Our economic situation - Part one

What are the real causes of our economic woes?

This is the first of three articles on our current economic situtation, and what we can do about it. The next article will be published tomorrow (Wednesday 23rd), and the last article the day after.

Listening to the Tory Chancellor, Jeremy Hunt, and his Labour counterpart, Rachel Reeves, is disconcerting.

Hunt said last week that the contents of his budget announcement would lead to "lower energy bills [and] higher growth". If any reader of this column finds evidence of this please write in the comments section below as it appears to have passed most observers, including this one, unnoticed.

Reeves’ grasp of what is happening is similarly at odds with reality. She labelled Mr Hunt's tax rises and spending cuts "an invoice for the economic carnage" created by the Liz Truss mini budget. “Economic carnage”, fair enough, but failing to see beyond the Truss-Kwarteng flop budget betrays a dreaded combination of ignorance, exaggeration, and over-simplification.

What are the real causes of our economic woes?

Consumers of energy, food, or fuel (i.e., all of us) will be acutely aware that living in Britain used to be a bit cheaper than it is now. The rapid increase in the cost-of-living has been caused by supply-side shocks of lockdowns, exacerbated by the war in Ukraine. Capital and labour were unable to respond swiftly enough to extreme and sudden economic changes during the pandemic. Demand collapsed at the height of Covid restrictions, to suddenly revive when the country unlocked, only to find an unproductive tools-downed post-Covid economy that hadn’t even started its pre-match warm up routine yet. The abrupt contraction of the supply of energy, and many other goods, following the Russian invasion of Ukraine, added fuel to the fire.

In essence, too many people needing or wanting things, of which there is a shortage, is bad for price stability. And if you want to make things even worse, have the government engage in unproductive borrowing and/or print tens of billions of pounds of money and get it swilling around the economy. Exactly what the now Prime Minister, Rishi Sunak (presented to us as a safe pair of hands) did when he oversaw the Treasury during the pandemic. 

It is also worth making a nod to, but also putting into perspective, the impact of the significant recalibration of leaving the single market. Brexit represents a notable discontinuity in our political-economic relationships. The adjustments will be felt for many years, and the benefits (if anyone in government is ever intelligent enough to harness them) will trickle through across a long-term timeline that will never be experienced as an identifiable windfall in and of itself.

However, the disaster critics predicted did not materialise. The impact has been absolutely nothing compared to the economic costs of lockdown, and anybody who claims it is the prime cause of our situation is to be pitied more than anything.

So, what can policy makers do about inflation? The textbook answer is to raise interest rates. The primary objective of central banks is to try to control inflation and recover price stability. Higher interest rates dampen the supply of money in circulation by making borrowing more expensive. The Bank of England has begun to do just this. Interest rates have been a fraction of 1% for more than a decade. At the time of writing, they are now at 3% and expected to be lifted further. But these rises are coming very late in the day and are not that much relative to historical norms (the average between 1975 and 2008 was around 10%). Why has it been left so late, and the population forced to take a year of rampant price rises? And why don’t they raise rates more aggressively now to control inflation quicker?

Well, the problem is, raising interest rates in response to inflation will likely cause a recession. Economic activity will slow as money costs more to obtain (and there is a return on hoarding your savings). And mortgage payers will feel the cost-of-living even more acutely when their fixed term deals expire. But recession has been inevitable for some time anyway, so why not just get on with it?

Here we hit the nub of the matter. Public debt is so high, the interest rates will gobble up an ever-increasing portion of the budget the more the Bank of England push them (£100bn per year is likely, about the same amount as the annual education budget). This is unaffordable in a country with public services performing as badly as ours. Much private debt simply won’t get paid back, blighting people’s lives, and we risk a financial crash akin to that of 2008. Yet, the only alternative is to let inflation continue and reduce the national standard of living further and further. In fairness to policy makers, they are in quite a bind.

So, the way Hunt and Sunak see it, the public debt needs to be reined in back to normal levels, rather than to continue at emergency levels.

The next two articles will cover the damages the latest budget will cause, and what policies would create prosperity.