The UK is in a crisis of living standards, not public finances

The government isn't fixing the public finances, it's worsening the recession

The country is once again in the jaws of recession. It’s likely to be longer and deeper than that faced by the rest of the G7 due to three particular economic failings here in the UK. This article discusses each of these failings , and presents new analysis of the effects of a fresh round of austerity on public services. We find that, even without further cuts, just failing to protect department spending from inflation at this week’s Autumn Statement will push many public services back to the depths of the austerity years. Even spending per head on the NHS is now at risk of falling in real terms for the first time since 2013. Further cuts planned on top of this would push services over the brink.

It is said that bad things come in threes. In the last two years we’ve experienced the worst public health crisis, followed by the biggest one-year fall in living standards, in more than half a century. Now, according to the Bank of England’s latest forecasts, the next two years look set to bring the longest economic downturn since the 1920s.

But there is something unnerving about this third round of anticipated economic hardship. The triggers to global pandemics and price shocks are largely out of our control. Though we can and should do a far a better job at building resilience to these shocks, they can’t be prevented from happening in the first place. But some of the key drivers behind why the UK is likely to have a longer and deeper recession than other counties are different. They are of the government and the Banks’ own making.

The Truss-Kwartang incompetency premium’

There are three chapters to this story of self-inflicted economic pain. The first chapter, lasting only a few months, is the Truss-Kwartang government. Though for many it looms largest, it is also the least significant. Investors in finance and currency markets didn’t buy the idea that £45bn a year in tax cuts, which would disproportionately benefit the UK’s very highest income families, was a credible plan to improve the economy. The pound crashed, government borrowing costs spiked and market expectations for interest rates and inflation rose rapidly as investors essentially charged an incompetency premium’ for putting their money into the UK.

Borrowing costs and inflation expectations have returned to their respective levels since immediately before the mini-budget’, effectively wiping out the long-term effects from the budget itself. But that doesn’t mean all the harm has been undone. The UK’s institutional credibility has taken a knock and financial instability was exposed. There is also the remaining damage incurred purely from the anticipation of a Truss administration. Investors started charging their premium as early as August on the likelihood of a Truss leadership victory, and this is still yet to recover fully.

But the sum total of this remaining damage is modest. We know this because the [KG2] [AS3] deterioration in the public finances since the March 2022 Budget driven by changes in the economic forecast is expected to be broadly in line with that usually seen between fiscal events (formal government budgets and statements), and is certainly unremarkable. At most the remaining incompetency premium can only be responsible for a portion of this still non-remarkable total. Therefore, much of the UK’s self-inflicted economic harm must lie elsewhere.

Aggressive monetary policy

The second chapter of economic damage spans almost a year. The Bank started raising interest rates earlier than either the US or the Eurozone, with a rate rise announced at every meeting of the monetary policy committee since December 2021, culminating with the largest one off rate increase seen since the 1980s earlier this month.

This so called monetary tightening’ reflects the Bank’s effort to manage the macroeconomic impacts of imported inflation caused by the covid pandemic and the Ukraine war. The Bank cannot tackle this type of inflation at source, but it can offset it or reduce the extent to which it becomes embedded. Higher interest rates do this by making it more expensive for businesses and families to borrow, thereby suppressing spending in the domestic economy. This doesn’t eradicate the pain but rather spreads some of it about in a different way; with more of it manifesting as lower earnings and higher unemployment, rather than higher prices. The intention is that this also makes the overall damage lower than would otherwise be the case.

But the Bank’s strategy of particularly aggressive tightening (raising interest rates fast) to prevent embedded inflation is high risk and low reward. The fragility of the UK economy, and the fact that unlike every other G7 countries we are still in the recovery stage of the cycle, raises the stakes. Both the sensitivity to over tightening’ is higher, and the potential consequences are far more serious in terms of economic scarring’ (permanently lower levels of family income). A lot is riding on the Bank correctly interpreting the economic data in real time, but the problem is that even the best evidence in these circumstances can only ever be circumstantial. It’s a bit like trying to put out a fire of an unknown size, with a bucket of water contaminated by an unknown amount of petrol.

Meanwhile, that all important economic evidence remains mixed. It’s true the labour market does have some of the pre-conditions required for imported inflation to embed domestically. Most notable of these is a high number of job vacancies relative to those looking for work, which might help workers to negotiate inflation matching pay settlements.

But there are other pre-conditions that offset this. Weak union density in many sectors limits the ability of workers to negotiate higher pay. Even where worker leverage is stronger, the UK has an unusually high proportion of firms with weak productivity and narrow profit margins, which limits the ability of employers to raise pay quickly. Increasingly weak demand from credit constrained consumers, with low incomes relative to costs, also limits the scope for business to grow their way out of the problem.

Indeed the tensions between these pre-conditions appears to be playing out in the data. According to the Bank, nominal private sector wage increases now appears to be stabilising at around 6%: a rate far higher than anything seen in recent years (outside of pandemic related anomalies) but still some way short of headline inflation that is settling above 10% over the near term. Public sector pay meanwhile is only rising by a little more than 2%. This means overall real earnings have contracted by around 2.5% on the year for five months in a row – by far the worst squeeze since 2009. It’s too early to know conclusively whether the Bank has made the wrong call, or how damaging this mistake could prove, but the signs don’t look good.

Perhaps the key point though is that the Bank embarked on this course knowing that the costs associated with getting monetary policy wrong are not symmetrical. Had rates been kept deliberately low, this would have risked higher inflation for longer. But this also has a solution: fiscal policy (government tax and spending) can step in to offset the distributional consequences. Targeted support for those that need it most could be delivered through cash transfers and price caps, and this can be prevented from adding its own lasting inflationary pressure by raising taxes on those that can most afford it.

But if the reverse is true, and rates have risen too far and too fast, the risk is a far deeper self-inflicted recession than was either intended or necessary. Worse still, in this world, fiscal policy will struggle to offset the mistake. That’s because a Bank committed to raising interest rates would be expected to respond to government attempts to stabilize the economy by pushing rates up even further to wipeout the effects of any intended fiscal expansion. The consequence for us all in this world are horrendous. Millions more people would fall into the misery of struggling with rising prices, lower pay, higher debt costs and threats of redundancy than would otherwise have been the case. It is this world the Bank is risking and we may be only beginning to pay the price.

Austerity: past and present

The final chapter of self-inflicted economic pain straddles more than a decade. It concerns a persistent bias from government to shrink the size of the state, irrespective of the particular challenge being faced. Whether the drivers are political opportunism, ideological dogma or inter (and intra) departmental power play, the outcome has proven the same: painfully slow productivity growth, the worst decade of suppressed real wages on modern record, the least effective unemployment safety net among advanced economies, record NHS waiting times, rising child poverty and life expectancy flat lining for the first time in decades, even before the pandemic. The political disengagement and cynicism generated by austerity was also likely crucial in the vote to leave the EU, which has further compounded economic and social decline.

One of few non-cynical rationales for austerity was an attempt to better prepare the country for the next crisis. But this framework of thinking was predictably and tragically exposed as false by the Covid-19 pandemic and following gas price shock. The UK spent a decade systemically stripping itself of resilience. Whether it was endemic low pay and precarious work that couldn’t be furloughed, an NHS routinely tipped into crisis by seasonal flu, our vast potential for renewable power going untapped, a social security system that replaces just 15% of average earnings or some of the coldest, draftiest and least energy efficiency homes in Europe, the UK could hardly have been worse prepared for what was about to come.

It’s hard to imagine an approach to economic policy failing so categorically, and with such lasting and devastating consequences. And yet, despite this, the austerity narrative arc has now come full circle. The new prime minister and chancellor are preparing the UK for another round of spending cuts at the Autumn Statement this Thursday, supposedly asking the country to buy into the same failed approach all over again.

New analysis prepared by NEF shows exactly what these cuts might mean for government departments. Even without further discretionary cuts, the effects of higher inflation since the spending review alone will see overall spending on resource departmental expenditure limits’ (RDEL) – day-to-day spending on public services – down by at least 8.3% in real terms (£43bn a year, today’s prices) between 2021/​22 and the end of the spending review period in 2024/​25. Here we use the consumer price index (CPI) measure of inflation rather than the more commonly used output measure (GDP deflator) for public spending, because the imported price shock from the past two years has driven a wedge between the two. If spending were to keep up with output prices only, it would imply deep real-terms cuts to public sector pay, damaging the quality of services through issues of recruitment, retention and morale.

Taking a longer view back to 2009/​10, and considering population adjusted spending by departments, shows just how serious the effective cuts purely from higher inflation will be. While many (though not all) departments have seen nominal spending per capita rise above 2009/​10 levels, for the majority this has been more than wiped out by inflation. For some it means spending per person falling back to the depths of the austerity years. For example, spending per head on education would be 17% (£226, today’s prices) lower than 2009/​10 levels by 2024/​25. Per capita spending at the Ministry of Justice is likely to fall 32% (£64, today’s prices) below 2009/​10. The NHS and social care will still have higher population adjusted spending in real terms compared to a decade ago, but thanks to the effects of inflation this could now fall by 2% (£49 per capita, today’s prices) between 2021/​22 and 2024/​25 – the first sustained fall of this kind in health spending since 2013.

Figure 1: After adjusting for inflation and population change almost all departments are set to see budgets fall below 2009/​10 levels again

The reality is that the government is planning to make additional cuts to spending on top of the effects of inflation. Our analysis shows the effects of this would be devastating. To illustrate what this might mean, we modelled the effects of taking either £5bn or £15bn a year out of day-to-day and investment budgets (respectively) by 2024/​2025. We exclude the NHS and social care budgets from day-to-day cuts as the government have indicated they are likely to be protected’ at least in nominal terms. Similarly, we exclude the Ministry of Defence and Foreign, Commonwealth and Development Office from investment cuts due to these likely being protected too.

For day-to-day public services, cuts at £15bn a year would see average spending per capita fall 10% below 2009/​10 levels in real terms, with some departments down to 55% below 2010 levels (Figure 2). Even education would see day-to-day spending per head fall 20% (£262, today’s price) below 2009/​10 levels by 2024/​25.

Figure 2: Further cuts on top of the effects of inflation could push per capita funding on services 10% below 2009/​10 levels

Austerity is being used as a deliberate political distraction from the real economic crisis

Of course, back in the real world, there is precious little justification for these spending cuts that stands up to serious interrogation. Two points in particular are key. The first is that the crisis itself has been deliberately misspecified for political expediency, since it is far better for the prime minister to focus opposition and media bandwidth on a notional fiscal crisis. This distracts from the real crisis of recession and cost of living, for which Rishi Sunak, as the previous chancellor, is more obviously culpable. The recent economy-driven deterioration in the public finances over the past six months is real, but as previously mentioned it is expected to be in line with the average seen between fiscal events in recent years, and the paths for debt and borrowing (respectively) are far lower in the UK than in much of the rest of the G7.

The real crisis is one of recession and rising prices, characterised by weak pay and social provision, long-term weak demand and the latest global supply-side shocks – all of which predate the past six months. These problems require active and redistributive (if not reflationary) fiscal policy in order to solve: not reduced debt and borrowing. The EU have completely suspended their fiscal rules until 2024 for this very reason. And in the words of the Director General of the Confederation of British Industry of all people (CBI), further cuts at this point will re-trigger an austerity doom loop”, where the government attempts to address the economic weakness brought on by public spending cuts by making even more cuts.

The second point is that, even if the crisis hadn’t been deliberately misspecified for political gain, much of the debate around the public finances lacks sufficient accuracy. Fiscal rules (targets for public debt and borrowing) actually tell us very little about fiscal space (the ability of governments to increase borrowing) which is dependent on a complex array of factors.

For example, with the Truss-Kwartang mini-budget we know rising debt per se was not the problem. Bond investors reacted nervously to both the anticipation of unfunded, regressive tax cuts over the summer, and then again when the tax cuts were confirmed at the September mini-budget. But in between there was no observable concern from the energy price freeze to protect the economy against imported inflation, despite this requiring a far larger increase in debt. Meanwhile countries like France and Germany set out similar overall paths for borrowing to fund price caps and social protections, also without a notable market reaction. Cleary it would seem it is not the level of public debt and borrowing that in the end matters; it’s what you use it for.

The actual numbers involved in the current public finance debate are also largely spurious. The fiscal hole’ has had various estimates starting at around £30bn. But all they represent is the difference between arbitrary targets for debt and borrowing, which are highly sensitive to nuances in accountancy classification; and uncertain forecasts, which are highly sensitive to even very small changes in economic fundamentals. For example, a one percentage point change in either GDP growth or government borrowing costs sustained over the forecast period is worth tens of billions in allowable (under the fiscal rules) public debt from 2025 onwards. And if the accountancy definition for public debt were to be reversed to the one used by government before October 2021, then any fiscal hole (based on current forecasts) could be wiped out entirely.

The current framework of fiscal rules is an extremely poor basis upon which to make spending cuts that will push the UK into a longer and deeper recession. Instead, political opposition, the public and the media should be calling on this government to address the actual crisis at hand. The required path is threefold: a change in the Bank’s mandate to make it easier to raise interest rates more slowly when inflation is imported and the underlying economy is weak; more targeted support for families struggling with the immediate cost of living, combined with more investment in energy efficiency and renewables to reduce exposure to high gas prices; and increased taxes on high incomes and wealth to ensure government spending doesn’t add to inflation overall.

Perhaps most important of all is that the UK learns the right lessons from the Truss-Kwartang mini-budget. The lesson is not that governments get punished for borrowing that supports the economy and society; rather it’s that they get punished for borrowing that fails to support the economy. Whether we can learn the right lesson today could define the 2020s.

Image: iStock/​DGLimages

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