Paul Diggle
Hello and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle
Luke Bartholomew
And I'm Luke Bartholomew
Paul Diggle
And today we are talking about the UK, its public finances, about decisions that the Labour government may make in its forthcoming initial Budget, and about the interaction of monetary and fiscal policy in the UK. So for those that don't know, the Chancellor, Rachel Reeves, will be presenting her first Budget on the 30th October and it may contain some Halloween nasties.
The Prime Minister, Keir Starmer and the Chancellor have been on a full-blown expectations management mission in recent weeks, talking about the difficult decisions that they may end up making in the Budget. But on the other hand, recent UK economic growth has been better. Inflation's close to target and rate cuts are underway. So in this episode we are asking what can we expect from the Budget? Are Starmer and Reeves talking the economy down when they were meant to usher in an era of political stability that attracted investment and boosted business sentiment? And should we be worried about potential accounting trickery that they may do with the Bank of England balance sheet? And more broadly, what is the state of the UK economy? So Luke, Reeves has spoken about a 20 billion pound black hole in the public finances. Where does that come from? And is the Chancellor right to pin the blame on the previous Conservative government?
Luke Bartholomew
Well, look, at the risk of some rank political punditry, I think there is a degree of political theater or narrative setting going on here, in the sense that the new government would like it to be the case that these quote unquote, “difficult choices”, difficult decisions they're going to be making in this Budget and no doubt in future fiscal events are in some sense associated with and blamed on the past government.
And you can sort of think of this as being analogous to what the coalition government and George Osborne in particular did back in 2010, where a lot of the fiscal decisions back then were framed in and described as being consequences in some sense, of the fiscal policy run by what was then the previous Labour government. And that was quite an effective political strategy.
So, I think that's what a Labour government is up to this time, at least politically. I mean, on the substance, I think it is fair to say that most people agree that this government has inherited a very difficult fiscal legacy from the last government, in the sense that the previous government's fiscal plans over the medium-term were only able to quote unquote “add up” by making some frankly, pretty implausible assumptions around future spending.
So effectively, what was going on was that the impact of higher inflation on taxation was being counted as a benefit from the government's perspective of higher revenue from the higher inflation. But at the same time, they weren't accounting for the likely higher spending that comes on the other side of that, higher inflation. So you were getting the benefits of higher inflation without reflecting the likely consequences of that on the spending side. So effectively, what the government, the previous government, was penciling in was extremely big real term spending cuts, which were simply not plausible. So there's a sense in which that represents a black hole, I suppose, over the medium to long run. Now, this 20, 22-billion pound black hole that Reeves has been talking about most recently actually relates to current year spending. So rather than that medium-to-long-term issue that I've just described, it's that the present fiscal challenge. And I think on that, you know, it's, again, there is some aspect of politics to it, and it's slightly nuanced and complicated. So certainly current expenditure does seem to be running slightly above what was forecast by the OBR and the government back in March this year, and there was a sense in which, you know, some spending political choices that any government would have made had not been accounted for or budgeted. But at the same time, some of that 20 billion, perhaps half of it, represents the consequences of Reeves and the government more broadly, accepting the pay increases recommended for the public sector by the public sector pay boards. And perhaps that's a perfectly reasonable, legitimate decision. But it's a decision that has costs, and it's a decision that the previous government claims it wouldn't have made.
So in some sense, it seems a little bit unfair to claim that the government, the last government, should have budgeted for a decision it said it wouldn't have made. You know, maybe that's not a black hole from the previous government. It's just the consequences of the new government's priorities. A perfectly fine priority, but a decision it itself should probably own.
Paul Diggle
Yeah. So whatever the cause then of the shortfall there’s no doubt, as you say, it is a difficult fiscal inheritance. And Labour's number one answer, solution, to that difficult fiscal inheritance to having a positive programme for government more broadly, to being reelected in the next election, is growth. This is a government that will ultimately be judged on its ability to raise growth rates, trend growth in the UK economy, and their programme to do that, which you might call a sort of form of supply-side progressivism, even a sort of UK version of Bidenomics, I see, as having sort of four key legs to it.
The first is political stability, bringing some sort of dividend in business investment, confidence and activity. The second is planning reform, especially raising homebuilding, setting explicit homebuilding targets, more broadly easing the planning process to encourage infrastructure investment. And that is, I think, a very worthy aim. It's also an aim that many, many UK governments have had and often fallen short of. And I think we know it's easier said than done. The third is green industrial policy. I think GB Energy is the flagship part of that agenda, although my sense is that Labour's green industrial policy is no, its no Inflation Reduction Act. It’s not on the scale of stimulus equivalent to the US efforts. And the fourth is close relations with the EU. Starmer’s been in Europe talking to EU counterparts about perhaps some kind of alignment on standards, on regulation, on mutual recognition of qualifications. But that's going to fall a long way short of rejoining any of the European institutions, the customs union, single market, freedom of movement, the sort of things that probably would have larger economic benefits. I don't think he can go that far. So my read is that the risk distribution around the medium-term UK growth outlook is more positive than it's been in a long time, but we won't see immediate benefits to UK trend growth just yet, and certainly not from the measures that will be taken in this Budget. But that being said, Luke, actual cyclical growth, short-term growth, has been a bit better in the UK, quite apart from anything that the new government has been doing. So what's been going on with UK cyclical growth?
Luke Bartholomew
Yeah. So the UK does seem to be in a relatively good place, cyclically speaking at least compared to say, the eurozone or the US or indeed even China at the moment.
In fact, the UK economy was the fastest growing in the G7 in the first half of this year. And the current pace of growth is something like 2% annualized, which is pretty good by UK standards. It's almost certainly above potential growth in the UK. I mean, this does come in the context that the UK was, of course, in a shallow technical recession last year while the likes of the US and the eurozone were not. So perhaps what's going on is more about cyclical disalignment, which is somewhat flattering the UK right now, rather than absolutely being in a particularly strong position. But nonetheless, relatively, it does sort of stand out right now. And moreover, you know, headline inflation has come down significantly. We got all the way back to the 2% target briefly. It has subsequently risen slightly since then and is likely to do so for much of the rest of the year as well, on the back of energy effects. But we're talking inflation around 2.5% or so, which, compared to the journey that we've been on, is quite significant progress and moreover and perhaps more importantly, the underlying rate of inflation or inflation pressures generated by the labour market, services inflation do seem to be slowing. And that's the kind of thing that's been giving the Bank of England confidence to start easing. It's already delivered one interest rate cut in August. We're expecting another cut in November, followed by, you know, further modest easing throughout next year as well. So that should be supportive or perhaps more strictly speaking, should reduce some of the headwinds facing the economy, as well as interest rates come down. So I think it's fair to argue that the cyclical position in the UK is probably the best it's been for several years right now.
Paul Diggle
That sounds like a pretty good backdrop for Rachel Reeves to be delivering her first Budget against. How much does that help her?
Luke Bartholomew
Well, it's certainly better than an environment of high and rising inflation, rising unemployment, recession conditions. It's definitely a better environment than that. Although, you know, there are some rhetorical challenges that it potentially poses, as discussed. I mean, Labour want to try and paint their inheritance as particularly bad. I mean, I think the distinction worth having in mind here is between the cyclical environment, which arguably is okay at the moment. You know, you could argue that over the last 15 years or so, growth hasn't been great. And so the growth inheritance as a whole is not spectacular, but cyclically, right now things seem to be pretty solid. And then the fiscal inheritance, which as we've discussed, is much more challenging. And unfortunately, this cyclical strength doesn't do a huge amount to deal with the structural fiscal challenges. In fact, that turns far more on potential growth. And if anything, that's likely to be a source of headaches for the new government in the sense that the OBR is currently forecasting potential growth of 1.5% or so. So this is the rate of growth that the economy will stabilize at over the very long run. That's the idea of potential growth - a non-inflationary rate of growth. And this 1.5% forecast that the OBR has penciled in, and indeed on which the fiscal forecasts are based, is considered quite optimistic by most private sector forecasts and the Bank of England as well and there's this expectation that that forecast is probably going to come down in time. Perhaps some of those supply side measures that you mentioned Paul, could in due course, increase it. But for now, the direction of travel feels to be one of potential growth coming down - and that actually increases Labour's fiscal headaches. And then slightly more subtly, there's also the possibility that if we're learning something about equilibrium interest rates by virtue of this ongoing strength, then that could be bad news for the fiscal position.
And the argument would be that, you know, the fact that growth has proved to be reasonably resilient through this period of high interest rates maybe tells you that the equilibrium rate of interest rates is a bit higher. So where interest rates settle over, the very long run will be a bit higher. And that obviously has first order consequences for the fiscal position because it implies government debt costs will be that much higher, the interest rate the government will have to pay on its debt could be higher as a consequence of that. So yeah, it's good news in the short-term, but it does probably nothing to alleviate the longer-term fiscal situation Labour finds itself in and potentially even makes it more challenging.
Paul Diggle
Okay, so growth is the sort of number one answer that Labour has to its fiscal challenges. But two other answers that are likely to feature in the Budget are tax rises, which we'll get get into, but also given you were talking about the Bank of England policy there Luke, possible changes to the way the Bank of England losses, which are a drag on the public finances are treated in the kind of accounting and the fiscal rules. So these are quite technical but I think very important changes. Tell us what's been going on with Bank of England losses, why it matters for the Treasury and what Rachel Reeves might do.
Luke Bartholomew
So as you say, it's quite technical. So maybe the best place to start is actually with a bit of history. So back in 2009, before the Bank of England undertook quantitative easing (QE) for the first time, which of course is a large scale purchase of government debt by the central bank, Mervyn King insisted, he was giving the Bank of England the time, he insisted that the Treasury provided an indemnity on any potential losses that could come about as a consequence of this QE, and the idea was that this was meant to insulate the Bank of England from political pressures that could come about because of any of these losses, and so the size of the QE program could be calibrated just on the basis of economic considerations alone. Now, as we'll see, that turns out to be quite ironic. But for most of the 15-years that that indemnity has been in place, it's actually been an extremely profitable arrangement for the Treasury. So since 2012 the Bank of England has been remitting profits to Treasury on the back of the profits that have been made from the asset purchases and they amount to something like 125 billion pounds that were passed over to the Treasury up to 2022. So that's a proper chunk of money that Treasury was able to receive as a consequence of this indemnity and the accounting arrangement that existed. But recently that, arrangement has become much more challenging for Treasury because of the rise in interest rates. The Bank of England is now making quite significant losses on its asset purchase facility. So, we're talking about something like 20 billion pounds a year or so over the course of this Parliament, which added up, could end up wiping out the entirety of the profits that have been made and then some as well. So the thought is that perhaps this impact of monetary operations can be excluded from the fiscal rules and that generates a fair degree of extra fiscal space for the government to play with because it doesn't have to worry about these losses and passing money back to the Bank of England to make up for the losses it's making on its asset purchases.
Paul Diggle
And is there something fishy going on there, tweaking the way the Bank of England losses are treated on the government's balance sheet against the fiscal rule? Is there a reason that the market should be concerned about that? Does it change anything fundamentally about the UK public finances and fiscal position, or is it all accounting trickery?
Luke Bartholomew
So I think the thing you have to hold in your head, at the same time, is that these losses are very real in quite a deep sense. They do have implications for the long-term government budget constraint. But at the same time, it's an entirely contingent feature of the specific accounting rules that we use and the specific fiscal rules that we have that it is interacting with fiscal policy in quite the way that it currently is. Other accounting rules for the central bank are available, other fiscal rules are available. And indeed they may be optimal compared to what we currently have in the sense that they're being less distortionary. So I don't think there's anything wrong with rule changes per se. That being said, there does always feel something a bit funny about changing the rules halfway through the game and especially when the game starts to go against you, because of course those profits that the Treasury was taking certainly did count towards the fiscal rules in the good times. So maybe it's a bit strange that they don't get to count against the rules in the bad times. And I think that Labour was quite conscious to the concern that it would be considered a bit fishy if it did something about the rules. And there's always some risk that as a government interfering with monetary policy, especially with, you know, relatively technical aspects of monetary policy, people might feel that you're doing something slightly suspicious, maybe endangering central bank independence in some way, and especially if it's a new government that's just come in, maybe hasn't had a huge amount of time to build up its credibility with the market. And so that kind of consideration is why I think Labour hadn't planned on making these changes in its first Budget. I think it felt like it was something to address a little bit further down the road. Over the course of this summer policymakers and market participants have been involved I think in quite a lot of conversations around this, and the reaction has been pretty relaxed.
I think people understand why the change is coming, what it means, and it has pretty limited implications for monetary independence per se. In fact, it might even strengthen it now to remove this sense in which Bank of England losses are having first order impacts on fiscal policy. And so, I'd be quite surprised at this point if there wasn't an announcement in the Budget that made some changes. Precisely how they do this and the exact institutional arrangements that they come up with to be determined, but some change I think is likely. And I'd also be pretty surprised if there is a material adverse market reaction as a consequence. That being said, I mean, it is worth saying that the reason you change the rules like this is, you know, because you want to get the benefits from it in terms of having to cut spending less or having to increase taxes less. And presumably that does have implications for gilt market issuance for the kind of fiscal impulse that the economy will receive. And that itself does have market implications. So, it's not like this doesn't matter for the market. I just don't think it matters in the sense of it's a reason to be concerned about fiscal and monetary independence.
Paul Diggle
Yeah. And part of the way that Labour wants to keep markets onside and project fiscal responsibility has also been the updates they've done to the charter for budget responsibility , so enshrining the OBR’s role in fiscal events. That's clearly a response to the Truss/Kwarteng Budget sidelining the OBR. But I think it is also a conscious echo of that great act of political economy, institutional change, by the 1997 new Labour government, making the Bank of England independent. So sort of bolstering the independence, enshrining the role of the of the OBR is a little bit of a shout back to that, and I think is also part of efforts to reassure markets.
I mean, talking though of fiscal responsibility, the other big thing that's going to happen in the Budget then is going to be tax increases as well. So you can't plug all of the so-called ‘fiscal black hole’ just with technical changes to how Bank of England losses are treated. There's also going to be revenue raisers and I suppose Labour have tied their own hands in a way by ruling out increases to the big four taxes in the UK, income tax, National Insurance, VAT and corporation tax, which together are the majority of tax take. So then they have to really turn to a lot of the smaller taxes and potentially increase them by a lot. So Labour have already announced VAT on private school fees and a windfall tax on oil and gas. And I think we've seen a lot of kind of kite- flying for potential measures that could be taken up in the Budget. A lot of these measures are actually very, very last minute. But things that we know are in contention are an increase to capital gains tax. So currently the top rate of capital gains tax is 28%. That could be increased as far as 45% to match the top rate of income tax. Changes to inheritance tax, perhaps tightening up a lot of the exemptions and exceptions that are in the inheritance tax rules. Lowering pension tax reliefs. So perhaps lowering it to 20% for everyone rather than currently where pension tax relief is at your marginal rate of income tax - so up to 45% - actually it would lower that lot. Increasing fuel duty, perhaps changes to the tax treatment of electric vehicles, and there could be many others. And I think Luke there are legitimate questions or criticisms of a lot of those potential changes. For example, there can be behavioral changes that limit tax take of some of those tweaks. Business pages are already full of reports of wealthier households selling assets or investment properties ahead of possible capital gains tax changes, or accelerating inter-generational wealth transfer ahead of inheritance tax changes. I suspect that over the medium run, this sort of front running won't materially lower the overall tax rate, but we could see some distortions in behavior at the margin. Capital gains tax, you know, likewise, it can be distortionary. There will still be ways to try and reduce that inheritance tax, burden. We might want to incentivize investment and tax consumption. You know, economists think of consumption of goods as more of an optimal taxation. Lowering pension tax relief - that can be at odds with the need to build pension pots in the UK to increase pension funds home bias to invest in productive assets in the UK. So I think there are problems with all of these potential measures. I mean, really what probably should be happening here is a reversal of the final cut in National Insurance under the previous government. Those cuts themselves I think, were at odds with fiscal responsibility. They failed even in their own terms because they didn't seem to support the Conservative vote all that much, and they seem to sort of salted the earth a little bit for Labour, because Labour then committed to not touching National Insurance and the other big taxes. So hence why they have to go rummaging around to, you know, in all the smaller taxes to actually raise money.
Luke Bartholomew
All right. Well, I think that is all we have time for this week. So as ever, please do allow me to remind you to subscribe and like wherever it is that you prefer to get your podcast. And then all that remains is for me to thank you all for listening. So thanks very much and speak again soon.
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