Luke 00:06

Hello, and welcome to Macro Bytes the economics and politics podcast series from abrdn. My name is Luke Bartholomew, and today, we'll be talking about what has been going on in UK politics, markets and the economy recently. It has been an extremely volatile time for UK asset markets following the government's so called 'mini budget' a couple of weeks ago, which has unleashed significant volatility, required Bank of England intervention and has seen sort of serious questions about the government's economic strategy and indeed its long term survival. So I'm delighted to say that I am joined today by Jeremy Lawson, our Chief Economist and Head of the Research Institute, and James McBride. James leads Forefront Advisors political and policy analysis in the UK. James has a background in Westminister, having worked as an official in Whitehall, and as an economic policy adviser to the Labour Party. So there is no-one better, I think, to help us understand some of these developments. Now, I should say we are recording on the 11th of October today. And these are very volatile time so much could have changed by the time you are listening to this. But perhaps the best place to start is James, maybe you could sort of give us some background as to how we got into this situation. And in particular, how the Truss government understood the problems it was going to be confronting, when it came into government, and why it thought the kind of policies that it announced would be appropriate in that context.

James 01:51

Thank you, Luke. And thank you for having me. And look maybe I'll start by saying something that's fairly counter consensus, because I know everyone is going around saying that a new government is a big departure from recent Conservative governments. And of course, that is true. I don't want to understate it or dismiss it entirely. But look, this is a Prime Minister and this is a Chancellor who served in governments under Boris Johnson under Theresa May and under David Cameron. These are not kind of Corbyn, Jeremy Corbyn-like figures. And of course, Corbyn would never have served under Ed Miliband, Gordon Brown or Tony Blair, so they have strong convictions that mean, you know, stand in contrast to recent Conservative administrations, but let's not overstate it, I think the biggest point of difference is actually the personnel - so the advisors around them. And this is where actually a comparison with Jeremy Corbyn the hard left is perhaps more applicable, because this new administration have surrounded themselves by advisors, particularly on economic policy, who are largely outside of the scope of kind of normal politics in Westminster. So people from the IEA, the Institute of Economic Affairs, or the taxpayers Alliance. These are people who have, frankly, sat on the sidelines, and have thrown rocks at the Tory party for the last decade or so. And now they're inside the tent, trying to come up with government policy. And I think they are in danger of beginning to believe their own propaganda. So at the moment, they are arguing that the UK has suffered from low growth. And one of the reasons we've suffered from low growth is an obsession with redistribution. So this is the kind of, let's not care so much about how we divide the pie, but we need to focus much more on growing the pie. And I say they're in danger of believing their own propaganda because if you look at the contents of the mini budget, and if you look at the substance of the supply side reforms that the government will be bringing forward in the coming weeks and months, they're not particularly profound. Look at the mini budget. The main elements of the mini budget was first of all, not going ahead with a corporation tax rise that was pencilled in by Rishi Sunak. Second element not going ahead with the National Insurance rise, proposed by Rishi Sunak. And third, yes, politically very important, but fiscally pretty irrelevant, abolishing 45p income tax rate. So you put this all together, there's a grand mission to do things differently. But so far, at least, let's get on to talk about the market response, which of course, was profound, but politically, intellectually, I'm not sure the mini budget stands up to the rhetoric, stands up to the claims from Liz Truss and Kwasi Kwarteng.

Luke 04:52

So Jeremy, perhaps that's a good point to bring you in. James sort of described some of the measures there as not being especially profound and perhaps We can over egg, the ideological stripes of this government. So why is it that the market did react so poorly do you think to the mini budget's announcements?

Jeremy 05:10

I think that there are a few reasons. So one is clearly that the mini budget, which of course, is really a maxi budget, it's not a mini budget at all, in terms of its sort of size and scope, we'll call it a maxi budget, not a comprehensive one, because it didn't sort of really involve sort of shifts in the plans for government spending, but it was sort of fairly significant announcements. But it follows an already very large and consequential decision to heavily subsidise households' and firms' rising energy bills, which itself was going to be financed via debt issuance, rather than through spending cuts elsewhere, or tax increases elsewhere. And so you have this sort of, I think, perfect storm of a market, in which duration is coming under pressure. So what I mean is government bond yields are rising in a lot of economies. So the ability of markets to absorb news, that they'd have even more debt that they would have to purchase over the coming months and years, that was sort of difficult. You have a government that is pointing fiscal policy in a very different direction from monetary policy, and where the Bank of England had surprised the market the previous day, with what I would describe as either a relatively dovish 50 basis point increase in interest rates, or potentially a complacent view on exactly how imbalances in the UK economy are evolving. And so if you pair the international environment, with the tensions at the heart of the policy announcements, and this perception, I think that policymakers are sort of complacent about the nature of them. And then you pile on top of that a pension industry that had been taking particular decisions around how to match their long term assets and liabilities, and a sense of inherent vulnerability to anything that would sort of lead to increases in interest rates, particularly long term interest rates, you have this sort of perfect storm, I think, for a market to react very, very badly to it. And I don't think anybody, you know, going to bed on the Thursday before the budget was announced, I can't imagine anybody forecasting exactly what would unfold on the Friday, or on the Monday or the Tuesday afterwards. And the fact that the Bank of England would have to sort of step in, and then multiple times since then. But that broad background is one in which you have policy that is very much not pointed in the direction of what we might sort of describe as the principles of good governance, and good demand side management. And so then a market that reacts very badly as this, this sense of the credibility around UK Inc is starting to weaken and the reality of how much of a adjustment is going to have to ultimately occur particularly through monetary policy to bring it all under control.

Luke 08:39

So James, Jeremy described there the market's perception that the government is in some way complacent or doesn't understand the appropriate principles of demand management. Now, I guess since the original announcements, we've seen some slight backtracking from the government. They've ditched the 45p tax cutting pledge, they brought forward the timing of the medium term fiscal plan so that significantly, it's now before the Bank of England's next meeting. And also they've appointed as head of the Treasury, someone who I guess represents more orthodox thinking around Treasury policy. So is that a sign that the government has learned something from this process and they've become less complacent?

James 09:22

I think they are less complacent. But just just quickly going back to the the mini budget, or as Jeremy says, maxi budget, they were genuinely shocked and almost annoyed by the response of the markets. And of course, the first 24, 48, 72 hours is revealing in terms of the way they played it. They didn't say, oh, we might have miscalculated here didn't tone down their rhetoric, they did the opposite. The Chancellor went on the Sunday political broadcast programme and suggested there was going to be more tax cuts to come. That said, I do think over time over the course of the following Monday, Tuesday, Wednesday, they were somewhat more humbled by the market response. But I would caution in the lead up now to October 31, when we get the so called medium term fiscal plan against believing that they've learned their lessons enough, sufficiently so that they will present numbers that are both politically credible and fiscally credible. They have an almighty task ahead of them. And I'm not sure they're going to be able to pull off one or both of those tests. So there are two tests here, right? Is the political test and is the fiscal test? Yes, they're making the right noises, as you suggested, and outlined around the OBR, the Permanent Secretary talk of sustainability in the public finances, but they still have an almighty task ahead of them.

Luke 10:49

So the Institute for Fiscal Studies has just come out with a report today, as I said, 11th of October, talking about potentially the need for 60 billion pounds worth of public spending cuts to bring the budget back onto a sustainable footing. I mean, James, do you do you see that the government is thinking in those terms, that that's the kind of level of cuts that are required? And sort of if those are sort of the figures, and where does the government think it might turn to in terms of having spending reductions that the market would see as credible?

James 11:24

Yeah, I don't think 60 billion is at all possible, Famous last words, get me back in two weeks time. But I just don't think it's possible. That will be not only along the lines of austerity that we saw from 2010 onwards. But you know, austerity and a bit more, you know. The level of cut, I just don't think those levels of cuts are politically sustainable. And that's what I meant when I said earlier, I'm just not sure they're going to be able to square the circle. There will be some cuts for sure, particularly in capital. It's fairly easy to cut capital, obviously a bit harder to cut day to day government spend. They can also not increase international aid. And in aggregate, you know, we're looking here 20, 25 billion. But depending on the macro forecasts provided to them by the OBR, that might go only halfway to meeting the challenge in terms of the fiscal hole. Whether halfway is enough for markets, I don't know. But I don't think they can go the whole way in terms of meeting the fiscal challenge via spending cuts.

Jeremy 12:39

It's broader than that as well, because the credibility gap isn't just what is your plan? It's now what are you prepared to do now to reinforce the credibility of that plan? Like for example, if to try and square the political circle, any spending cuts are punted into the period beyond the next election, then I think most market participants will rightly sort of see that as something that probably there's a low probability of being delivered, even if the OBR declares that yes, this won't unwind the problem completely, but it will help it. And so there is a market credibility gap that needs to be addressed, which is beyond the political credibility gap. And of course, then you have to get into the question of, if you're still a government and you're presenting spending cuts alongside tax increases in the current environment, is that something that the average voter is going to buy? And it strikes me that that's going to be quite challenging.

James 13:39

Yeah. And of course, in normal times, Chancellor's can and have got away with this. Right. So in 2015, George Osborne, when Chancellor ahead of the 2015, election, promised spending cuts on the other side of the general election in order to hit his fiscal rules. I don't think many people thought that was particularly credible. I certainly didn't. But of course, it didn't matter at the time, the economic context was different. And the government didn't have the sorts of credibility challenge that they have today. But you're right, the vast majority, if not all of this fiscal consolidation will be at the back end of the forecast. So after the next general election, and I strongly suspect that the fiscal rules when we see them will not be static. It will not be we are targeting a certain rule in a certain year. It will be a rolling fiscal rule, which always means, you know, the promise is to do it tomorrow, not today.

Luke 14:37

So James, I think this reference to normal times is a particularly telling one because, as I mentioned, that there does seem to be sort of a symbolic significance to moving the medium term fiscal statement to be before the Bank of England's monetary policy report. And normally, that wouldn't matter at all, that sequencing, you'd expect the two macro policy institutions to sort of work within a consistent framework where everyone expected policy to be adjusted appropriately over time. But this time, the very fact that monetary policy can now be seen to sort of be chronologically responding to the fiscal policy - i.e. it comes after it - does seem to be of more importance. So, Jeremy, you talked a little bit about some of the Bank of England's interventions. And it has been an important part of this story. But before we dive into that, maybe it is worth sort of saying a little bit more about this principle that we've talked of before, that monetary policy always goes last. I mean, what do we mean by that, in terms of that being what underpins stable macroeconomic framework?

Jeremy 15:46

Yeah, so I think what we really mean, in essence is that the primary job of macroeconomic stabilisation falls to the central bank. And that in some medium to long term sense, price stability, and so we'll sort of say that that is the Bank of England's 2% target, that achieving that is consistent with an economy operating broadly in line with its potential over time. So there's no conflict between its growth and inflation objectives. But it's primarily the central bank's job to ensure that that happens, and if the central bank is independent, then what it does is broadly, it takes what the government does as given, and then responds accordingly, right. So the Bank of England has no direct influence over fiscal policy. And so I mean, think about the post global financial crisis period, then fiscal policy was too tight for the economic conditions prevailing, that was making it harder for the Bank of England to do its job, when it ultimately meant was the policy rate stayed at the effective lower bound, and quantitative easing was sustained for longer than it would otherwise have been. But that is the sense in which it was acting last, it was responding to that macro environment and that policy environment being set exogenously, and then doing what it could do to restore equilibrium. Now, it's tasked with doing the same thing, but in reverse, which is that instead of fiscal policy being too tight, for what is required, it's far too loose. And so ultimately, the Bank of England needs to do more. But of course, the environment I think, is even more politically difficult that it's trying to do that in. First of all, this market volatility in the gilt curve is significantly complicating its job, and sort of meaning that what it wants to do from a financial stability perspective, which has becalm the market, particularly at the long end, is potentially in conflict with what is sort of trying to do and signal around monetary policy, particularly to the extent that there's a question of whether it can sort of exit these interventions. But then secondarily, there's a reason to question whether, okay, so let's say that the Bank of England takes the bit between the teeth tightens policy very aggressively in November, December, validates current market pricing, right. And so then the economic consequences that flow from that. Could we be completely confident that the government says, you know, what, the Bank of England is doing its job. Yeah, that's appropriate. And if a recession has to occur, so be it. Or is there a possibility that actually, the fiscal authority reacts to the central bank tightening, you know, by in a sense, looking to ease policy for political reasons. And then you get this potentially very destabilising cycle where people begin to question whether the central bank is moving last into something, what we might call a form of fiscal dominance, or actually, it's the Bank of England that is in some ways forced to accommodate or can't completely counteract what a government that is set on the wrong path does. And through there, you get even more destabilising economic and market outcomes than we've seen so far. So that's not our base case right Luke - you know, that that type of vicious cycle occurs. But the fact that we're asking questions about it, for the first time, I would sort of say in more than 50 years in the United Kingdom,and certainly since Thatcher came to power at the end of the 1970s, you know, I think speaks a lot for just how uncertain and concerning the current environment is.

Luke Bartholomew 19:22

Well perhaps that's the question to put directly to James, then. I mean, we've seen the financial market fall out from the budget, but it hasn't really been the case that we've had the economic consequences start to properly hit. That's more of a story for next year, right when mortgage free refinancing comes through, and the economy very likely falls into recession. So does the government have a strategy about how it might respond to that? And is it plausible that we sort of see the fiscal authority start to ease policy in a way that unleashes this sort of unstable dynamic where there's this sense in which monetary policy is no longer in control of the economy? How does the government act in response to a recession next year?

James 20:05

Yeah. Well, look, I think that's all possible because of course, the temptation for politicians of the next 12, 24 months, particularly considering some of the economic headwinds, will be to do more not to do less. So yes, the government on October 31, will promise a degree of fiscal consolidation, albeit as Jeremy quite rightly says, all of it, or almost all of it will be after the next general election, not before the next general election. But notwithstanding their promise for fiscal consolidation in the medium term, the incentives are stacked in order for them to do more fiscal loosening, not less dependent on of course, how those economic headwinds turn out to be. What's pretty remarkable is I don't know whether you saw it, the YouGov study, the YouGov poll out on Sunday, which showed most members of the public blamed the government for not only the recent increase in interest rates, but basically the entire bulk of increased interest rates. They are now owning this problem. And that will come at an almighty political price come the ballot box in the autumn of 2024. And it seems to me pretty clear that, and I think this is the view in the Treasury, that the Bank of England will do only the bare minimum in the short to medium term to stop systemic risk or dysfunctional markets. They will not be stepping in to prevent fairly aggressive repricing of assets. It seems to me that they want the government own this. It is the government's problem. And it's the government's responsibility to solve this not not the Bank's.

Luke 21:54

So I suppose a deep irony of the fact that a recession is quite likely next year is this is a government that came to power, saying it was deeply committed to boosting growth. So maybe we should just talk a little bit about what it is that the government's sort of growth agenda entails. So James, in the first instance, could you say a little bit about what they plan on passing, and then maybe Jeremy a few words as to how likely and credible some of those policies are to have the effect that the government expects?

James 22:24

Yeah, well, look, I don't want to sound too cynical. But I am sceptical of the government's ability to first of all come up with with particularly profound or robust supply side reforms. And even if they did, I'm sceptical that they will be able to get those through Parliament, because there is a inverse relationship between radical supply side reforms and the ability to deliver upon them. And as I said, at the top of my remarks, the mini budget, of course, was focused on the demand side, as opposed to the supply side. And so it's perhaps not surprising that we didn't see supply side measures in the so called maxi budget. But I do think it's under the sequencing that tells us something about the mindset here. This is not a government, and these are not people who have a particularly profound, sophisticated or well thought through plan for supply side reforms. Perhaps let's just take one example, a very narrow example around financial services. There will be a package that will go beyond Solvency Two, but the package will lean very heavily on Solvency Two. This is a reform to insurance that Brexit supporters in particular, have been arguing for, for the last six years. And the fact that the Solvency Two package, which will sit at the heart of the financial services reform, leans on something that we've been talking about for the last six years, I think speaks volumes. So look, I'd love to be surprised. But I'm not expecting to be surprised. I don't think the supply side reforms will amount to much. And even if they did, I'd be very sceptical about their ability to get through Parliament.

Luke 24:12

Jeremy, I think that's a view that we largely share. But perhaps you could say a little bit about, you know, even if the politics were favourable for the government, what the chances are of being able to boost potential growth to the two and a half percent rate?

Jeremy 24:24

Exactly. It's just extraordinarily unlikely. Right? So the OBR I think pins potential growth in the UK around one and a half percent at the moment. I think our estimates are actually that it's a little bit below that. But let's take them at their word and say that it's one and a half percent. You can count on one hand, how many developed countries have boosted potential growth by a percentage point or more in the last 40 years through supply side reforms, and I don't mean that there wasn't the political will to achieve them. I mean, that even those governments that pursued supply side reform with vigour weren't able to achieve that type of boost to long term potential outlook. On top of that, there is this myth, I think, pervading about the British economy, that it is regulation, that is the primary barrier to potential growth. The UK is already one of the most deregulated economies in the world. If you look at the OECD's product market indicators, or its labour market indicators, this is not an economy that screams sclerosis through regulation, right, almost all of the research that's sort of been undertaken into the things that are holding long term potential growth sort of back are things like investing in skills, the long term inadequacies in capital spending around infrastructure. You know, if the UK were to decide it wants to increase the wedge between how financial services are regulated in the UK, and how they're regulated in Europe, you have to counterbalance any benefits in terms of access to markets outside Europe with potential loss to, you know, to access to markets inside Europe. And so both the reality and the substance is likely to fall a long way short, and I can't see how the OBR could do anything close to validating this idea that two and a half percent was sort of a reasonable assessment of where medium term growth could be. The IFS assessment, you know, which, which sort of relied on sort of forecast that Citi Group had provided, you know, that suggested that the UK economy might grow only by 0.9%, on average per annum over the next five years. I suspect that our forecast might even be a little bit lower than that, if we were to extend them and fully take into account what's happened in the last sort of few weeks. And so again, the thing, the bottom line here is that there's a reality gap that almost sort of borders on, I mean I hate to use the word delusional, but it sort of has elements of that. And, of course, you know, politics is about perception. But as James said, at the moment, the consequence of this, of these mistakes is that people sort of see financial markets performing poorly, their cost of borrowing rising very, very substantially. And it's very difficult to do anything but hold the government accountable for that.

Luke 27:27

Well, James, perhaps then, on that note that the government is being held accountable to that. A final question, seems to be, given this very negative backdrop we've painted I mean, what chances of this government being toppled in the near future?

James 27:43

Yeah, well, look, it sounds like a really ludicrous question, but I don't think it is. It all hinges on how October 31 goes. If they can land this successfully in both Westminster and in the markets, then they can limp on, and they have the space to potentially turn things around. However, there's a very good chance that the October 31 medium term fiscal plan does not land well with one or both of those audiences, the political audience or the market audience. And if that is the case, I think further U-turns will be forced upon the government. I think at the top of the list is the corporation tax cut that is planned to be introduced from next spring, which will cost around 17 billion a year. There's a good chance, I think, particularly if the medium term fiscal plan does not land well, that a U-turn will be forced upon the government. And then I think we get into question marks about both the Chancellor's future but also potentially the Prime Minister's. You know, getting one fiscal event wrong, is bad luck. Get two fiscal events wrong in the space of only five, six weeks is incompetence. So it really does hinge on how well October 31 goes.

Jeremy 29:09

Can I make one observation on that Luke just quickly? You know, I worked in Australian politics in the distant past and one of my rules for working out how much in trouble a particular sort of leader or government is in is don't pay attention to what is normal critics are saying is pay attention to what is normal supporters are saying, right? And so at the moment, the place you should be reading, right is The Spectator and parts of The Daily Telegraph, right. And when every second article in The Spectator is highly critical of the government, that's what tells you the most about how concerned, worried, angry, the normal support base would be. And that never happened under the Cameron Osborne government, even when I would argue that fiscal mistakes were being made. You didn't see that fracturing around the conduct of policy. The fact that's appearing now in these main sort of Conservative organs is the thing that I'd be worried about most about it was Truss and Kwarteng.

Luke 30:07

Well no doubt The Spectator and Telegraph will thank us for sending our listeners their way. But that is all we have time for this week. So, James of Forefront Advisors, thank you so much for your time today. Jeremy, thank you for joining us. It's been an excellent conversation. Please do rate, review and subscribe to us on your podcast platform of choice. But in the meantime, thanks very much for listening and we'll speak again soon. Thanks very much.

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