Photographer: Jose Luis Magana
Provider: AP
Source: FR159526 AP
This is Armchair Economics with Hamish McRae, a subscriber-only newsletter from i. If you’d like to get this direct to your inbox, every single week, you can sign up here.
Rachel Reeves has set out her stall: to increase growth was “our mission for the duration of this parliament”. So what should we think?
The first point is that when a government gives a fiscal boost to the economy it will, in the short-term at least, grow faster than it otherwise would have done. As the Office for Budget Responsibility puts it, “this Budget delivers a large, sustained increase in spending, taxation, and borrowing”. With only half the increase in spending financed by higher taxation and the rest by an increase of £32bn in borrowing, this is “one of the largest fiscal loosenings of any fiscal event in recent decades”.
So there will be more growth. But the aim, or at least the projections set out by the OBR, look modest. Yes, there is the forecast of 2 per cent growth next year, but beyond that growth is expected to be below 2 per cent through the rest of this decade. By the standards of the past few years that might seem encouraging. But on a very long view it is disappointing: the growth rate of the economy before the financial crash of 2007/08 settled between 2.25 per cent and 2.5 per cent a year.
Headwinds
Growth was at the top end of that range when Gordon Brown, the Chancellor in 2005, claimed that the country had experienced the longest period of sustained growth for 300 years. If the economy as a whole could achieve a 2 per cent annual increase in productivity, overall growth should far exceed 2 per cent, given the expected growth in the population over the next few years.
So the target is modest, not only by pre-2007 standards but compared with the US, where growth over the past decade has been much better than any of the other G7 countries. You might expect, given the UK’s number three position in AI development that Britain might be closer to America in its growth potential.
So there is a real possibility, given the additional spending on infrastructure outlined in the Budget, that growth might end up beating the undemanding numbers set out by the OBR. However there are three headwinds that the economy has to push against, and if anything the measures the Chancellor set out may make it harder for it to do so.
Gilt yields
One is the impact on employment. The increases in employers’ national insurance contributions, coupled with the rises in the living wage and the separate changes to labour legislation, will have some effect on employment. We don’t know how much. They could, in a strong labour market, be quite small. Maybe companies will be able to pass on the higher costs by increasing their prices. Maybe they can absorb the additional cost by boosting productivity of their staff. But there is a risk that employment will fall, and if that happens to any serious extent, not only does growth take a hit. The tax take falls too.
The second danger is the impact of higher borrowing on long-term interest rates. If the Government has to pay more to borrow, then everyone else does too. The reaction on the markets yesterday was discouraging. Gilt yields have in any case been rising over the past few days, as the stories came out that the Government was planning to borrow a lot more. However, at the start of the Chancellor’s speech the 10-year gilt yield dipped below 4.2 per cent, but as the news settled in, the yield shot up to over 4.4 per cent. It then settled back a bit, but was still well up on the day.
We should not make too much of any one day’s movement, but that was by any standards a big jump in the cost of credit. The Government has to accept that it will probably have to pay more for servicing the national debt than it would have done had it not changed the fiscal rules and upped its borrowings. That rise affects all would-be borrowers, including companies and home buyers, and therefore will be a dampener on the economy as a whole.
Spend less and save more
And third, there is the impact of the changes on what the famous economist, John Maynard Keynes, dubbed “animal spirits” in the 1930s. These are the emotional factors that influence economic decision-making – whether people are confident and take risks, or conversely batten down and try to spend less and save more.
We don’t know what the impact of the Budget will be on the emotions of business executives, investors, consumers, home buyers – the whole range of people who in their day-to-day decisions help shape economic outcomes. That is something that will emerge only gradually in the coming months. The initial market reaction was pretty muted, with the tax changes being not as bad as expected, pushing up the share prices of medium-sized UK companies a bit.
But that was offset by the borrowing numbers, which were rather worse.
Put it this way: Rachel Reeves went out of her way to stress how dire the economic inheritance she faced, and that was not designed to cheer people up. No lift to animal spirits there.
So yes, there are reasons to expect a short-term boost to growth from the Budget, but whether it will be sustained is another matter altogether.
Need to know
One of the endlessly fascinating things about economics is that we don’t know how people react to what are, in the broader scheme of things, quite small tax and spending changes. This Budget is a classic journey into that unknown territory. There is the impact on employment noted above, where my instinct is that in a strong job market the NICs increase probably would have little impact. But in a weaker job market, it could be big. I also fear that the changes in employment legislation will have a bigger negative effect than the NICs, but I really don’t know.
On the cost of borrowing, the biggest influence of all may turn out to be who wins the US election next week – and have nothing to do with us here. A Trump win would push up bond yields there, and I expect we would be caught in the crossfire, and see our rates go up too. I was worried by that jump in gilt yields, but maybe they will settle down in a couple of days’ time. As always when it comes to budgets, second thoughts are better than first ones.
As for the animal spirits thing, the bit of economic theory I find most helpful is called “revealed preference”: basically that you look at what people do rather than what they say they would like to do. It was developed by Paul Samuelson in 1938, and there is a good simple description here.
Remember that before Donald Trump became President in 2016 a lot of Hollywood celebrities said they would leave the country if he were elected? But they didn’t. On the other hand a lot of non-doms have indeed left the UK.
So will people choose not to start businesses in Britain, or do so instead in Dubai or wherever, as a result of the various changes yesterday? We can never know. I am reminded of a time some years ago when I was talking with a very senior Welsh politician. We were talking about Wales’s strict planning controls and whether they discouraged inward foreign investment. He said there had been only one instance where this had happened, so the controls were not a serious problem. I nearly replied by asking him whether he had any idea of how many foreign firms had heard of the story, and decided not to bother even including Wales as an option for location. But then I shut up because it would have been rude.
Moral: look at what people do, not what they say.
This is Armchair Economics with Hamish McRae, a subscriber-only newsletter from i. If you’d like to get this direct to your inbox, every single week, you can sign up here.