Rachel Reeves has delivered her second Budget and most of the media coverage, predictably, has focused on the winners and losers of specific tax and spending decisions.
These make the political headlines, and politics matters because we live in a democracy, not a technocracy. But while mansion taxes and 2-child benefit caps might be the story politically, economically they are a sideshow.
To understand the economic impact of this budget, we need to consider the three I’s: Inflation, Interest rates, and Investment.
Inflation
It is nearly five years since I predicted that release from the pandemic would see the return of sustained inflation for the first time in 25 years. A contrarian view at the time (interest rates were at 0.1% and would remain there for a further 10 months), I argued that loose fiscal and monetary policy combined with constrained and dislocated supply would lead to systemic price rises.
I also argued then that, given the enormous increase in public debt during the pandemic, a bout of inflation might prove to be the least painful option available to policymakers. It would be hard to argue that both government and Bank of England didn’t play their part in facilitating sustained price rises through 2022 and early 2023.
Indeed, it was inflation that has allowed public sector net debt to decline (slightly) as a percentage of GDP compared to February 2022, despite every government since having run a prodigious deficit in every subsequent year. The value of the debt has simply been eroded by inflation.
Why not continue the conjuring trick?
Interest rates
The problem with letting the economy ‘run hot’ is that eventually people notice what you are doing. Those people include buyers of government debt – the bond markets. The UK is now paying approximately 4.4% interest on its long term debt; more than a whole percentage point higher than the average of the other G7 countries.
This is commonly misinterpreted as a judgement on the government’s credit-worthiness but it is really not that. The UK, with a sovereign currency, can print its own money so should never need to default on pound-denominated debt.
No, instead, these higher interest rates reflect – mostly – the perceived value of the currency in which these debts will be redeemed. If I am to be returned x number of pounds in 10 or 20 years, I should reasonably ask: what will be the value of those pounds at that time? And that is determined by the rate of inflation in the intervening period.
So, to reduce the rate of interest that it pays on its debt, the UK government has to convince the markets that it will not perpetually indulge high inflation.
But that’s not the only reason fiscal credibility matters.
Investment
The government’s credibility on inflation doesn’t only determine its own interest rate; by extension it also affects the rate everyone – households and businesses – pays to borrow money in sterling.
And this, really, is the crux of the budget’s impact. The most important factor in determining long term economic growth is productivity. And to increase productivity you need investment – not only from the government but also from the private sector. Better infrastructure, capital equipment, technology and training increase the output per worker-hour.
At OCO Global, we advise hundreds of investors every year on their domestic and international expansion plans and the simple truth is: if you want to build a gigafactory or invest in new technology, costs are up front but revenues are deferred well into the future. So the rate of interest really matters. Discounting future revenues at 3% instead of 4% per annum compounds to make a huge difference for investments over, say, a 20-year time horizon.
So: to deliver the long term economic growth that could answer Rachel Reeves’ prayers, lower interest rates really are key.
Verdict
With all this in mind: how did Reeves do?
The response from the bond markets so far has been a cautious welcome. On the plus side, the increased ‘headroom’ – the wiggle room between current tax and spending plans and the fiscal straightjacket the Chancelor has set herself.
Set against that is the credibility of the plans to achieve a lower deficit. That the hard work of tax rises is largely deferred to the end of this parliament and beyond detracts from the likelihood the plans will be fulfilled. We intend to go to the gym tomorrow more often than we actually go today.
Had Reeves followed through with her floated plans to increase rates of income tax (rather than merely freezing thresholds) interest rates on both government debt and private sector borrowing would have fallen more significantly yesterday. And that would have been good news for the economy.
However, politics does matter. A brilliant plan for the economy that cannot be carried politically is no plan at all. In a democracy, manifesto pledges are significant, whether they were well thought through in the first place or not.
It is in that context yesterday’s budget should be judged. Threading the needle between the expectations of bond market traders and Labour MPs was a tough act, and it could have been a lot worse.
Where do we go from here?
Having made a contrarian prediction five years ago, here is another: that notwithstanding the popular lament that the UK is stuck in a doom loop of higher taxes and weaker growth, we may now be on the cusp of a period of better performance.
In early 2021, I argued several meta trends were set to reverse or diminish: globalisation, impact of technology, fiscal policy and monetary policy.
We may again be at an inflection point.
Globalisation has faced headwinds for several years but with US tariffs now largely settled and potential peace dividends in the Middle East and Ukraine, there is potential upside here, particularly for energy prices which have disproportionately blighted the UK economy.
On technology, market valuations for AI stocks may be frothy, but the implied productivity gains in the wider economy cannot be ignored. Anecdotally, we see companies getting serious about embedding AI in their processes – and thriving as a result.
Finally, then, fiscal and monetary policy. Arguably the most important takeaway from yesterday’s budget wasn’t the increase in headroom or the degree of fiscal rectitude but rather the recognition that these things matter at all. This is the signal that intentionally loose fiscal policy is over.
If this is true, it may pave the way for lower inflation and give the Bank of England room to cut interest rates, gradually, perhaps, but consistently, opening the doors to a virtuous circle of investment and productivity gains.
To paraphrase Mark Twain, reports of the UK’s death may be greatly exaggerated. The night is always darkest before the dawn.
