Liz Truss and Kwasi Kwarteng, the UK’s new prime minister and chancellor of the exchequer, are gamblers on a huge scale.
According to the Institute for Fiscal Studies (IFS), the two-year energy package set out by Kwarteng on September 8th is likely to cost £100 billion (€114 billion) – 4 per cent of gross domestic product – in the first year alone. Its total cost might be £150 billion.
To this should be added permanent tax cuts amounting to more than 1 per cent of GDP, expected to be announced later this week. Perhaps worst of all, as Paul Johnson, director of the IFS, notes: “The failure to provide any official sense of a costing was extraordinary, and deeply disappointing.” I would call it “frightening”.
Some such energy package was necessary, for reasons I laid out two weeks ago. The soaring prices of energy are the result of a Russian war on Ukraine. It was necessary to protect the British people and the economy from the immediate consequences.
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Price controls
Moreover, I argued, the rise was too huge to be dealt with only by targeted assistance. In the short run, there should be price controls, coupled with additional financial help for those households most adversely affected by what would still be very large price rises.
So, what is wrong with what Kwarteng has done, apart from not even trying to tell the world what it might cost?
The UK is not the US. The foreigners who finance it have to believe it is managed by sober and responsible people. With soaring inflation and fiscal loosening, the UK is now on trial. Kwarteng’s duty is to avoid its being found guilty.
First, it is too generous. Under the plan, energy prices for the typical household are capped at £2,500 for two years from October of this year (up from £1,100 before the crisis). If targeting of the more vulnerable were more generous, the price cap could have been set at, say, £3,500, still below the predicted cost of £4,586 from January 1st and almost certainly still higher later on. This would have been more affordable and also a sharper spur to energy efficiency.
Second, too much of the cost falls on public borrowing. The government is bearing all the cost of lowering the prices, instead of imposing price controls on domestic energy producers, as I suggested. Moreover, it is not raising additional taxes on windfall profits or on those able to pay more.
I argued instead for a temporary “solidarity levy” on better-off taxpayers, which would have been fully justifiable in such circumstances. Higher taxes on the prosperous have historically helped pay for war.
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Third, given the failure to raise taxes on the better-off or increase support for the least-well-off, the package is ill-targeted. True, according to the IFS, the gain from the package of support is 14 per cent of household budgets for those in the bottom decile and only 5 per cent for those in the top decile, because the former spend far more of their income on energy.
But, in cash terms, the top decile will receive some £2,000 each, against £1,600 for the poorest. According to the Resolution Foundation, if one adds the likely reversal of Rishi Sunak’s changes to national insurance, the richest households gain over twice as much in cash terms as the poorest.
Poor hardest-hit
Moreover, the latter will still be harder-hit by the rise in energy prices relative to their incomes than the former.
Fourth, this package is unsustainable. Suppose energy prices continue to be so high for more than two years. What would the government do then? Indeed, that point is likely to come even sooner, since the planned support package for business expires in six months. If the crisis lasts as long as that, the government would have to let prices rise, target assistance better and raise taxes. It should set out its follow-up plan soon.
But it seems likely that the Bank of England will consider that the boost to demand will offset the gain from lower headline inflation and adopt higher interest rates than would otherwise have been the case.
Finally, the combination of a large fiscal loosening with low unemployment, high inflation and a weak exchange rate creates significant macroeconomic risks. For the Bank of England, the package has the advantage of lowering peak measured inflation by some four percentage points, according to the Resolution Foundation. That was presumably part of its aim.
But it seems likely that the Bank of England will consider that the boost to demand will offset the gain from lower headline inflation and adopt higher interest rates than would otherwise have been the case.
Whether the impact of such a combination of looser fiscal policy with tighter monetary policy would also raise the exchange rate depends on the most important impact of all, which would be on confidence in the UK.
Alas, the new growth target, this fiscal loosening and the expected decision to introduce permanent tax cuts look like one of those “dashes for growth” that have blown up this economy (and those of many others) in the past. This is a risk the country cannot afford to take, especially given the risk-aversion in today’s world economy and the aftermath of Brexit.
The UK is not the US. The foreigners who finance it have to believe it is managed by sober and responsible people. With soaring inflation and fiscal loosening, the UK is now on trial. Kwarteng’s duty is to avoid its being found guilty. – Copyright The Financial Times Limited 2022
