After yet another U-turn and the replacement of the chancellor, I am wondering about the role of policy orthodoxy and how far governments can safely depart from it.
It is surely legitimate for governments to challenge orthodoxies on all sorts of issues. Without this, how would policy change and adapt? But there is an acute difference between economics, or at least the financial part of it, and almost all other areas of policy. Finance is all about arithmetic. What cannot be raised in taxation to cover government spending has to be borrowed. We have a government that wants to reduce taxes and does not want to cut spending. Ergo, you might think, that means that, other things equal, we will have to borrow more. This sort of “orthodoxy” is well worth hanging on to.
Part of the Government’s response has been that with our debt ratio still low by international standards, we could readily afford to borrow more. The other part was that other things aren’t equal. Supposedly, tax cuts will pay for themselves.
There are cases when this is true. When the 50p tax rate was cut to 45p in April 2013, for instance, this produced a surge in tax revenues. But that is a far cry from establishing that this is always true. In particular, there is a big difference between the consequences for tax revenue of a cut in a particular tax and an overall reduction in taxes.
Admittedly, a lower tax burden may eventually bring stronger economic growth – and higher tax revenues. I believe that this happened under Mrs Thatcher. But her reforms were not only about tax reductions but also about tax restructuring which had the effect of radically reducing key marginal tax rates. And even then, the benefits didn’t occur overnight. Institutions, structures and habits had to change. This takes time. Moreover, Mrs Thatcher’s radical programme also encompassed other major changes, including privatisation and the taming of the unions.
This Government seems to have believed that it was possible to pull off a major result over the next two years. But hardly anybody else believed this: not Treasury officials, not the Office for Budget Responsibility (OBR), not the Bank of England and not the financial markets.
There’s the rub. With financial policy there is a large and well informed audience of professionals who are constantly assessing the implications of the Government’s policies. Moreover, their views are instantly visible in the foreign exchange and bond markets. And the latter have a key bearing on the finances of ordinary people (aka voters) through the effect on the cost of mortgages.
There is no fooling financial markets and there is no scope for cuddling up to them or asking for their loyalty. There is nothing equivalent with regard to foreign, defence, education, transport, health policy or anything else.
The upshot of all this is that whatever you think of the financial orthodoxy, you would do well not to throw it out of the window and/or disparage those who still embrace it. And because of the importance of confidence, it is as well to follow established norms of behaviour and to cleave to established institutions and procedures. That allows you to achieve more change while retaining confidence.
What now? Changing the Chancellor will not be enough. It is policies, rather than personalities, that matter. Accordingly, there may be a second shoe to drop. When the fiscal plan is finally published, scheduled for 31 October, all eyes will be on whether, when and how it puts public debt on a sustainable path. If it achieves this through assuming real economic growth of 2.5%, the OBR will not play ball. It will assume something much more modest, with adverse consequences for the public finances.
There will be no tolerance for fantasy economics or hoping for the best. To placate the OBR and head off another financial crisis, it seems likely that the Government will have to eschew any hopes for net tax cuts and abandon even more of the mini-Budget’s measures. That is unless it cuts government spending and/or resorts to levying a tax on the banks by ending the payment of interest on the reserves that they hold at the Bank of England (which would lead to other complications).
This doesn’t mean to say that the Government must abandon all of its ambitions to boost growth. Rather, it must focus on the relatively small things it can do without spending more public money, including relaxing various regulations in key areas. Nevertheless, such things are inherently difficult, by contrast with the apparently easy fix of cutting taxes. The trouble is that in economics, if something seems too good to be true, it usually is.
One of the key problems with Truss’s radical agenda is that it was conceived when the governing party had been in office for more than 12 years. By contrast, the key thinking behind Mrs Thatcher’s economic reform programme had been done in opposition.
Which brings us to the Labour Party. What are the lessons it must learn from recent turmoil? Most importantly, it must stick to the fiscal orthodoxy and support the institutions that guard it. That doesn’t mean that there cannot be radical measures. But Labour must avoid an equivalent, though opposite, delusion to the one that has gripped this Government, namely the fantasy that huge rises in government spending can be financed by tax rises only on “the rich” and/or that the tax burden can be increased more without adverse medium-term economic consequences. This means that they will have to establish priorities and work out the sequencing of their desired measures. The time to do this is now.
Perhaps the only good thing to have come out of this crisis is that, following “New Labour” in 1997, the Labour Party will be bound to fiscal orthodoxy, like Odysseus to the mast. The tricky bit will be to reconcile this with its ambitions for public spending.
It’s time for Truss to change tack on economic orthodoxy
Embracing established institutions can achieve results – and retain confidence