Jeremy Hunt’s fall statement presented us with big tax hikes and spending cuts to avoid a big “fiscal hole” created by the need to lower the debt-to-GDP ratio by 2027-28 – the new “budgetary rule”. But it will make the recession worse and, ironically, will also ruin public finances.
Public borrowing is an important policy instrument, which allows a government to do two beneficial things: first, to keep tax rates stable at levels suitable for long-term growth, and second, to allow fluctuations in the budget balance. to dampen the economic cycle. The government must also balance its long-term accounts, as ours has always done for two centuries. But the words “long term” are essential. They mean that, going forward, government debt must always be able to be reliably repaid.
In practice, we can test it by making long-term projections, generally at least 10 years, to verify that the debt/GDP ratio drops to a level such as 50% where it does not pose any sustainability problem. Now let’s move on to Thursday’s statement to see how the government got into this mess. Why was 2027-28 chosen as the year in which the debt ratio must fall?
This choice is both too strong and too weak. Too strong because it prevents the flexibility needed for the two functions identified above. The tax rates essential to support growth, in particular corporate tax, are sacrificed to it. Also a bad recession that is coming, which the government should mitigate, will on the contrary be aggravated by a pro-cyclical budgetary tightening. This declaration will therefore aggravate the recession and harm growth.
But this choice of date is also too weak because it does not reassure us about the sustainability of the long-term debt. Indeed, because growth will be hurt, the UK’s long-term debt-to-GDP ratio will deteriorate sharply. According to our Cardiff models, which have been fitted to UK data and are therefore more pessimistic than the Office of Budget Responsibility on the effects of tax increases, growth will be reduced to zero. Then, if anything like current spending plans are maintained, the debt-to-GDP ratio will spiral to dangerous levels.
Such projections reveal the importance of growth not only for the standard of living of our fellow citizens, but also for the financial health of our government.
Yet if the OBR had done its math on alternative fiscal policies that did not hurt growth, then, according to our Cardiff models, growth would return to its 2% per year trend over 30 years until the pandemic. Then the OBR would find that the debt-to-GDP ratio would trend down safely over the next decade.
This completely arbitrary budget rule therefore means that the declaration not only destroys the economy, but also public finances in the long term. This is the fundamental flaw in his whole approach.
There is also a particular error in the OBR’s arithmetic that greatly increases the pessimism of its debt projections. This relates to the cost of the Bank of England’s quantitative easing (QE) program whereby the Bank purchased government bonds and other market assets by printing money in the form of bank reserves.
Treasury/OBR accounting treats bank reserves as debt, with interest charged at the bank rate. But this is expensive nonsense; bank reserves can only be exchanged for cash, which has a storage cost and earns no interest. The Bank does not need to pay interest on bank reserves to control the cost of credit. It has a toolkit it can deploy to determine this, including setting reserve ratios and lending directly to markets.
This practice by the Bank did not cost the state much when bank reserves were low – as was the case before the financial and Covid crises, or when interest rates were close to zero. But bank reserves are now huge after all that QE, at £950bn; and with interest rates at 3%, interest costs now amount to almost £30 billion a year.
This is a totally unnecessary addition to government costs. This amounts to paying commercial banks an exceptional subsidy equal to the short-term interest rate, without justification. Excluding the Bank’s debt sales, this error cumulatively increases the OBR’s debt-to-GDP ratio by almost 10% of GDP by 2027, and the OBR’s “fiscal hole” in 2027-28 around £50 billion.
Finally, let’s come to the strategic reason invoked for this austerity 2.0: to reassure the bond markets on two points: that we pose no solvency risk and that British inflation is well under control. Both are misunderstood.
Our credit default swap rate remained subdued even at the height of the hysteria over the previous Liz Truss plan. As for current inflation, it is largely the result of commodity supply shocks that regularly reverse as supply bottlenecks ease. US inflation has now passed its peak and ours is close to it; bond market inflation fears are very subdued so would pose no threat to a statement that supported the economy instead of trashing it like this.
The monetary causes of inflation – excessive money printing during Covid – have now been not only reversed, but pushed into monetary overkill, with near-zero annual money supply growth in the US, EU and in the UK. Inflation forecasts for 2023 are now around 5% in most developed economies. The Chancellor’s announcements will make no difference to commodity prices. But they will make wage inflation worse by reducing people’s take-home pay. Moreover, they worsen long-term solvency by reducing growth.
In short, the fall statement is a wrecking ball – deepening the recession, hurting growth, damaging long-term public finances and even increasing inflationary wage costs. Amendments from the House of Commons are needed to restore common sense to these plans.
Patrick Minford is Professor of Applied Economics at Cardiff University and a Fellow of the Center for Brexit Policy