Is Sunak Going To Overcorrect Truss’s Fiscal Mistakes?

(Bloomberg Opinion) -- There’s a school of thought that says the mini-budget Liz Truss and Kwasi Kwarteng announced in September was a disaster not because Britain’s economy couldn’t handle tax-cutting or added borrowing, but because they failed to “roll the pitch,” or prepare markets for what was to follow. We’ll never know.

But in the short time since he’s been prime minister, Rishi Sunak is doing a lot of pitch-rolling — only it’s in the other direction.

Sunak and his Chancellor of the Exchequer Jeremy Hunt are preparing the public for an increased tax burden and far-reaching spending cuts. Sunak will be hoping, first, that his plan reestablishes the government’s reputation for fiscal probity. That in turn should reduce borrowing costs and make it easier to release the reins. But he also no doubt wants to give himself room to cut the tax burden closer to a general election.

Will any of this help create conditions for growth? Bloomberg Opinion’s Therese Raphael speaks with Bloomberg Economics’ Dan Hanson about what’s ahead.  

Therese Raphael: Whatever the Bank of England decides on Thursday — and the consensus is for a 75 basis-point rate hike — it will be based on the assumption of a pretty sharp fiscal consolidation when the government announces its plan on Nov. 17. What level of spending cuts will Hunt need to find later this month to allow the BOE to loosen monetary policy down the line or at least prevent further hikes? 

Dan Hanson: The numbers being talked about, a consolidation of somewhere between £30 billion ($34.8 billion) and £50 billion, make it likely that the BOE will eventually pivot toward cuts, but probably not until it has seen inflation fall to within touching distance of its 2% target.

Remember, the decision to end the price cap on household energy bills early, which was part of Hunt’s strategy to shore up market confidence, will mean inflation is higher next year than it otherwise would have been. We now expect annual CPI to average 9% instead of 5.5% in a world where the cap was kept in place for two years. That will limit the space for the BOE to cut, even if the economy is in the throes of a recession.

TR: Sunak says Truss was right to call out the UK’s poor record on growth. It’s hard to disagree. But what does his plan, which is feeling a lot like Austerity 2.0, mean for the UK’s growth prospects?

DH: The impact on growth will depend a lot on the profile of spending cuts and tax rises. The greater the front-loading (that is, the more pain is taken on early as opposed to spread out over time), the bigger the likely economic impact. That’s because monetary policy operates with a lag so the BOE would not be able to offset the effects. I also doubt the BOE would be willing to ease its stance over 2023 given the outlook for inflation.

In our forecast, we have assumed the consolidation ramps up over the next five years, knocking about 0.2 percentage points off growth in 2023 and 2024. Beyond 2024, we assume the BOE keeps monetary policy looser than it otherwise would, to keep the economy running on trend.

TR: Instead of tax cuts without cuts to spending under Truss, we’re now set to get tax increases along with extensive spending cuts. Is there a danger that this government will overcorrect by hitting the fiscal brakes too hard? 

DH: Absolutely. A lot of the hard work restoring confidence in UK assets has been done, with Hunt reversing the majority of the tax giveaways and announcing that he will set out a plan to get the debt burden falling. Rishi Sunak’s presence as PM also appears to have bolstered sentiment.

Clearly the government has to make good on its commitment to fiscal sustainability, but I think the cost to the economy of overcooking the consolidation outweighs the credibility dividend of pulling the debt burden down quickly. Remember the economy is facing a recession, probably akin to the one seen the 1990s. Fiscal policy has a role in providing support during this difficult period.

TR: Sunak claims his ultimate goal is to be a tax-cutter. But as a result of both the pandemic-era spending and the last six weeks, we are looking at falling GDP and a recession lasting at least until the end of 2023, according to Bloomberg Economics analysis. At this stage, is there anything the government can do to shorten the recession and restore growth or is this more about laying the groundwork for future growth? 

DH: The government has a big decision to make around what level of energy support it wants to provide beyond April — that’s where it could impact the near-term outlook most. Whatever it has in mind, it’ll help to make a decision quickly so households and businesses can plan.

Given the constraints it now faces regarding fiscal policy, the government should be looking for additional savings on the measures it has already announced. It could accelerate work on breaking the link between wholesale gas and power prices, which is magnifying the pain for households and businesses and raising the cost of government interventions. Another option would be to raid the profits of electricity producers that don’t rely on fossil fuels, one measure in a new law allowing the government to impose a cap on revenues.

The bigger picture here is that the economy is currently overheating, so unless measures are efficient and well-targeted, stepping up support will prompt a more aggressive response from the BOE.

TR: France has imposed energy price controls and has managed to bring headline inflation down to 7.1%, the lowest in the euro area. Markets haven’t freaked out and growth is expected to be faster than the UK and Germany next year. Is there a lesson here for Hunt and Sunak on the best way to tackle inflation that stems from energy prices? Or is France sui generis here? 

DH: Price caps definitely tackle inflation in the near term but they are poorly targeted. In a tight labor market, excessive support exacerbates domestically generated inflation, something that is likely to require a relatively chunky monetary policy response to keep supply and demand in balance. Given the context, the best thing the British government can do is opt for more targeted support after the cap ends.

TR: A lot of emphasis was placed on getting the Office for Budget Responsibility’s scoring of the government’s fiscal policy. How important is the OBR here and are there limitations to their scoring we should keep in mind? 

DH: If the past month has done nothing else, it has highlighted the importance of independent institutions. The forecasts the OBR puts out will be pored over, but it’s important to remember they are highly uncertain and, like any point projection, will almost certainly be wrong.

Ahead of what is undoubtedly a bleak winter, I just hope the budget watchdog isn’t excessively pessimistic about the outlook for the economy. The government will have to make decisions within the parameters the OBR sets and those policy choices will have real world consequences. A forecast for significantly slower trend growth, for example, would force the government to find more savings to fill the hole in the public finances, leaving the economy risking a protracted period of weak growth while the repair job is completed.

TR: We’ve heard a lot of about rising national debt levels. How important is a falling national debt burden and what is the right target here to keep markets onside and demonstrate fiscal responsibility? Is it worth raising the tax burden to ensure that debt is put on a downward path as a percentage of GDP?

DH: I don’t think there is a magic target. Markets accept that sometimes level shifts in the debt-to-GDP ratio are required to support the economy through a difficult period. Once that period has passed, the key is to show you are taking steps to put the debt burden on a sustainable path.

On whether it should be achieved through higher taxes or lower spending, I think that in the UK’s case it is going to have to be a combination of both. Following the austerity on the 2010s — when there were sharp cuts to capital expenditure in the UK — and against a backdrop of high inflation and increasing demand for public services, it just isn’t feasible to expect the money to be found in departmental budgets. Lower investment spending will help in the near-term, but that budget isn’t massive anyhow. Meanwhile, cutting benefits when inflation is in double digits is politically challenging.

That leaves taxation to fill the gap. Sunak has form on this too: When he was chancellor, he was willing to raise the tax burden to its highest since the late 1940s. He and Hunt appear to be laying the groundwork for a return to that approach on Nov. 17. That bad news will probably be accompanied by a promise to cut if the outlook allows.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Therese Raphael is a columnist for Bloomberg Opinion covering health care and British politics. Previously, she was editorial page editor of the Wall Street Journal Europe.

Dan Hanson covers the U.K. for Bloomberg Economics in London. He previously spent seven years at HM Treasury working on a variety of U.K. macroeconomic issues.

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