Not what it said on the tin

As I have noted many times before, UK budgets are a strange mixture of policy announcements and pantomime and they exist in their present form purely for reasons of tradition. Once upon a time they were put together behind closed doors with ministers sworn to secrecy in case any of the details leaked out. Back in 1947 Chancellor of the Exchequer Hugh Dalton resigned after an off-the-cuff remark which hinted at forthcoming tax changes. But the era of ‘Budget Purdah’ is no more: We have been bombarded with news of what was likely to be in the autumn budget for weeks as the process morphs from a one-off event to a rolling news story. Indeed, the Speaker of the House of Commons expressed concerns that budget measures were leaked to the press before being announced in the House of Commons, which is a breach of protocol. The Deputy Speaker who presided over proceedings on Wednesday welcomed Chancellor Rishi Sunak to the Despatch Box with the pithy comment that she looked forward to the “remainder of your announcements.”

This does not mean that the process of digesting the information is any easier. The government’s 2021 budget was accompanied by the usual 192 page Budget Redbook, which this year also contained details of the Spending Review, whilst the OBR put out its regular 244 page Economic and Fiscal Outlook. Once we factor in the plethora of supporting documentation, it is clear that there is a huge quantity of material to digest. You can thus be sure that a serious amount of work has gone into the impressive overnight summaries produced by think tanks and the detailed analysis conducted by the quality press.

There are essentially three things to focus on in this year’s budget analysis: (i) what are the economic assumptions underpinning the budget; (ii) what fiscal measures has the government announced and (iii) how big is the spending envelope within which government departments have to work? These allow us to form an overall impression of the fiscal stance: The bottom line is that the projected outturns do not square with the message which the Chancellor has tried to put over. In short, living standards are likely to improve much more slowly than in the recent past; we are all going to be paying more taxes and the voracious health sector will continue to gobble up an increasing proportion of the nation’s resources. If the low tax, small state policies of Margaret Thatcher have long since been buried, this latest budget represents a dance on their grave.

The state of the economy

One of the defining features of the economic forecast is that real output is projected to get back to its pre-pandemic level by end-2021 which is slightly earlier than in the March projection and far sooner than anticipated last year. The OBR also reduced its estimate of the impact of the pandemic and now anticipates a permanent output loss of 2% (this was projected at 3% in March). However, it reckons that Brexit will lead to a permanent output loss of 4% in the longer-term. For all the concerns about the economics of the pandemic, it is Brexit that will inflict the most long-term damage. Obviously the pandemic feels like a big deal because the economic impacts are compressed into a relatively short time frame. Moreover the wider social costs are incalculable (140,000-plus deaths and counting) but much of the economic damage will be recouped quickly.

In many other ways the economy is predicted to quickly resume its pre-pandemic state with the unemployment rate on a two year horizon projected to fall to 4.2% – close to pre-2020 levels. One thing we will have to get used to is higher inflation, which the OBR forecasts will peak around 4.4% in the second quarter of 2022 – more than twice the BoE’s target rate – with risks tilted to the upside. Whilst this will squeeze real household incomes it will also inflate the tax base which will support tax revenues. All in all, there is not much to get excited about in the macro forecast. There are always areas for discussion but on the whole it seems a solid enough assessment. The real areas of disagreement lie in the fiscal detail.

The fiscal measures

The biggest single giveaway represented changes to Universal Credit designed to provide a boost to low earners (a £3bn giveaway over five years). This was welcome following the announcement last month that the temporary uplift to welfare payments during the pandemic was to be scrapped. In response to the storm of criticism that followed this decision, the Chancellor announced that the taper rate at which benefits are phased out as claimants transition back into employment is to be lowered. This was previously set at 63%, meaning that above a certain income threshold claimants lose 63p of every pound of benefit they receive, implying a very high marginal tax rate. This is to be reduced to 55% and is a move I have been advocating for a long time. However, as the Resolution Foundation points out, this is “not sufficient to compensate most UC recipients for the loss of the £20 a week uplift introduced at the start of the pandemic.”

Looking down the list of items, the next biggest giveaway was a further freeze on fuel duties (£1.6bn) – somewhat ironic given next week’s COP26 Summit at which the UK is hoping to take credit for brokering a global climate deal. Sunak also announced a 50% reduction in domestic Air Passenger Duty in order to “bolster UK air connectivity” which is similarly incongruous.

The spending envelope

The good news is that almost all departments will receive an increase in their day-to-day budgets over the period to fiscal 2024-25. The bad news is that in real terms many departmental budgets will remain below the levels prevailing when the Conservatives came to office in 2010. The era of austerity may be over but not by enough to overcome the damage done in the decade prior to the pandemic. One of the lessons we have learned the hard way is that spending on health is important and that it was underfunded prior to 2020. Thus spending on health and social care is projected to be over 40% higher in real terms by 2024-25 than in 2009-10. However, spending by the Department of Transport will be 32% lower in real terms and the Ministry of Justice will suffer a 12% cut (chart below). Sunak made great play of the fact that “the health capital budget will be the largest since 2010” and that the budget “will restore per pupil funding to 2010 levels in real terms.” Yet it is hardly a great boast that spending levels are to be restored to levels prevailing when the Tories took office 11 years ago, and calls into question what was achieved by the years of austerity.

What to make of it all

By common consensus this was a high tax and spend budget. It marks a seismic shift in the fiscal philosophy of a Conservative Party that has extolled the virtues of a small state and lower taxes for the last 40 years. Sunak’s goal may be to reduce taxes, as he told us in his budget speech, but in reality the overall tax burden is set to rise to its highest in 70 years. In some ways this is an inevitable response to the challenge posed by the pandemic. 

In his parliamentary speech Sunak outlined his old-style Tory leanings: “Do we want to live in a country where the response to every question is: “what is the government going to do about it”? Or do we choose to recognise that Government has limits.” The truth is that many people do want more government – or at least, they don’t want less. For a start they want some return on the large slice of income that they hand over in taxes. Furthermore the pandemic has highlighted the importance of having government act as a backstop (ditto the GFC of 2008-09). 

Sunak is an intelligent man and I am sure he knows this. The thought therefore persists that the budget was in part a job application to the Tory faithful in the event that they tire of Boris Johnson as leader, whilst simultaneously following Johnson’s requirement to shower the electorate with money. In the end all budgets come down to politics but this one perhaps more so than usual.

Finding a reverse gear

The Bank of England’s Monetary Policy Report is required reading for those interested in UK macro trends and today’s report was no exception. Listening to some of the media commentary ahead of the report’s release, people might have been forgiven for believing that monetary tightening was imminent. In reality, that was never the case although the BoE did provide some guidance on the sequencing as to how the easing of the policy throttle will occur.

The economic outlook supports lifting the foot off the gas

Turning first to the details, the BoE’s macro forecast suggested that UK GDP will grow by 7¼% in 2021 and 6% in 2022, and only slow to trend (1.5%) in 2023. One implication of this is that the level of output will get back to pre-recession levels by end-2021, which is a far sharper rebound than expected a year ago. As a result the output gap is expected to be almost eliminated this year and an excess demand position is anticipated in 2022 (i.e. a positive output gap). With inflation projected to hit 4% in Q4 2021/Q1 2022, questions have been raised as to whether the current exceptionally lax monetary stance is warranted.

One member of the MPC (Michael Saunders) voted to limit gilt purchases to £850bn (it currently stands at £825bn) rather than press on to the currently mandated upper limit of £875bn. Although the idea of calling a halt before reaching the current target is unlikely to make a great difference in the grand scheme of things, it would send a signal of intent that the BoE is prepared to scale back its asset purchases as circumstances dictate. Indeed, when the MPC announced an expansion of the upper limit for gilt purchases to £875bn in November 2020, inflation was expected to peak at 2.1% in late-2021/early-2022 whilst output was not expected to get back to pre-recession levels until early-2022 (i.e. one quarter later than in August).

As the MPC minutes pointed out, the MPC “had policy guidance in place specifying that it did not intend to tighten monetary policy at least until there was clear evidence that significant progress was being made in eliminating spare capacity and achieving the 2% inflation target sustainably.” Although “some members of the Committee judged that … the conditions were not yet met fully”, it is hard to know what more evidence they need to justify scaling back monetary easing with inflation running at twice the target rate and with the output gap set to close. It is important to stress at this point that I agree with those who believe it is perhaps too early to significantly tighten policy. But this is not to say there is a case for easing off the throttle. On the basis that the stock of assets purchased is more important for policy purposes than the flow of purchases, setting a lower limit for gilt purchases implies a very moderate reduction in the degree of planned monetary easing.

Dealing with tightening

The BoE did indicate that when the time for tightening comes, its preference is to use Bank Rate as the instrument of choice and suggested that “some modest tightening of monetary policy over the forecast period is likely to be necessary.” As the Resolution Foundation has pointed out, this has the advantage of being swift to implement and can swiftly be reversed if necessary. But the BoE also indicated that it “intends to begin to reduce the stock of purchased assets, by ceasing to reinvest maturing assets, when Bank Rate has risen to 0.5%.” This could lead to a swifter unwinding of the balance sheet than might be expected and would go a long way towards assuaging the concerns of those who believe the balance sheet is too big.

To illustrate the impact of this, we start by looking at the details of the debt stock currently held by the BoE (here). We can use this information set to determine the precise maturity date of gilts on the balance sheet and my calculations suggest that the median maturity of gilt holdings is just over eight years. Assuming that Bank Rate reaches 0.5% by end-2023 and does not fall back below this level, allowing all maturing debt to roll off will halve the balance sheet in money terms by 2034. Further assuming nominal GDP growth of around 4% per year in the longer term, gilt holdings would decline from around 40% of GDP in 2021 to 12% by 2034. The BoE may, of course, choose to reinvest a certain proportion of maturing debt, rather than letting it all run off, and the resultant stylised scenarios are shown in the chart below. It is notable that even if gilt holdings remained at £875bn over the longer-term, the GDP assumption used here would be sufficient to reduce the balance sheet relative to GDP back towards 2013 levels even in the absence of any direct action.

In addition, the Bank suggested that it would be prepared to consider selling off assets once Bank Rate reaches 1%, thus adopting an even faster rate of balance sheet reduction. In my view, for what it is worth, this may prove unnecessary given the sharp pace of reduction generated by ceasing reinvestment. It may also significantly complicate the government’s efforts to finance the deficit. After all, if the BoE is selling gilts into a market which is saturated by primary issuance, the upshot is likely to be a sharp rise in bond yields.

Whilst there clearly are some risks associated with a policy of running down the balance sheet, the BoE believes that “the impact on monetary conditions of a reduction in the stock of purchased assets, when conducted in a gradual and predictable manner and when markets are functioning normally, is likely to be smaller than that of asset purchases on average over the past.” In other words, running down the balance sheet gradually is likely to have only a modest impact on the economy. However, it is generally accepted that central bank balance sheets will not fall back to pre-2008 levels any time soon. For one thing, there has been an increase in demand for central bank reserves by the banking sector due to changes in regulation and banks’ risk management techniques which has resulted in increased demand for high quality liquid assets. For this reason, it is unlikely that the BoE will follow a policy of full disinvestment over the medium-term.

The likes of the now-departed Andy Haldane expressed concern that the BoE’s balance sheet was too big. Therefore reducing it over the medium-term is likely to diminish the criticism that the BoE is somehow engaged in deficit financing – a point Governor Andrew Bailey was keen to refute during today’s press conference. Nonetheless, balance sheet management is a policy tool which is here to stay. With downward pressure on equilibrium interest rates, as a result of population and productivity trends, the scope for using conventional interest rate policy is diminished and balance sheets will therefore remain a useful addition to the policy armoury. But just as increasing balance sheets proved to be controversial, so the process of running them down will likely prove to be a lot more difficult than currently imagined, as the 2013 US taper tantrum illustrated.

Five years on

Five years ago today the world awoke to find that the British electorate had narrowly voted in favour of leaving the EU. The pre-2016 era feels like another world: in many ways it was, not least because Covid has had an even more transformative effect on the political and economic landscape. Looking back, the impact of the Brexit shock remains vivid and neither Leavers nor Remainers have since covered themselves in glory. Regular readers will know I regret the decision to leave the EU, largely on economic grounds but also because the UK is no longer part of a block which amplifies its voice on the world stage. However, it makes little sense to replay the debates of the past five years.

A quick retrospective

Nonetheless, this week marks a good time to assess the impact of Brexit, giving rise to a number of retrospectives in the British press. One of the best commentaries I have seen is this one by always excellent Fintan O’Toole, who points out that the Remainers never had a big idea which could overpower the simple narrative of taking back control espoused by the Leavers. As he put it, “Leave offered some kind of an answer [to the question of what defined British identity] – albeit a very bad one. Remain barely recognised the question.” He also argues that the project was not subsequently weakened by the “political discourse [which] ought to have doomed it … [because] uncertainty about what Brexit would mean in reality allowed it to sustain its character as a gesture.”

As a summary of what has happened over the last five years that just about nails it. As an economist, my mistake was to try and offer economic arguments against Brexit – not that they are wrong, but the simple but powerful notion of “controlling our own laws and our own borders” was a much more compelling vision. The fact that this was and is complete tosh is irrelevant – it is difficult to argue against a messianic vision with mere facts. The bigger concern is not so much the losing of the referendum but the way the process of departure was subsequently conducted, as the government tied itself in knots to reconcile many of the irreconcilable arguments made during the campaign.

A consultative (non-binding) referendum was treated as a winner-takes-all event with little attempt to engage with the near-half of voters which opposed the outcome. Three years of intense political debate eroded trust in the political process and far from lancing the boil of Euroscepticism which David Cameron feared would swamp his Conservative Party, the divisions opened up by the referendum have if anything grown deeper. This in turn has weakened the ties that bind the United Kingdom and given support to Eurosceptic movements in continental Europe. As the historian Timothy Garton Ash has pointed out, we find ourselves in a lose-lose position and it appears that the culture war which has largely been confined to the US for the last 25 years has now washed up on European shores.

A look at the economics

From an economic perspective there are no good arguments in favour of Brexit. Imposing barriers to trade with our biggest trading partner has no merit. The government has been telling us since 2016 that the UK will be able to strike better trade deals with third countries than those drawn up by the EU. There is little evidence so far that this is bearing fruit. Most of the agreements that have been struck so far represent a rolling over of existing EU trade arrangements. The first trade agreement to be drawn up from scratch was the recently-announced deal with Australia. However the government’s own figures suggest that this will increase UK GDP by just 0.02% over the next 15 years which is, to all intents and purposes, zero. On the basis that “the additional trade barriers associated with leaving the EU” will subtract around 4% from UK GDP over that period, Britain needs 200 Australia-type trade agreements merely to offset what has already been lost. To the extent that distance is one of the biggest obstacles to goods trade, the Australia trade deal is a largely meaningless exercise.

That said, most people have not really noticed the economic impact of Brexit (though in fairness, most people have not travelled abroad since the Covid crisis hit). But many exporters have highlighted the difficulties resulting from the erection of trade barriers and although year-on-year comparisons are distorted by Covid effects, a pattern is emerging whereby trade with the EU has fallen by far more than with the rest of the world. A recent report by the Food and Drink Federation noted that UK food and drink exports to the EU in Q1 2021 were 28% lower than a year ago whilst remaining unchanged to non-EU markets. On a more positive note, ONS aggregate data suggest that trade flows are slowly normalising but there is no doubt that UK-EU trade has taken a hit.

A synthetic control assessment

To obtain a handle on the joint impact of Brexit and Covid I have attempted a synthetic control exercise which constructs a synthetic (or “Doppelgänger”) GDP index for the UK based on trends in a panel of 23 other countries. The rationale behind the analysis is to use GDP outcomes in the control group to approximate what might otherwise have happened in the UK. When I conducted the analysis two years ago, I concluded that UK GDP was around 2.5% below what might otherwise have been expected which I attributed to Brexit-related uncertainty. Latest estimates suggest that GDP in 2021 Q1 was almost 10% below the synthetic indicator.

As can be seen from the chart, the UK began to underperform during 2017 as Brexit-related uncertainty kicked in and by Q1 2020 GDP was 4% below the synthetic control index which is in line with estimates made in 2016. However this pales into insignificance compared to the impact at the start of 2021. It is likely (but not certain) that the Covid-related output collapse contributed most to this underperformance and we will only be able to assess the impact of Brexit once the Covid shock dissipates.

Markets giving the benefit of the doubt

Despite this poor performance, markets have given the UK the benefit of the doubt with sterling trading at around 1.39 against the USD versus 1.36 at the start of the year (a gain of around 2%). In a similar vein, GBP is up around 5% versus the EUR whist the BoE’s broad effective exchange rate has appreciated by 4.1% since the start of the year. Sterling is still a long way short of where it was on 23 June 2016 (6.3% down on an effective basis) but it does seem to be moving in the right direction. UK stocks also continue to look cheap on an international comparative basis and there has been much discussion in recent months that the relative post-Brexit stability represents a good time to buy into the UK market.

To the extent that Brexit has not represented a seismic shock, there are good reasons why international investors might want to dip their toe in a market they have shunned in recent years. To the extent that much of the recent underperformance was the result of self-inflicted policy errors, so long as the government can avoid the mistakes of the last three years there may be some scope for catch-up. But the truth is we do not know how Brexit will pan out nor what the final balance of costs and benefits will be. Whilst Brexit has not proven to be a seismic economic event it may well prove to be a boiled frog problem with the cumulative effects building up over time. As it fades from the forefront of our consciousness and ceases to be the headline-grabbing event that has shaped the news agenda over recent years the devil will continue to make its presence felt in the economic detail.