After the mourning, Truss and Kwarteng could find themselves on a sticky wicket | Larry Elliott
Crunch time will come quickly for Liz Truss. After 10 days of national mourning to mark the death of Elizabeth II, Britain’s economic problems will return to centre stage this week. On Thursday the Bank of England announces its latest decision on interest rates. The following day Kwasi Kwarteng’s debut as chancellor will be the latest in a string of mini-budgets. Both will be significant occasions.
In one sense, Truss has benefited from attention being on the monarchy rather than on politics during her first two weeks in the job. She has been able to settle in at Downing Street and think about what to do with her new-found power. In cricketing parlance, the prime minister has had time to play herself in.
But, to extend the metaphor, Truss is soon to be faced by some nasty, short-pitched bowling. If things go wrong, her time at the crease will be brief.
Although inflation is at 9.9%, the economy is probably already in recession and the pound only one further serious downward lurch away from parity against the dollar, the government has things going for it. Ukraine’s military victories in the past week have had a marked impact on wholesale gas prices, which are down sharply this month. An end to the war, while far from a done deal, looks more feasible than it has at any time since Russia’s invasion in February.
What’s more, the labour market is holding up pretty well for an economy that has essentially moved sideways since the start of the year. The unemployment rate is the lowest it has been since early 1974.
If the government wants to be super-optimistic it can take comfort from the fact that previous periods of sterling weakness have not always been bad for the economy. The devaluation that followed Black Wednesday 30 years ago was the catalyst for a period of strong export-led growth in the mid-1990s. The last time the pound flirted with parity against the dollar was early 1985, but in the next three years the economy boomed.
Not so fast, though. After Black Wednesday the impact of the cheaper pound was bolstered by cuts in interest rates. This week the Bank of England’s monetary policy committee (MPC) will raise interest rates for a seventh successive time. Nor does the comparison with the mid-1980s entirely stack up either, because back then Britain was a net exporter of energy and less reliant on food imports than it is today. A lower pound makes imported energy and food more expensive.
Although overshadowed by the Queen’s death, Truss’s first decision as prime minister was a big one: the commitment to cap the average annual household energy bill at £2,500 for the next two winters will boost consumer spending power and will make the recession shorter and shallower. The government is budgeting for the cost to be up to £150bn, which would make it the most expensive intervention by the state in peacetime.
Further details of the government’s plan will be outlined in Kwarteng’s mini-budget, a term that hardly does it justice, since the chancellor is planning to announce a massive increase in spending, big tax cuts, a major package of deregulatory reforms, and lots more government borrowing. There is even talk that he will announce changes to the Bank of England’s inflation mandate. Kwarteng’s statement will not be accompanied by an independent analysis from the Office for Budget Responsibility on the likely impact of all these measures on growth, inflation and the public finances: a regrettable lack of scrutiny when the financial markets are so jittery.
It is not hard to envisage circumstances in which the markets respond badly to the Bank’s interest-rate decision and sell sterling – either because they think the MPC has done too little or that it is guilty of overkill. The chancellor will then have to explain why in addition to borrowing to fund the energy package he is also borrowing to fund tax cuts.
Truss and Kwarteng are frustrated by the economy’s lack of vim in the 15 years since the global financial crisis erupted in 2007 and prepared to allow the budget deficit to balloon. The theory is that tax cuts plus deregulation will lead to faster growth, which will eventually lead to a smaller deficit. A growth target of 2.5% will be set, modest by historic standards.
As the Resolution Foundation thinktank has pointed out, income per head rose more rapidly under Elizabeth II than under any other monarch dating back to 1271 (and before that too, almost certainly). The average growth in per capita incomes for the last 70 years has been 2% a year, double its rate when the UK was the world’s leading economy under Queen Victoria.
The economy’s overall growth rate – once growth in the labour force is accounted for – is even higher, standing at 2.4% since modern records began in the mid-1950s, according to Ruth Gregory of Capital Economics. But the average is dragged down by the poor performance of the economy in recent years. Productivity growth has averaged below 1% a year for the past two decades, and even allowing for a rising labour force, that leaves the economy’s underlying trend rate of growth at between 1% and 1.5%. Raising that to 2.5% is a monumental task, which will require a lot more than tax cuts and attacks on red tape.
Britain’s problem is not that it is over-taxed nor that it is excessively burdened with regulations (the labour market is one of the more flexible in the OECD) but that investment is so low. Setting a growth target is one thing, achieving it quite another.