Dr Gerard Lyons is a senior fellow at Policy Exchange. He was Chief Economic Adviser to Boris Johnson during his second term as Mayor of London.
Economic policymakers face a double whammy. The first is the likelihood of current difficult economic conditions continuing for some time, as monetary policy tightens to curb inflation and as the war in Ukraine persists. The second is that the policy response to present challenges is not helping our competitiveness.
There needs to be an economic refocus – almost like a time-out in sport. An opportunity to reassess tactics and strategy, so that we address immediate economic challenges while boosting competitiveness.
This requires a tighter monetary policy to curb inflation, alongside a looser fiscal policy centred on tax cuts to prevent recession. Indeed, tax cuts should form a critical part of improving competitiveness alongside much needed supply-side reform. Despite what the Government says, neither are centre stage when they should be.
The main current area of difficulty has been the Bank of England, where monetary policy has been loose, exacerbating inflation and squeezing spending power, weakening economic prospects. In turn, the Chancellor and fiscal policy have been given a hospital pass. Now with monetary policy tightening at a time when the economy is slowing, this has added to the pressure on fiscal policy to do more.
While a tighter monetary policy is needed, it must not be on auto-pilot. The speed, scale and sequencing of tightening must be driven by economic conditions. In the US, the Federal Reserve has talked about “negative feedback loops” from the economy as it weakens in response to higher US interest rates. We have to be mindful of the same here, as parts of our economy may be sensitive to higher rates.
This includes the housing market, as borrowing costs rise. Also, zombie firms may fold as rates rise but policymakers need to observe carefully that banks do not penalise viable small firms, who are being hit by a cost crunch now and who would be vulnerable if there was a wider credit crunch too.
It is a complex picture, as at the same time there are areas of the economy which will be resilient in the face of higher rates, and some people are helped by high savings.
Meanwhile, the Treasury appeared keen on a tight fiscal stance too, to reduce inflation and debt servicing costs. The latter, while important and rising, are often overstated, and the maturity of UK debt is relatively long, which helps.
Too tight a fiscal stance would have been a mistake, likely triggering a recession and a subsequent sterling crisis. Indeed, in recent weeks short positions against sterling have grown, with a weaker pound seen by traders and speculators as a necessary shock absorber.
Now fiscal policy has now been relaxed following the Chancellor’s latest stimulus.
That was the right decision. With the economy slowing significantly, this will not add to inflation. Also the new stance of policy – looser fiscal and tighter monetary – should improve fortunes for the pound.
But the components of the Chancellor’s package could have been better executed, with more use made of tax cuts.
There is often scepticism when fiscal policy is relaxed. It is after all taxpayers’ money that is being spent, and last week was the third big stimulus this year.
However, economic policy must be seen in the context of the time. A classic example is the 1981 Budget when 364 economists famously wrote to The Times to complain that fiscal policy was too tight. They were wrong. The economy grew strongly. Often overlooked, though, is that at that time, thanks largely to Alan Walters, Margaret Thatcher’s economic advisor, monetary policy was easing significantly and it was that, alongside a weaker pound, that then helped the economy.
There is no doubt that the UK needs to get its public finances under control, moving away from tax and spend to empowering the private sector and in the process boosting economic growth and generating more tax revenues to fund public services. The point is to deliver sustainable growth.
One thing not done well in the UK is getting public finances under control in good times. Plus, public sector reform should be higher up the agenda as it is essential, alongside investment, if we are to have affordable first rate public services.
Currently, the appropriate fiscal stance has to be seen in the context of downside economic risks.
Last week, the Chancellor was right to provide “timely, temporary and targeted” help to those on low incomes. I called for this in my previous column. But it would have been better if this had been through Universal Credit and thus linked to getting people into work. Benefits could have been raised in line with inflation immediately.
It was also right that action was taken to address high fuel prices, but here too a better approach could have been adopted. Instead of an unnecessary across the board £400 to all, including second home owners, there could have been cuts in VAT on fuel or a temporary suspension of the environmental levy.
I would have also favoured a one pence cut in income tax to help the squeezed middle. Incentives are far more effective through tax cuts than the Government randomly selecting winners – and could be aimed here at the four out of ten adults paying income tax.
As for the windfall tax, any revenue uplift appears more than offset by the negative consequences of this tax. An apparent U-turn on the windfall tax will not help businesses trust official announcements.
The Chancellor spoke to the CBI about his business friendly credentials. But his actions do not yet support the words. Business already faces a rise in corporation tax next spring. A new windfall tax risks damaging business perceptions of the UK.
Moreover, as there is no criteria apart from being popular in focus groups as to what will trigger a windfall tax, successful sectors could easily see themselves as future cash cows. This is not the predictable tax regime necessary to help encourage investment:
As part of the windfall tax, the Treasury introduced a new ultra high allowance designed to encourage investment. It will likely encourage bad investments. A similar feature happened in the past when exploration costs were offset against Petroleum Revenue Tax. When that allowance was scrapped, exploration activity fell but success ratios soared. The lesson is investments are done over the long-term. With a need now for increased investment in future energy needs, including renewables, such interference may deter firms from investing here, as opposed to elsewhere.
We need a three arrowed approach to economic policy focused on a pro-private sector pro-growth agenda. The arrows are: a credible monetary and financial policy; fiscal policy aimed at reducing the ratio of debt to GDP; and boosting the supply-side, including smarter and less costly regulations, increased investment and improving competitiveness.
The Chancellor talks of lower taxes, yet the tax take continues to rise. Time will tell if he is more likely to turn out to be Saint Augustine – “make me chaste and celibate but not yet” – or Roy Jenkins, who in the late 1960s ensured that the public finances were improving at a time when the economy and the Labour Government’s subsequent election chances could have benefited from a relaxation.
For the moment, the Chancellor is relaxing fiscal policy – which is good – but spending is not offering value for money and taxes are high – which is not good. Let’s hope for the economy’s sake the outcome is more Augustinian.