Summary. Markets have reacted poorly to the UK government’s new “mini-budget” combining energy price caps with tax cuts for the well off. The government’s search for a quick fix to economic growth is a mistake. In...more
The world’s eyes were on Britain during the Queen’s funeral on Monday, September 19, 2022. It was a somber, dignified, and stately affair. The following Friday, new Prime Minister Liz Truss and her finance minister, Chancellor Kwasi Kwarteng, announced their tax and spending plans. This “mini-budget” was the exact opposite — it promptly drove the pound down to its lowest level against the dollar in history, caused a collapse in the price of UK government bonds (“gilts”), and almost caused a collapse in pension funds on the scale of the global financial crisis. The IMF rebuked the plan, warning that they would stoke economic inequality.
While the UK’s bad week might look at first like a local affair, it’s symptomatic of a wider set of problems plaguing Europe. For all the faults of the Truss plan — and they are many — the focus on sluggish economic growth is appropriate. But if the UK and the rest of Europe are going to revitalize their economies, they need more than quick fixes. Both the public and the private sector need to commit to investing in productivity-enhancing technologies and in combatting climate change.
The UK’s bad week
As expected, Kwarteng’s “mini-budget” put a cap on energy prices for households and businesses, and it scrapped increases in payroll and corporate taxes. This was expensive. But what shocked everyone were the additional income tax cuts that were particularly generous to the wealthy. Altogether, these measures hugely increased UK government borrowing and sent public debt on an unsustainable path.
Usually, fiscal events of this magnitude are accompanied by detailed analysis from the political independent Office of Budget Responsibility (similar to the Congressional Budget Office), which forecasts what the impacts are likely to be and whether there is a credible plan for paying back the money the government is borrowing. The OBR produced some preliminary forecasts when Chancellor Kwarteng took office, but he has so far refused to publish them, presumably because they look pretty bad.
In the absence of independent scrutiny, the financial markets delivered their own judgement, and it was harsh. The value of UK government bonds collapsed and the sterling fell at one point to only $1.03. (It has since largely recovered.) The fall in the value of bonds signals higher mortgage repayments, because it reflects the expectation of higher interest rates, but it also meant that many of the pension funds who hold about $1 trillion of these assets became financially unstable. On Wednesday September 28, the Bank of England was forced to reverse its “quantitative tightening” policy and start buying these bonds en masse (£65 billion) to avoid a financial meltdown.
By Monday Oct. 3, Prime Minister Truss was forced to backtrack, reversing the plan to get rid of the UK’s highest tax bracket.
What was the government thinking? Their justification was similar to the rationale behind Trump’s 2017 tax cuts that also focused on cutting taxes for corporations and high earners. The idea is that lower tax rates will raise economic growth rate by so much they will generate enough extra tax revenue to pay for themselves. Hence, government borrowing will fall, not rise. This idea is codified as the “Laffer Curve” named after Arthur Laffer, who advised Ford administration and whose ideas went on to influence subsequent Republican administrations.
Unfortunately, outside a couple of fringe think tanks, no serious economist believes this theory matters for the empirical reality of the UK. Many high tax economies like Germany and the Nordic nations are robustly successful and big tax cuts for top earners have no clear relationship with growth (although they definitely increase inequality).
The markets followed the standard view and punished the government accordingly.
A Wider European Problem
It might be tempting to dismiss the whole sorry incident as another example of British eccentricity, much like Mr. Bean or Monty Python’s Flying Circus. Certainly, it is another example of monumental economic self-harm, following on the 2016 Brexit debacle which has already increased the cost of living by about 3% of UK incomes.
But Britain’s travails are part of a wider set of political and economic problems in Europe. First, Putin’s invasion of Ukraine has caused a huge spike in energy prices. Europe is much more dependent on Russian gas and oil than the rest of the world. For example, before the invasion, Germany received 55% of its gas from Russia. America is fortunate to be abundant in shale gas and trades relatively little with Russia. So although the U.S. is hardly immune, the shutting down of gas pipelines and trade sanctions have a much less direct economic impact.
Second, Europe has been slower to recover from the pandemic than the U.S., just as it took longer to bounce back from the global financial crisis. And all countries have faced slower productivity growth in recent years. The UK position was particularly bad in this respect, with GDP per hour running over five times as fast in the three decades prior to Lehman’s collapse as in the 14 years after 2008. This low productivity growth has meant slow wage growth and is the context for the desperate gamble of Kwarteng’s budget. Even if his solutions were wrong, his diagnosis of the low-growth problem is right: The UK, like much of Europe, badly needs to increase productivity and economic growth.
Third, these economic troubles have helped generate a surge in voting for populist parties with get-rich-quick solutions. Parties with fascist roots such as the Sweden Democrats and the Brothers of Italy have seized power in their respective countries. Their solutions? Blame foreigners and elites for all the problems and promise a harsh clampdown on criminal immigrants.
What the UK and rest of Europe needs is a focus on structural policies to help deliver sustainable productivity growth. These require supply side reforms for product, labor, and financial markets, as well as investments in skills, infrastructure, and innovation. This is at the heart of the European Union’s post-Covid €807 billion Recovery Fund, which has made progress in prompting member states to make serious reform plans. It includes funding for things like digitizing government services, investing in clean energy, and funding scientific research — all of which are evidence-backed ways to improve productivity. Italy’s government under ex-ECB boss Mario Draghi had such a plan, too. The problem is political: Many voters and politicians do not seem to want to accept the need for such reforms.
What Does All This Mean for Business?
Europe is still the world’s largest single market and remains an innovative and democratic hub in the world. Education levels are high and inequality lower in the U.S., with much better access to health care at reasonable prices. So it remains both an important destination market and home to many leading corporations. In terms of policies to tackle climate change, and to regulate powerful firms and the internet, it is setting standards which other countries (including the U.S.), are tending to follow.
However, Europe’s slow growth — partly due to slowing productivity and partly due to a rapidly aging population — makes it much less of an attractive destination for multinationals. If the trend towards inward-looking populism increases in many European countries, this will slow down (or even reverse) the falling costs of doing business across the EU. The EU’s crown jewel is the single market, but this is an ongoing project. Reducing regulatory barriers further in services could bring further huge benefits. But if populist parties start re-building barriers to the movement of people, goods, and services, this will make doing business within Europe harder, as Brexit has so vividly shown.
There has been a significant disruption of global supply chains due to both the Covid pandemic and to trade wars. The Ukraine conflict adds to this uncertainty. Increasingly, firms are shifting supply chains to gain more resiliency, even as the expense of some efficiency losses. Since Europe is so integrated into these supply chains, fracturing will have costs. Most likely, deglobalization will mean less of a repatriation of activity to expensive HQs in rich countries, but more regionalization (in say, separate hubs in Asia, North America, and Europe).
A major task of business is to help face up to the massive challenges facing the West. Tackling climate change and low growth requires a partnership between business and political leaders to make the long-run investments needed for prosperity. The market by itself will not solve our problems, and we need a new global “Marshall Plan” focused on green innovation. This is not a pipe dream. Partnerships between the public and private sectors helped deliver Covid vaccines in record time. There has been western solidarity against Putin’s land grab. But we must realize that policies for good growth are a long slog, a marathon of difficult supply-side reforms, and not a mad dash for growth from simple-minded tax cuts and bonfires of red tape as promised by the flailing UK government.
