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This circle can’t be squared

The UK government has spent the weekend heavily briefing that big tax increases are on the way.  The return of former Chancellors George Osborne and Philip Hammond to government circles also suggests another round of economy-crushing austerity is also being considered.  As George Parker at the Financial Times reported yesterday:

 “Rishi Sunak is set to sign off on raising taxes across the board as the new British prime minister looks to plug a £50bn hole in public finances.

“Treasury insiders said Sunak and chancellor Jeremy Hunt had agreed on Monday that while ‘those with the broadest shoulders should be asked to bear the greatest burden’, everybody’s taxes would go up.”

This could, of course, be intended to soften the public up ahead of the revised mini-budget in a few weeks’ time.  And as almost always happens with budgets, they will seek ways of sweetening the pill.  Nevertheless, it is a 180-degree reversal of the ill-judged package of corporate welfare and tax cutting attempted by Truss and Kwarteng, which sent the pound into a tailspin.  More importantly though, it is a big deviation from the “levelling-up” agenda of the 2019 Manifesto, which gave the Tories their surprisingly large majority at the last election.  Certainly, many of the “red wall” Tories risk being out of a job next time around if further cuts are made just as people’s living standards are plummeting.

The narrative being offered by the establishment media is that Truss and Kwarteng attempted to push through a budget so dangerous that it triggered a pensions crisis which pulled the rug out from beneath the pound and forced the Bank of England to intervene to maintain order.  The arrival of the rhyming slang Chancellor and the later appointment of the new Prime Minister, in contrast, meant that the adults were back in charge and a return to prosperity only months away.  The economic reality though, is that what is being offered by Sunak and Hunt is no less deranged than the package offered by Truss and Kwarteng.

The real economic context for Britain’s predicament is the global supply shock and, especially, the gathering energy crisis.  The financial consequence – which the establishment media probably don’t understand and certainly aren’t reporting on – is that the world is experiencing a slow-motion credit crunch as international banks have stopped loaning dollars.  It was this that scuppered Kwarteng’s attempt to rush through massive and – crucially – unfunded tax cuts and energy subsidies.  In short, the various lending banks, which in a more prosperous age might have funded UK government borrowing, decided that the risk was too great, and that the British government would have to offer a much higher interest rate to offset the greater risk.

The pensions crisis followed because pensions regulation obliged pension funds to hold government bonds, even though these pay less than pension funds need to meet their obligations.  To offset this, pension funds hedged against falling interest rates, meaning that they stood to lose a lot of money in the event that interest rates rose… like they did when international banks refused to fund Kwarteng’s tax cuts.

Although potentially damaging to pension holders, then, the pensions crisis was merely a symptom of a far more dangerous international situation rooted, in part, in the ongoing failure to fix the system after 2008, but exacerbated by two years of lockdown and the suicidally insane decision to disconnect the economy from the last source of cheap oil and gas on the planet.  The bottom line is simply that the banks – which create almost all of the currency in the form of debt – no longer believe that the UK economy is robust enough to meet its outstanding obligations and that, sooner or later, the pound is going to fall even further.  Thus, while lenders may be repaid the nominal amount that they loaned to the UK government, they are unlikely to recover the value.

It may appear then, that taking the tough decisions to balance the government books is exactly what is required if the government is to restore confidence in the UK.  But again, this ignores the context in which this is taking place.  Energy – which economists treat as just another cheap input – is what allows the economy to exist and is the source of the surplus value we create.  So that, when the cost of energy spirals upward – as it was long before the Russian invasion of Ukraine – the economy experiences a decline in value.  In your and my day-to-day experience of this, the cost of essential items goes up, forcing us to shift our spending away from discretionary purchases.  Higher interest rates have a similar impact since they drive up the cost of housing (even if the price of a house is actually falling).

This is the pincer that most British people are currently facing as winter draws in.  After energy companies filled up gas storage facilities using gas purchased at the high point earlier in the year, households and businesses face crushing energy bills.  At the same time, high priced fertiliser (made from gas) last year is now filtering through in the form of higher food prices, with staples like bread, milk and eggs seeing the steepest rises.  The result, as is already seen in the official inflation data, is that discretionary spending has slumped – food and energy are the only items still increasing, and this is the result of the supply shock rather than monetary inflation.

The UK economy is already in recession – although we will have to wait until the fourth quarter for this to be officially confirmed.  But recessions do not generate crises overnight, because each of us responds to them in a manner which makes sense to us but is deadly for the economy as a whole.  For example, a few weeks ago, online retailers reported a jump in sales of products like sweaters, hot water bottles and wearable sleeping bags as people sought ways of cutting their heating costs ahead of winter.  At the same time, businesses that only a few months ago were facing labour shortages, have cut workers’ hours rather than begin making people redundant.  More recently, we have seen a fall in savings as people struggle to meet rising costs.  Even more alarmingly given the 60 plus percent interest rates, there is growing evidence of people maxing out their credit cards in an attempt to make ends meet.  According to The Money Charity:

“At the end of august 2022, outstanding consumer credit lending was £205.1 billion, rising by £690 million on the revised total for the previous month.  Within the total, outstanding credit card debt came to £62.4 billion, an increase of 8.47% in the year to august 2022. Credit card debt averaged £2,244 per household and £1,177 per adult.

“A credit card on the average interest would take 25 years and 8 months to repay, making only the legal minimum repayments each month.”

This, of course, is the final stage before the defaults and bankruptcies begin.  And there is already evidence that households juggling their spending is having an impact in the wider economy, with more companies facing insolvency as cashflow dries up.  This is particularly true for those companies which did unexpectedly well during the extreme conditions of lockdown.  For example, as Michael Race at the BBC reports:

“Online furniture retailer Made.com has moved a step closer towards administration after the company’s shares were suspended on Tuesday.  The firm has stopped taking new orders and is running out of cash. Talks to find a buyer have so far failed.

“It is dramatic change in fortunes for the brand, which boomed in the pandemic and was valued last year at £775m.”

None of this is going away anytime soon.  The dollar shortage is worsening, forcing countries around the world to spend their dollar reserves – the international equivalent of you and I using up our savings.  Meanwhile, energy and food shortages are going to persist for years to come since there is no cheap and abundant alternative to the Russian oil and gas that European leaders have decided that we can get by without.  And even though rising food and energy prices are a supply shock not inflation, central banks will continue to raise interest rates in an attempt to lower them.  And it is into this environment that Sunak and Hunt apparently believe that tax increases and austerity cuts are going to have a positive impact.

For both households and businesses, tax cuts are yet another thing which pulls spending away from the discretionary sectors of the economy.  And to be clear here, the discretionary economy dwarfs the essential sectors so that, when it crashes, we are looking at something akin to the Great Depression of the 1930s.

Of more importance in the short-term though, is the question of whether the government can actually raise the taxes it claims.  According to the Institute for Fiscal Studies, in 2021-22 the UK government raised a total of £731.6bn of which, £472.9bn – 57.7 percent – came from the big three – Income Tax, National Insurance and VAT.  But with the economy in recession, it is doubtful that these can be increased.  Indeed, the paradox is that the more the state attempts to tax incomes, the more the economy slows and the less income there is to tax.  Moreover, as HMRC data shows, while income tax, business taxes and VAT remain above pre-pandemic levels, they have slowed in recent months, while Fuel Duty has fallen by £0.6bn since last year and £0.8bn below their 2019-20 level – the fall driven in part by home working and in part by households and businesses cutting discretionary travel.

If Kwarteng came unstuck by not being able to show where the money would come from to repay the debt, Hunt risks demonstrating that the UK government cannot raise the money at all.  And this is why an alternative used to some extent during lockdown is likely to become politically expedient in the coming months.  As Thomas Fazi at UnHerd argues:

“Addressing the economic and social crisis, as well as mobilising the investment needed to boost growth, requires more spending, not less, which can’t realistically be offset through higher taxes. Meanwhile, attempting to balance the budget — which would mean allowing millions of households to slide into poverty, letting businesses go bust, and pushing public services to the brink of collapse — would likely make Sunak the third Prime Minister to be kicked out of Downing Street in as many months.

“The good news for Sunak is that this is a false dilemma. The UK’s public finances don’t need ‘fixing’. As a currency-issuing nation, Britain can never ‘run out of money’ or become insolvent on its public debt. I’m inclined to think that Sunak is aware of this; after all, he personally oversaw a massive increase in the deficit during the pandemic, which he paid for by having the Bank of England print the necessary pounds, essentially bypassing financial markets (and the issuance of bonds itself). The resulting debt is entirely owned by the Bank of England, and technically doesn’t even need to be repaid. There’s no reason he couldn’t do the same now.”

It is a seductive idea – and perhaps the correct long-term option.  But it is no free lunch.  Yes, it is true that a sovereign government cannot go bankrupt… for all of its woes, for example, Zimbabwe never did.  But the energy and food – among many other things – that we are going to depend upon in the coming months and years have to be paid for in dollars not pounds.  And the problem is that the more pounds the government prints – i.e., the more of its own debt the government buys – the higher the cost of those dollars against the pound… and one way or another, the government still has to convince international lenders that it can pay back the dollars it needs to borrow.

For all of the reasons set out here, Britain faces a predicament not a crisis.  That is, there is no answer – at least not within the terms of debate of the political and establishment media “Overton window.”  Instead of facing up to decisions which ought to have been made in the late 1960s and early 1970s, successive governments of all colours chose to leave it to future generations.  And so, Britain’s manufacturing base was allowed to atrophy even as the money laundering City of London Ponzi scheme was allowed to dictate economic policy.  So much so that even the brief spurt of wealth from North Sea oil and gas was squandered on corporate welfare, tax cuts, and an unaffordable benefits bill.  Since 2005, when the UK became a net importer of oil and gas, even that income has gone away, and it is only the sale of what few state assets remain which brings in the foreign exchange needed to pay the bills.  And since the political class rashly decided to seize the assets of Russian oligarchs, even this is going away as potential foreign investors in the UK have drawn the conclusion that Britain is no longer a safe place to store wealth.

To some extent, all of us have been living beyond our means for decades – although, of course, it is those at the top who have done so to excess.  For better or worse – well, of course it is worse – the things that we could have invested in, such as alternative energy production and leading-edge manufacturing, didn’t get built.  Instead, we went from being a “nation of shopkeepers” to a nation of shop assistants… mostly on low-paid, part-time and zero-hours contracts, and all of it dependent on a mountain of debt.

It is for this reason that Fazi’s suggestion that we print our way out of the current crisis may be the best of a set of bad options for the long-term.  First, a fall in the pound to a level that better reflects the UK’s non-financial economic base will make British exports cheaper even as it makes imports less affordable.  Second, faced with higher import costs, we might finally engage in a process of “import substitution” – producing in our own economy at least some of the things that we have grown accustomed to importing.  Third, given the dearth of energy that faces us for years, and likely decades to come, a lower pound and less ability to import will force us to simplify our economy within the limits of our energy and material base.  It won’t be pretty, but it is better than turning us into a nation of debt-serfs.

As you made it to the end…

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