Taxes will rise further whatever Hunt says
There is a hunger for good economic news after a draining few years of Covid lockdown and then the ‘cost of living crisis’ and a winter of strikes. The government and its supporters fervently hope that putting responsible adults in charge of the economy will bear fruit in sustained recovery.
The Labour opposition is hoping that its big idea around ‘green investment’ will get Britain out of its prolonged malaise of dismal productivity growth and stagnant living standards.
I wish. But I find it difficult to see how we get to sunnier uplands. There are several big problems which will preoccupy the government and the Bank of England for the foreseeable future and severely reduce the policy options available.
Inflation is running into double figures with no sign of it seriously abating. 10% inflation means that anyone on a fixed income or wages growing only in single figures is experiencing a cut in living standards. The independent Office for Budget Responsibility expects that living standards will fall by 6% on average in this coming financial year.
The Bank of England is responsible for reducing inflation to its target level of 2% and rising interest rates are its weapon. Although (official) interest rates are now 4.25% – – the highest since the financial crisis in 2008 – they are still negative in real terms and are working only slowly so far.
In due course the rise in the cost of credit will have some effect in curbing economic activity and make it more difficult for business to push up prices. But the process could be long and painful, with rocketing mortgage costs felt much more keenly than gradually falling inflation.
There are, moreover, problems in relying on monetary policy to stabilise the economy. Interest rate rises are exposing dangerous cracks in the financial system. Banks and other financial institutions grew complacent In the long period of ultra-cheap money designed to keep the economy afloat after the financial crisis.
They filled their balance sheets with long term government bonds and other illiquid assets whose value has fallen sharply in response to interest rate rises. The ensuing losses have triggered panic amongst some depositors in the USA and EU.
Britain is less exposed to a financial crisis than in 2008 and better regulated. But the Bank of England, like other Central Banks is now very wary of pushing up interest rates further. Consequently, inflation is likely to linger for longer, postponing recovery.
Further, higher interest rates will impact on the housing market. A correction to the house price boom would be welcome and restore a greater degree of affordability. But the scale of correction is crucial: too small and there is little impact on affordability; too much and there will be large numbers faced with negative equity and repossession with a major shock to overall economic confidence.
The government is also boxed in in its budget and its use of fiscal policy. Overriding priority is being given to undoing the damage of the Truss/Kwarteng experiment and restoring the ‘kindness of strangers’ on which government depends for its borrowing.
In practice, that means reducing the level of public net debt, which is now over 100% of GDP and rising. Successive governments have borrowed heavily to cushion the impact of the financial crisis, then Covid, and recently the higher energy costs resulting from the Ukraine War. They were right to do so. But these deferred bills must now be paid.
The government got a pass mark from its creditors in the March budget only with the help of a bit of creative accounting.
Meanwhile the budget is stretched painfully thin. The planned 1% growth in departmental spending is unsustainably low and money must also be found for the inevitable pay rises for doctors, teachers and civil servants.
The biggest casualty of the budget squeeze is likely to be public investment: the transport projects which are crucial to regional levelling up. I recall from government the way in which an unsympathetic Treasury wields its axe on public investment to make the budget numbers add up and contain public borrowing.
I fear that great damage is now about to be done by mothballing vital improvements in connectivity to ease short term budget pressures. I also fear that Labour’s attractive plans for large ‘green investment’ will face the same brutal questions: ‘Now minister, is the borrowing to pay for this wonderful idea going to be at the expense of schools or the NHS or welfare recipients? Have you thought about the bond markets?’
Taxes have already risen albeit hidden in frozen tax thresholds. They will simply have to rise further whatever totemic ‘tax cut’ Jeremy Hunt tries to conjure up before the next election. Britain is still a relatively low tax country and there is plenty of scope for raising taxes further however fervently politicians deny it. The future promises higher taxation, but it will not be popular.
All these painful dilemmas become less painful if the debt constraint could be reduced, as it was in post-war years, by a combination of inflation and economic growth (since GDP growth reduces the ratio of debt to GDP). But inflation is targeted to come down to 2%. And the economy is not expected to grow next year. Thereafter growth (and living standards) depend largely on productivity growth which has stagnated since the financial crisis and has been further hobbled by Brexit.
I am sufficiently optimistic to believe that Britain can revive with patient policies to invest in education and skills, a long-term industrial strategy, plenty of infrastructure investment, a nurturing of innovation and entrepreneurship, and a liberal immigration policy.
But the near future promises none of those things. Both this government and the next face a hard slog: slow growth, a squeeze on living standards, austerity and high taxes.
Sir Vince Cable is a former Secretary of State for Business, and led the Liberal Democrats from 2017-19.
