Don't Panic: Truss vs the Sensibles

The IMF, the £, and the mini-budget

The IMF is less than impressed with Liz Truss and Kwasi Kwarteng’s first mini-budget. It’s worth quoting their statement in full:

“We are closely monitoring recent economic developments in the UK and are engaged with the authorities. We understand that the sizable fiscal package announced aims at helping families and businesses deal with the energy shock and at boosting growth via tax cuts and supply measures.

However, given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture, as it is important that fiscal policy does not work at cross purposes to monetary policy. Furthermore, the nature of the UK measures will likely increase inequality. The November 23 budget will present an early opportunity for the UK government to consider ways to provide support that is more targeted and reevaluate the tax measures, especially those that benefit high income earners.”

As Sky's Ed Conway notes, it's “the kind of statement one normally expects to hear about an emerging economy facing a current account crisis”. But emerging economies in crisis rarely have oversubscribed bond auctions, and the UK does. So what's going on here?

The principle objection is that UK fiscal policy is going to undermine the Bank of England’s good work, feeding into inflationary pressures. There are two components to this concern. The first is the government’s commitment to capping energy prices. This is expected to cost about £60 billion over the next six months, and, given the newfound proclivity for gas pipelines to mysteriously explode, could end up costing rather a lot more.

But the energy price cap is a rare example of a government policy that spends a lot of money while reducing inflation; the Bank of England directly credits it with CPI inflation being expected to rise less. This shouldn’t surprise us: inflation includes energy prices directly and indirectly, as they drive up the cost of other goods. Holding energy prices down holds measured inflation down, at the cost of running up a tab for the future. It would definitely be better to target this support - as I’ve written elsewhere - but it’s not previously caused market panic.

This leaves us with the second component: the package of tax cuts, valued at around £45 billion per year in the long run. But note that phrasing: over the nearer term, the various tax cuts and changes are worth rather less: £4 billion this year, and £27 billion next. This is a smaller boost to demand, and one that's easier for the Bank of England to deal with; nobody thought the £15 billion cost of living package announced in April would drive prices spiralling out of control. Even taking into account permanent income considerations, the existence of credit constraints means the short-term demand boost is unlikely to be massive. And markets didn't panic when Truss won the leadership race, despite committing to the most expensive cuts in advance.

The IMF cares more about equality than growth

So if the government isn’t about to send inflation spiralling out of control, why is the IMF freaking out? One possible answer lies in the second part of the statement: “the nature of the UK measures will likely increase inequality… [the government might want to] reevaluate the tax measures, especially those that benefit high income earners”.

This is a bizarre statement to make. The UK is substantially less unequal than the USA, and the inequality/growth relationship is not particularly strong for developed economies. Should the IMF be expressing concern that the American economy will be undermined by its low top tax rates?

The cut in the highest rate of tax from 45% to 40% has driven a huge amount of media coverage, but is expected to cost around £2 billion a year once behavioural responses are taken into account. As the IFS notes, it may very plausibly end up costing nothing.

It does, however, run contrary to an interesting strain of thought that has begun to predominate the IMF’s guidance to Britain. In this analysis, what really matters is how equal a country is, rather than how well off rich and poor are. It’s the failure of people to understand this important principle that sees misguided souls leave countries like Pakistan - fractionally less unequal than Britain - in the mistaken belief that they will live better lives in the UK.

To get a taste of how the Fund thinks Britain should be run, we can look at their country reports from earlier in this year. The UK needed a “revenue-based strategy” for funding government spending, which meant tax rises. Among the suggested options were increasing income tax for the upper 50% of the population, applying a one-off wealth tax “payable on all individual wealth… above £2bn and charged at 1 percent a year for five years”, or raising dividend taxes for higher rate payers to 26%.

These suggestions are insane. Economists uniformly recommend against ‘one-off’ wealth taxes precisely because after a government’s done it once, nobody will ever believe that they won’t do it again. The damage this does to the incentive to invest or situate wealth in Britain would be huge, particularly as it probably wouldn’t actually raise very much: anyone with more than £2bn in assets is likely to simply leave the country rather than pay. Similarly, taxing dividends for the people most likely to invest in companies is a great way to shut off capital for British firms.

The March of the Sensibles

One explanation for this is that the IMF has been captured by a deep cover cabal of Soviet sleeper agents desperate to bring down the capitalist system and revert to communism. I am sympathetic to this argument, but think we can probably do better. Financial markets didn’t much like the Truss budget either, and while they may be many things they are rarely hotbeds of Trotskyism.

I’ve written about the market reaction elsewhere, but to summarise, my view is that they are understandably pessimistic about the ability of the UK government to produce the sort of supply growth it’s promising. They expect inflation to increase. Generally, this should drive a currency upwards (see my thread here). This means the drop signals either a sudden panic over the long-term fiscal sustainability of the UK, which would be entirely unwarranted, the competence of the government (which won’t affect the previous), or - most plausibly - Mike Bird’s suggestion that markets don’t think the Bank of England will do its job sufficiently well to mop up the inflation created by the tax cuts (although, again, it’s debatable just how much inflation will be caused).

The IMF’s reaction doesn’t fit neatly into these categories, and I think that’s because it’s driven by something else entirely. The IMF is staffed by a certain sort of person who is commonly found in the policy world, writing at papers like the Financial Times, working at think tanks like the IFS, or speaking soberly about fiscal sustainability in the Treasury. We can call this group the Sensibles.

Sensibles pride themselves on being, above all else, Sensible. Sensible means not doing anything that might rock the boat; like the apocryphal provincial official, their working orders are to ensure that nothing changes. In macroeconomic policy, that means making sure that the government doesn’t do anything unusual. If the country is on a long, slow path of decline - like the UK very much is - then that’s bad. But if an attempt to shake that up fails and drives up borrowing costs, that’s much worse: now you’re paying more on your debt, and still in decline. Much better to try the Approved Method again and see if it works this time.

The Sensibles hated the mini-budget. It put growth ahead of the deficit. It didn’t go out of its way to appease bond markets and keep borrowing rates ultra low - resulting in borrowing costs rising to a dizzying 0.2% real yield. It made lots of sweeping statements about planning reform and deregulation - risky! It wasn’t at all what British economic policy orthodoxy has preached for the last decade.

The Sensibles have quite a lot riding on this. If the mini-budget and the associated supply side reforms work in the long run, then everything we were repeatedly told was Sensible was not. This would be quite damaging if your career is based on sitting in an office and wisely telling people that changing anything is bad. Doubling down on Sensibleness is the only response open to the mini-budget: if you can bully Truss into changing course, then Sensibleness prevails. If Truss changes course after failing to get further supply side reforms through, you look like a genius. And if the policies work, well - you’ve lost anyway.

Image courtesy of Esperluette on Flickr