Jeremy Hunt’s Autumn Statement offered us huge tax increases and spending cuts to plug the huge fiscal “hole” created by the need to reduce the debt-to-GDP ratio by 2027-28 – the “new fiscal rule”. But it will worsen the recession and, ironically, destroy public finances as well.
Public borrowing is an important policy tool that allows the government to do two useful things: first, to stabilize tax rates at a level that is consistent with long-term growth, and second, to allow the budget balance to change over the period reduce business. The government must also balance its books over a long period of time, as we have always done for the past two centuries. But the words “long-term” are vital. They mean that, looking ahead, the government’s debt should always be credible.
In practice, we can test this by making long-term projections, typically at least 10 years ahead, to verify that the debt/GDP ratio falls to a level like 50 percent, where there is no sustainability problem. Now turn to Thursday’s Statement to see how the government got into this mess. Why has 2027-28 been chosen as the year when the debt ratio should decline?
This option is both very strong and weak. Too strong because it avoids the flexibility needed for the two functions mentioned above. Tax rates needed to support growth, including corporate tax, are sacrificed to it. Also the looming recession, which the Government will have to mitigate, will instead be exacerbated by pre-cyclical financial stress. So this statement worsens the recession and hurts growth.
But this choice of date is also very weak, because it does not give us certainty about the long-term sustainability of the loan. Indeed, as growth will suffer, the UK’s long-term debt/GDP ratio will worsen significantly. According to our Cardiff models, adjusted to UK data and therefore more pessimistic than the Office for Budget Responsibility’s about the impact of tax increases, growth will fall to zero. So if anything like current spending plans are maintained, the debt/GDP ratio will rise to dangerous levels.
Such forecasts show the importance of growth not only for the standard of living of our citizens, but also for the financial health of our Government.
However, if the OBR had done its arithmetic on alternative tax policies that would not have harmed growth, then according to our Cardiff models, growth would return to the 30-year pre-pandemic 2 per cent annual trend. The OBR then finds that the debt/GDP ratio is likely to fall safely over the next decade.
So this arbitrary fiscal rule means that the Proclamation will destroy not only the economy but also the long-term public finances. This is the main flaw of the whole approach.
There is also a particular error in the OBR’s arithmetic that increases the pessimism of its debt forecasts. This refers to the cost of the quantitative easing (QE) program by the Bank of England, whereby the Bank bought government bonds and other market assets by printing money in the form of bank reserves.
Treasury/OBR accounting accounts for bank reserves as loans with interest at the bank rate. But this is expensive nonsense; Bank deposits can only be exchanged for cash, which has a holding value and does not pay interest. The bank does not need to pay interest on bank reserves to control the cost of the loan. It has a toolbox it can use to determine this, including setting reserve ratios and lending directly to markets.
This practice of the Bank did not cost the government much when bank reserves were low – like before the financial crises and Covid or when interest rates were close to zero. But bank reserves after all this QE are now huge at £950bn; and at 3% interest the cost is now about £30 billion a year.
This is a completely unnecessary addition to government spending. It is tantamount to paying a sudden subsidy to commercial banks, equivalent to short-term interest rates, without justification. Regardless of bank debt sales, this error would cumulatively increase the OBR’s debt/GDP ratio by around 10% of GDP by 2027 and the OBR’s “fiscal hole” by around £50bn in 2027-28.
Finally, we come to the strategic reason given for this Sasterity 2.0: to reassure the bond markets in two respects: we do not pose a liquidity risk and inflation in the UK is firmly under control. Both have misconceptions.
Our credit default swap rate remained stable even at the height of the hysteria over the previous Liz Truss scheme. In the case of current inflation, it is largely the result of supply shocks that are gradually being phased out as supply constraints ease. Inflation in the US is now past its peak and we are close to it; The bond market’s fear of inflation is very low, so it doesn’t threaten statements that have supported the economy, rather than trashing it.
The monetary causes of inflation – the excessive printing of money during Covid – have now not only been reversed, but have been pushed into a monetary surplus, with annual growth in the money supply across the US, EU and UK approaching zero. Inflation forecasts for 2023 are now around 5 percent in most developed countries. Chancellor’s announcements will not affect the prices of goods. But they make inflation worse by reducing people’s wages. In addition, they worsen long-term liquidity by reducing growth.
In short, the Autumn Statement is a wrecking ball that will worsen the recession, hurt growth, reduce long-term public finances and even raise wage costs. A general overhaul of these plans is needed to restore health.
Patrick Minford is Professor of Applied Economics at Cardiff University and Fellow at the Center for Brexit Policy