The (un)changing face of politics

Although I have tried hard to steer clear of politics on this blog over the last year or so in order to focus on the economics, in many ways the two subjects are intertwined. The onset of the global financial crisis in 2008 raised a number of questions that politicians have failed to answer, with the result that the discontent which was already bubbling under the surface spilled out in ways that mainstream politicians have been unable to counter. Populists and authoritarians have had a field day, giving us Orban in Hungary; the Law and Justice Party (PiS) in Poland, not to mention Trump in the US and the Brexit crowd on this side of the pond. But the complexities of real life conspire to confound the simple appeal of many populists, with the result that PiS is a diminished (though still important) force in Polish politics; Trump is out of office (for now) and the gang of zealots that inflicted Brexit upon the UK seem to be fading away into the background.

Indeed, for a long time the British government has appeared to be drifting inexorably to the right, engaging in culture war rhetoric rather than attempting to tackle some of the bigger economic and social problems facing the UK. The sacking of Home Secretary Suella Braverman (the reasons for which you can read here) perhaps marks a watershed as Prime Minister Rishi Sunak realises that the further towards the fringes his party goes, the less likely they are to escape a major trouncing at the next general election, which is expected to be held anytime in the next 6-12 months. The surprise return of former PM David Cameron as Foreign Secretary is the big news, both at home and abroad, and is a sure sign that Sunak is attempting to drag his party back towards the centre before it is too late. If nothing else, it may reassure Tory voters in the shires who have increasingly found the current incarnation of the party unpalatable.

Whether or not Cameron will be the right person to convince the electorate is moot. After all, he is widely blamed for losing the Brexit referendum and ushering in a series of prime ministers who proved themselves more inept than their predecessor (Sunak broke that trend, although he did follow Liz Truss, whose main claim to fame in the eyes of many voters is that she was outlasted by a lettuce). And in an irony that has not gone unnoticed on social media, since Cameron is no longer an MP, he can only enter government by sitting in the House of Lords and cannot be held to account by the House of Commons. Remind me again, but wasn’t one of the benefits of Brexit that we could get rid of unelected bureaucrats?

While it is certainly possible – indeed likely – that changing the composition of his government will allow Sunak to eat into Labour’s polling lead, which has averaged 19 points over the past year (chart above), will voters be sufficiently pacified to draw a line under the last seven years of chaos? If the evidence which is emerging from the Covid inquiry is any guide, Conservative politicians of recent years have a lot to answer for. The tales of incompetence which emerged under Boris Johnson’s leadership will not easily be forgiven or forgotten, highlighting the extent to which governance has been compromised. The Truss government’s short-lived but chaotic tenure severely damaged the Conservatives’ reputation for economic competence while politically contentious decisions such as the cancellation of the northern leg of the HS2 rail project will do little to convince voters in the north that the Conservatives deserve another term in office.

It's the economy stupid

It is only four years since the last election and a lot of water has since flowed under the bridge. But one of the great consistencies of the intervening period has been the Conservative government’s failure to interpret the electorate’s mood in 2019. It did not win a huge mandate because the electorate was concerned about immigration or “wokeism” but rather because it wanted an end to the Brexit wrangling, which Johnson promised, and because Jeremy Corbyn was viewed as an unelectable leader of the opposition.

Matters have been compounded by the fact that the government has failed to deliver on its levelling up agenda – not altogether a problem of its own making, since the pandemic drove a coach and horses through that policy. It has also presided over the fastest rate of inflation in four decades – again the result of forces outside its control. However, it has doubled down on Brexit despite evidence that this is an increasingly unpopular policy, and voter satisfaction with the NHS has fallen to record lows, which is increasingly blamed on government policy (some of which is fair criticism, some of which is not).

Brexit is not to blame for many of the economic ills that the UK now faces, although it does compound them. Dissatisfaction over the state of public services is to a large extent the consequence of the austerity policy introduced by the Cameron government, which resulted in a two percentage point decline in the central government contribution to local authority financing (chart above). Increased unhappiness over the provision of services by public utilities is partly due to a lack of private sector investment following the privatisation of many of these utilities in the 1980s and 1990s. A policy of less government and more private sector involvement is thus not perceived by voters to be acting in their best interests. The debate is obviously more complex than that, but as I have pointed out many times before, the UK cannot afford to operate the same economic model as it did between 1979 and the onset of the GFC in 2008. Demographics are increasingly a headwind and there is no North Sea oil to fund tax cuts. Like all western economies, the UK looks set to experience a sharp slowdown in growth and a commensurate slowdown in the pace at which living standards improve.

As we look ahead to the next election, the party that does best will be the one that has a credible plan to tackle many of the UK’s underlying economic ills. How this will be done is a subject for another time. But changing government personnel does not sound like the game-changer that the UK needs. Forget culture wars and wokeism – the next election will be fought against the backdrop of the economy. Or as Bill Clinton’s strategist James Carville put it in 1992: “it’s the economy stupid”.

Alienation nation

It has been a hell of a month in the UK. Four weeks ago, the death of the Queen marked a symbolic shift in the institutional fabric, the implications of which we have yet to work out. Her funeral was an event televised around the world and confirmed that whatever else the UK does, it remains a world leader in pomp and ceremony and projecting its imperial past to relay an image of itself far beyond its significance as a modern global power. Four days after Her Majesty was laid to rest, the realities of modern Britain were highlighted by the government’s unveiling of what was described as the worst budget (sorry, not a budget – a fiscal event) of modern times – perhaps ever.

As an economic package it was gobsmackingly awful. For the full details, see here. But in short, the government (or perhaps we had better describe them as the latest collection of radicals to hold parliamentary office) outlined a Growth Plan with the stated aim of restoring the trend GDP growth rate to 2.5%. This entailed a series of supply side measures which amounted to unfunded tax cuts totalling £45bn or 2% of GDP. The rise in NICs announced last year will be reversed; planned increases in corporation taxes are to be scrapped; the basic rate of income tax will be reduced from 20% to 19% next April and it planned to abolish the higher rate of income taxation (45%) before it did a U-turn on the idea.

As a package of economic measures, it was always doomed to fail. First, the UK’s trend growth rate is hampered by unfavourable demographics so it will be hard to raise without a very big rise in productivity. The evidence does not support the notion that companies will boost investment in response to lower taxes, thus putting a hole in the productivity-enhancing rationale for lower taxes. In addition, an influential IMF paper in 2015 comprehensively debunked the notion that cutting taxes for the well-off has any impact on growth (“a rising income share of the top 20 percent results in lower growth – that is, when the rich get richer, benefits do not trickle down”).

As a political gambit, the fiscal event is probably the worst brand-destroying exercise since jeweller Gerald Ratner described his products as “total crap” and suggested that some of the earrings he peddled were “cheaper than a prawn sandwich from Marks and Spencer’s, but I have to say the sandwich will probably last longer than the earrings.” Ratner did not last long in the job after that. The findings by the Resolution Foundation that the richest 20% of earners will benefit from two-thirds of the gains from lower taxes may not directly have influenced voters, but they know well enough when they are getting a raw deal. This has contributed to Labour’s opinion poll lead widening from 12% four days ago to 24% today (chart below). Just as in 1992 when the perception of Tory economic competence was shattered by sterling’s ejection from the ERM, so the fiscal events of recent weeks could have the same impact on the current government.

Indeed, it was the pound that was initially the centre of attention in this fiasco as it briefly plunged to all-time lows against the dollar early last week. But it is the gilt market, where rising yields forced pension funds to scramble for cash to meet margin calls on their hedging instruments, where attention is focused and BoE action to calm the market (the merits of the BoE's actions are a subject for another day). To the extent that mortgages are priced off the gilt curve, rising yields imply that mortgage rates are likely to rise sharply, thus making life harder for households already facing a major cost-of-living squeeze. As it is, data from Refinitiv suggest that the 129 bps rise in 10-year gilt yields in September was the biggest monthly jump on record (chart below).

What’s next?

If the last few weeks have demonstrated anything it is that handing the keys to the kingdom to increasingly ideological governments is doing no favours for the economy or the majority of most of those dependent on it. Indeed as the excellent FT infographic (below) suggests, “out of 275 parties in 61 countries, the Tories under Trussonomics rank as the most rightwing of all” with the author concluding that “The Tories have become unmoored from the British people.”

It has almost become a cliché to repeat Dean Acheson’s 1962 quip that Britain lost an empire but failed to find a role but it goes to the heart of the Brexiteer fantasy that somehow leaving the EU would restore past glories. What many of us pointed out is that it would actually weaken Britain, exposing those weaknesses that could be masked by remaining within the EU. But at least Britain could console itself with the fact that it had a stable political system, not prone to chaos, and administered by a competent civil service.

Chaos is now the watchword in government and whilst the competence of the civil service is not in question, the firing by Kwasi Kwarteng of his most senior Treasury official sends a bad signal about the quality of advice the government can expect to receive. The fact that the OBR’s offer to provide an economic assessment of the government’s fiscal plan was rejected also calls into question the form of scrutiny to which the government is prepared to be subjected.

The fact that the government has back-tracked on cutting the 45% tax rate is a further forced error from both a political and market angle. It was slated to cost only £2bn and will not change the market’s view of the unfunded tax giveaway. The real error is failing to find ways to plug the revenue gap resulting from NIC cuts and income tax reductions. Markets will not easily be assuaged although the fact that yields fell following the announcement suggests that they expect more backtracking in the weeks to come. Politically, the government now looks weak because it has performed a U-turn despite Liz Truss’s assertion yesterday that she was committed to abolishing the 45% tax rate. Moreover, if market pressure does force the government to find savings, it may be forced to cut spending further. It is pretty certain this will not be a vote winner. Public services have been stripped to the bone in the last decade and voter appetite for further austerity is limited.

I concluded my last blog post more in hope than expectation by noting that “voters will be hoping that she [Truss] can deliver them out of the dark place into which Boris Johnson led them. Surely she cannot do worse. Can she?” A month in the job and she has more than lived down to expectations. Every prime minister it seems, manages to be worse than the last. This is not a cycle that the country can afford to continue. In the words of Martin Wolf in an unusually strongly worded FT opinion piece, “these people are mad, bad and dangerous. They have to go.”

In Liz we Truss(t)

Three years and 43 days ago, I asked “If Johnson is the answer, what is the question?” I never did get an answer to that question. As the blond bombshell moves out of Downing Street to be replaced by Liz Truss, a similar question can be asked of her. But whereas Johnson “only” had to deal with the difficulties of Brexit, Truss has two problems to contend with. On the one hand, she faces arguably the most toxic combination of economic circumstances in living memory. On the other she leads a fractured and fractious party which seems in many respects to have lost its way. How she deals with these issues will not only define her premiership; it may well determine the future of the current incarnation of the Conservative Party.

Over the summer, as the Tory Party devoted its efforts to matters other than governing, there was a distinct sense that many voters felt abandoned as the cost-of-living crisis intensified. This has been reflected in polling data which give Labour an 11 point lead – not by any means terminal for Truss but not a good position from which to start. Aside from the cost-of-living issues, there are a whole lot of other matters in her in-tray which her predecessor singularly failed to tackle (indeed, probably made worse): the increasing strain on the NHS; generally low morale amongst public sector workers and the dreadful state of the criminal justice system to name but three domestic items. Added to this are international matters such as maintaining relationships with the EU and dealing with Russia and an increasingly assertive China. Perhaps Rishi Sunak can console himself that the leadership contest was a good one to lose.

Big government is back

However much Truss may profess her love of a small state and associated low taxes (her campaign pledges included unfunded tax cuts), all western European nations now realise that the state will have a big role to play in keeping the economy – perhaps even the wider social fabric – intact. Nowhere is this more evident than in the debate over how to provide support to consumers whose energy bills will spike sharply this winter in the absence of intervention.

Despite her opposition to “handouts” Truss really has little choice – politically and economically – other than to cap household energy bills which would otherwise rise by 80% in October, with the average household paying £3549 per year (150% more than in winter 2021-22). The prospect of a further 50% rise in January 2023 would mean that the average household would be required to pay 17% of its net income in the form of energy costs. To get a sense of how big this increase is in real terms, see the chart below based on calculations by the Resolution Foundation. This would make its presence felt in inflation, which the BoE estimated in August would hit 13% at the end of 2022 and would feed through to affect other prices where energy is a significant input cost. The fact that the price cap is likely to rise even more than the BoE assumed suggests that inflation would rise even further with Goldman Sachs suggesting that this could push inflation above 20% in the early months of next year.

On the basis that many businesses would go to the wall if the full costs of energy were passed on to the consumer, the government is believed to want to limit the rise in energy bills to around 27% (restricting average household bills to a still-significant £2500 per year). But this will not come cheap. It has been suggested that freezing household energy bills at current levels could cost up to £100bn (over 4% of GDP) as the government subsidises the difference between the price paid by the distributor and the consumer, with another £50bn expected for business support. What then becomes important is how the subsidy is funded. 

One option would be to levy a windfall tax on the profits of energy distributors. Since the cap is designed to limit the amount that distributors can charge per unit of energy such that their profit margin is limited to 1.9%, if the wholesale price of energy were to double, so profits also double. The case for a tax on these excess profits is appealing on social justice grounds. However, Truss takes the view that levying higher taxes sends the wrong signal for a government that wants to support enterprise. Consequently, it is likely that the government will fund the subsidy by increased borrowing. This will of course raise debt levels, and the idea that a future generation of taxpayers should fund the energy needs of today’s consumers may strike some as distasteful.

Suggestions that the Truss government will reverse the recent rises in corporation taxes and NICs in a budget later this month at a time when the public sector is desperate for additional funding does strike me as bad policy. As I have noted previously, the UK (in common with other western European nations) does not have the favourable demographic profile that will prevent tax cuts from putting a significant hole in public finances – in contrast to the 1980s. Back in 2010, Bill Gross described the Gilt market as resting on a bed of nitroglycerine. What was an inaccurate portrait of UK public finances in 2010 may be more apt description of the current situation.

The political dimension

We should also not overlook the political challenges that Truss will face. Although she won 57% of the votes cast in the leadership ballot, this was on a turnout of 82% implying that only 47% of those eligible voted for her. The fact that 53% of party members voted for her opponent or did not vote at all, is hardly a ringing endorsement. It should not be forgotten that Rishi Sunak polled more votes than Truss amongst MPs in each of the five ballots prior to the final one amongst party members. Although the Tories will present a unified face  in public – at least for a while – there is little doubt that the Tory party remains split along ideological lines with the Brexit fissures continuing to run deep.

The ultras in her cabinet and on the backbenches continue to see the EU as the bogeyman responsible for many of the UK’s ills. Truss herself has become a convert to the Brexit cause. Despite having supported Remain in 2016, she has had to continue to sound hawkish on Brexit in order to appeal to the party faithful. However, as every PM has found to their cost, tough talking is not the way to achieve success in EU negotiations. Worse still, with the global geopolitical situation increasingly unstable, it is incumbent on the UK to find common cause with the EU on a range of economic and political issues. Truss knows only too well that the EU issue has played a role, directly or indirectly, in the downfall of her three immediate predecessors. 

Whatever one’s views on Truss – and her approval ratings are not exactly stellar – voters will be hoping that she can deliver them out of the dark place into which Boris Johnson led them. Surely she cannot do worse. Can she?