Crisis, what crisis? The good news is the economic rebound from the pandemic continues and that the jobs market has returned to broad health. In fact, latest data this week confirmed that in November the economy returned to its pre-pandemic level. Also, we may be over the worst of the pandemic, although the possibility of new variants means learning to live with covid and avoiding further lockdowns may be a key priority in 2022.
Yet, it is not this recovery, but two other economic issues that look set to dominate policy this year: the immediate cost of living crisis and, less talked about, where the economy will settle post pandemic. Views on the latter may influence how policy responds to the former.
While the economic consensus sees growth of around 4.5% this year, after 7% last, there is still much pessimism about the future trend rate of growth. This has been decelerating since the 2008 global financial crisis. If future growth is low, more of the budget deficit is structural, not cyclical, and needs to be addressed through fiscal restraint, such as higher taxes.
That thinking, which seems to dominate at the Treasury, will be resistant to reversing planned tax hikes for this spring. Moreover, the economic consensus – including in policy circles – is that Brexit will exacerbate this challenge.
However, it is not leaving the EU, but what you choose to do once you have left that will determine the future pace of growth. In this respect there is still the need for a market friendly pro-growth economic strategy.
It also has bearings for now.
There is no easy way to stop a cost-of-living crisis but the first thing you should do is not implement policies that will make it worse. If these are addressed then it will be less of a “crisis”, but more of a “squeeze”, still painful but short-lived.
Currently the crisis has multiple components: inflation that is set to peak at over seven per cent in the spring; higher energy prices which, while global in nature, are exacerbated here by decades of poor energy policies (including price caps that are now being lifted); and there have been two separate decisions taken to raise taxes this spring, but both will impact at the same time, including a tax on jobs in the form of higher national insurance and a stealth tax in the form of a freeze on income tax allowances; and then there is a postponement of the triple lock on pensions so they rise by less than the increase in inflation.
Often at times of economic shocks the search is for measures that are seen as timely, targeted and temporary. That is, they address the immediate problem but do not reverse or change the longer-term policy. Perhaps that is what the Treasury should be looking for here.
An obvious one is to cut VAT on fuel, but this was ruled out by the PM last week as a blunt measure. But that means that no-one gains, as opposed to everyone. Similar thinking would suggest that the planned tax increases will not be reversed.
Yet, reversing the tax increases makes sense. Not just because it would alleviate the cost-of-living challenge, but because the fiscal numbers don’t merit such tightening. One of the present economic debates is how much fiscal space governments across western economies have – despite that fact that public debt levels are at an all-time high globally.
It’s less about providing a case for rampant state spending, and more about avoiding being pushed into tightening fiscal policy aggressively and unnecessarily.
There have been some calls to reduce the green taxes that are incorporated into current energy prices. A change here, however, would seem unlikely, running counter to the longer-term green agenda.
A high level of debt adds to the problems but if the rate of interest is less than the rate of economic growth, this creates fiscal space, and improves the chances of debt sustainability. But if inflation rises, rates rise, yields increase and debt sustainability becomes a concern. It is perhaps not fully appreciated how unstable the present macro-economic policy situation is in the UK because of the inflation risk and lack of growth strategy.
Debt to GDP can be reduced, steadily, provided growth is solid and inflation does not let rip.
However, the Bank of England, like many other central banks, has been asleep at the wheel over the last year. The risk is the inflation genie is already out of the bottle, as inflation expectations rise and firms raise prices. In all likelihood, inflation will peak in the second quarter – some of the initial supply shocks are now over after all and imported inflation may have peaked already – and after staying elevated for a short while, will decelerate.
But chances cannot be taken and this will force the Bank of England to raise policy rates but also reverse their printing of money and implement Quantitative Tightening (QT).
These decisions are not easy. There is no right or wrong answer. It is about judgement calls, both to address the immediate challenge as well as to position for the future.
We witnessed a short-lived cost-of-living crisis in the wake of the 2008 global financial crisis, when a weaker pound triggered a temporary rise in inflation. But the last major crisis was in the mid-70s.
Perhaps the first lesson is to keep comparisons with the 1970s in terms of the problems that the UK faces in context. Then inflation was sky high. Also, in a battle against inflation, it is vital to have the public on side. Not only so they can understand the tough policy context, but also in the case of inflation to avoid what are termed second-round effects, or put more bluntly, the need to avoid a wage-price spiral.
While there are not many economic lessons to heed from that period, one interesting one springs to mind. In June 1975 the annual rate of inflation hit 26%. The Prime Minister, Harold Wilson, decided that every household in the country needed to receive a pamphlet about his policy to fight inflation. I still have a copy.
Entitled, “Attack on inflation: A Policy for Survival – a Guide to the Government’s programme” its sixteen pages made clear why inflation needed to be brought under control. One telling message, in bold capitals was, “the battle (against inflation) cannot be won in one year… but the battle could be lost in one year.”
In the event the Labour Government lost the battle. Policy focused on a wages and income policy, culminating in the winter of discontent in 1978-79. The annual rate of inflation did not fall back into single digits until 1982, after Mrs Thatcher was in power and following a deep recession.
The economy now is nothing like the 1970s, so comparisons with them are not right. I am not advocating such a booklet, but the lesson is the importance of ensuring people understand the context of what is happening – especially when, as now, there is so much uncertainty.
The best that can be done is to control the controllables. Reverse the tax hikes, explain why, ease the pain, and focus on a pro-growth strategy.
Please note, the value of your investments can go down as well as up.