The global background is sending mixed signals. After a strong rebound, doubts about the global recovery have risen, not helped by the pandemic. In the US, consumer confidence has weakened while in China recent data shows a slowdown. If the world’s two major economies were to lose momentum it would be a worry.
As if that is not enough, oil prices are high. Earlier this year rising oil prices were seen as good news, reflecting global recovery. Now they are seen in a negative light, indicative of a global energy crisis. High oil prices are often a warning sign of economic slowdown, raising costs and squeezing spending power.
While the UK economy is on track to return to its pre-crisis level of activity soon, here, too, uncertainties have risen. The Institute of Directors survey at the end of September warned of confidence in the economy “falling off a cliff”.
Inflation pressures are building. Some of this is due to supply bottlenecks but lax monetary policies have not helped.
For a year the Bank of England has behaved like a driver who has kept their foot down on the accelerator while whizzing past every warning sign on the road: beware cost pressures ahead, dangerous inflation pressures imminent and building. On it went, printing money through quantitative easing, feeding asset price inflation and financial instability.
Now, following a host of hawkish statements, the Bank gives the impression of being like a driver keen to put their foot on the brake just as the car tries to ascend a steep hill. Costs are rising, supply bottlenecks evident, energy prices firming and there has been much talk of a cost-of-living squeeze.
The prospect of inflation and higher rates is weighing on the Chancellor’s thinking, as each raises the cost of servicing government debt, via index linked gilts or overall borrowing costs.
The Chancellor’s room for manoeuvre is limited, with borrowing high following his sensibly targeted generosity during the pandemic.
This Budget’s message will reflect that we are in a transition phase to stabilise the fiscal dynamics. The options are straightforward: borrow, squeeze spending, raise taxes or create the fiscal space through stronger economic growth.
Inflating the debt away is not a policy option. Slightly higher inflation may appear to make it easier to repay debt, but it is not easily controlled if inflation rises, with wider negative consequences and it will require tighter monetary policy, which adds to debt servicing.
Consensus thinking is that as trend UK economic growth is low, more of the budget deficit is explained by structural and not cyclical factors. Thus, higher taxes or a squeeze on spending is needed to close the structural budget gap. In contrast, if cyclical, then the deficit can be closed by a rebound in growth.
The economic climate and recent improvement in the public finances suggests the Chancellor does not have to be tough this week.
Many tax increases have already been unveiled for the future, such as freezing income tax allowances and higher rates of national insurance and corporation tax. I don’t think he should or will raise taxes this week and he should aim to lower them as soon as economically possible. But the spending review looks set to be difficult for many government departments.
The margin of error on official projections of the budget deficit is huge. Recognising this can allow one to challenge tax hikes or too tough a spending squeeze.
In the first half of this fiscal year the budget deficit was £108.1 billion, a sizeable £43.5 billion better than the forecast made by the Office for Budget Responsibility (OBR) as recently as March.
The OBR may not reflect all the recent improvement in their new forecasts. If they did, their deficit forecast of £234 billion for this full fiscal year should be lowered significantly. If that continues, the Chancellor may be able to lower taxes before the next election.
One danger is the Budget unveils new fiscal rules, such as planning to only borrow to invest by the middle of the decade. In the past such rules have not stood the test of time.
In his previous Budget the Chancellor announced that “a significant part” of the Treasury was to move from London to Darlington. Perhaps he should consider a further fundamental shift in Whitehall to aid the path to recovery.
Policy Exchange’s Reform of Government Commission noted, “the transactional relationship between the Treasury and individual departments can also prevent cooperation across Whitehall.” They proposed many reforms, including more joint bids from departments and adopting a US style office of Management and Budget.
Perhaps, though, one could go even further.
In the 1930s Keynes criticised the “Treasury view” that opposed public investment.
In 1964 Harold Wilson said you may be in office, but you are never in power. The power, he said, lay with the Treasury. He tried to address this by reforming Whitehall, including establishing a Department of Economic Affairs, partly to counteract the Treasury’s short-termism.
The Treasury is now a super-ministry that combines functions separate in many other countries: economic management and control of the public finances. It sees itself primarily as a finance ministry with its main task to balance the budget. It rarely succeeds, but the pro-growth agenda takes second place.
Wilson's comments arguably have some resonance today. While the Treasury may see itself as tempering a big spending Prime Minister, the danger is this further reinforces its image as being a department focused on tax and spend, as opposed to fundamentally considering radical supply-side reform aimed at boosting investment and innovation and raising the UK’s trend rate of growth.
The debt to GDP ratio is a large 95.5% and the aim will be to reduce this steadily, over time, helped by a pro-growth supply-side strategy. Delivering such a growth strategy needs to be the Chancellor’s post-pandemic focus.
This article was published in The Times on October 23rd 2021.
Please note, the value of your investments can go down as well as up.
