less then it can’t be done.
Low economic growth means low government tax revenues, and higher spending. This creates a deficit which in turn increases Government debt. Right now we are spending over £8bn a month just on interest.
So why is growth so low and why is the deficit so high?
Low growth is the product of two things; low levels of business investment, and a tight labour market. After the Brexit vote businesses invested less in the UK due to uncertainty about our future trading relationship and damage to our reputation as a sensible grown up place to do business. Boris’s deal was awful for British businesses, which led to even lower levels of investment. Brexit is making us a poor, low wage, low investment country.
A tight labour market makes it harder for firms to recruit, which makes it hard for them to grow.
Partly this is about immigration – lots of EU workers went home post Breixt or during Covid and new rules make it hard for them to come back again. Lots of them don’t want to come back – there are more attractive destinations right now for people with in demand skills.
But a big part of our labour market problem is British workers leaving for early retirement or ill health. We had the worst record on Covid in Europe and a massive wait for NHS treatment – which has left us with lots of people too sick to work full time or caring for others. Falling real wages make it harder to retain workers nearing retirement age in the workforce when they would be better off taking their pension early. By the second quarter of 2022, 200,000 older workers (age 50 to 69) had left employment due to ill-health since the start of the pandemic. In all, about 600,000 UK workers that would otherwise have been looking for work have quit the labour market, restricting the supply of skilled people and hampering economic growth.
But it’s not just stagnation. The economy is growing slowly and going through a period of inflation at the same time, which makes normal economic policy making difficult – do you cut back to tackle inflation, or try and expand the economy to tackle low growth
Inflation is the product of 3 factors: war in Ukraine, restrictions in supply changes post Covid, and Boris’s Brexit deal. Two of these are temporary and will in time work through. The last one is permanent and accounts for about half of the increase in inflation – about 6% on food and drink prices right now. Increasing interest rates and cutting spending won’t impact on inflation because it is driven by other factors.
The Government doesn’t really have a choice which path they take – Truss’s disastrous budget spooked financial markets. If the government wants to keep on borrowing from financial markets they need to keep them on side, and the price of that are policies that will keep them from panicking again. This means austerity, the price we all pay for bad economic decisions.
When markets lose trust in an economy the price they charge to lend money goes up, which means that the amount the Government is paying in interest rises. Currently the UK is paying a record amount in interest on it’s borrowing, which squeezes spending even more.
It is easy to blame all of this on Liz Truss, after all she did mess up the UK economy badly. But in reality the damage was coming a long before, she just made it into an issue in financial markets
For a long time it wasn’t acceptable to talk about the impact of Brexit for fear of being demonised, but this is changing. This is starting to change, and this is an economist from the Bank of England speaking at the Public Accounts Select Committee:
So was Osborne right? If we hadn’t had a period of austerity in 2010 would markets have reacted the same way?
Unlikely in my view. Osborne inherited an economy that was growing strongly and consistently. There had been a one of hit to public sector debt due to recapitalising the banks, but we could have had a much smaller set of cuts and allowed growth to reduce the rest.
Financial markets were still happy to lend to the UK Government at very low rates – in fact all of the signals from financial markets were that they were happy for the Government to borrow more. In 2010 banks were still rebuilding themselves after the credit crunch. Interest rates were near zero and Governments could borrow as much as they wanted without a risk of a lack of confidence. Government borrowing creates Government bonds which help banks to rebuild their liquidity position.
The impetus for austerity was ideological – a belief that shrinking the state was a good thing in it’s own right. I have no doubt that some period of austerity or retrenchment was necessary after 2008. The Government had taken a bit hit on their finances when the nationalised the banks, and this had to be dealt with. But the speed and scope of austerity were political decisions, not economic. The Government went too far too fast, not because markets demanded it, but because of a political ideology that believed that shrinking the state was an end in itself
In the end austerity failed – the deficit didn’t come down as planned, and economic growth was consistently lower afterwards – this is one of the reasons why we are in the mess we are in now. That dream has died. We will be a high tax, big state economy for the foreseeable future.
To add to Osborne’s errors he also, like Truss, believed in the magic Laffer curve – unfunded tax cuts could pay for themselves by higher future growth. All he achieved was undermining public finances for years to come.
There is one policy choice open to the Government that would boost growth and reduce inflation all at the same time – scrap Boris’s rubbish deal and accept regulatory eq uivalence with the EU – effectively shadowing the Single Market.
But while that would work brilliantly and cost us nothing we won’t do it, because Ministers are still scared of telling the truth about the mess they made of Brexit and the lies which were told to persuade us to vote leave.