A new PM, a new economic approach

Economic policy will be changing this Autumn. What we know so far.

The near-term path of British economic policy is now in the hands of something under 200,000 Conservative Party members. By early September the country will have a new Prime Minister and, presumably, a new Chancellor. Both will have big decisions to make pretty much immediately.

Now we are down to two candidates, it is possible – just about – to start to sketch out what this all means.

Things are going to change. Cake-ism is over.

The divide between the two remaining candidates appears unusually large. In the parlance of many commentators Rishi Sunak is running as the ‘establishment’ candidate whilst Liz Truss is flying the banner for the right of the Party. But the man that whoever wins will replace was an unusual sort of Conservative Leader. The charitable interpretation of Boris Johnson’s time as Prime Minister is that pulled together a broad – and unusual - voting coalition by promising targeted tax cuts to some traditional Conservative voters coupled with a rather ill-defined but distinctly dirigiste programme of levelling up involving more public spending on areas of the country that his Party won in 2019. All of this was wrapped in a harder line approach to Brexit. The less charitable interpretation is that he tried to be all things to all people, to have his cake and eat it and was always keen to buck a tough choice.

Whoever wins, the time of cake-ism looks to be over.

In one sense, the gap in economic policy between the two candidates is smaller than it appears. Liz Truss is casting herself as the Thatcherite option – in favour of deregulation, lower taxes and a smaller state. But the rhetorical Rishi Sunak is in a similar place. Of course the actually-existing Rishi Sunak is a rather different proposition. Over his time has Chancellor taxes have risen to their highest share of GDP in decades.

Both are more obviously classically Conservative in their policy instincts than Johnson. The real divide is that Sunak has constantly put his fiscal conservativism and the desire to manage the deficit and debt above his hopes to cut taxes. Truss, whilst she will no doubt make fiscally conservative noises, is clear that tax cuts are her number one priority. She may present herself as the Thatcherite in this race, but when it comes to fiscal policy she seems more Reaganite in approach. She’ll cut taxes now and hope that growth picks up enough to close the revenue gap.

Neither candidate seems especially clear on inflation.

Both of course agree that it is a problem. Both seem to think that restraint on public sector pay is part of the solution¹.

But neither seems ready to engage with the grim reality that most of the high inflation that Britain is currently experiencing is the result of a negative shock to the British economy. Rising global energy and food prices, coupled with global supply chain disruptions, effectively mean the country is worse off than we expected to be.

The real debate for policy in 2022 and 2023 is how the country apportions the pain rather than how to make it go away. Of course, debates in those terms don’t make for especially appealing political platforms.

The Bank of England is in for a difficult two years.

I don’t especially take the noises about questioning the Bank’s independence, re-examining its remit or ‘marking its homework’ more that have emerged during the campaigns so far seriously. And no, no one is going to impose money supply targets on the Bank.

A fair case can be made that the Bank’s communications have been a mess for the past 18 months or so, that QE could have been stopped earlier, that forward guidance has become a confusing mess and the Bank’s inflation forecasting – and just about everyone else’s to be fair – has been woeful.

But in the final analysis, the Bank is a convenient punching bag for politicians when inflation is high. They can blame the Bank without engaging with the counterfactual in which households and firms received far less support in 2020 and 2021.

Threadneedle Street has a thick skin and can mostly ignore the sniping. Things will start to become more uncomfortable for the Bank in the months ahead as they do what politicians have been calling on them to do and continue raising rates to tackle inflation.

The whole point of an independent central bank, in the theory, is to act as the bad cop to politicians. To keep inflation expectations anchored by a credible threat to raise interest rates if they start to move higher. The Bank has now begun doing just that.

The interesting thing though, is that the Bank has never really had to do this in it’s 25 years of independence. Sure, there have been five hiking cycles since May 1997 but none of them have been either this rapid or, crucially, into a slowing economy.

Hiking into a possible recession is hardly ‘taking away the punch bowl as the party gets going’. It’s more like ‘hosing down the party goers with cold water even as people get ready to go home’.

If Truss, the bookmakers’ favourite, wins and follows through on her pledge to cut taxes almost immediately the Bank’s response will almost certainly be faster rate hikes. I can’t imagine that being especially popular in Downing Street.

Levelling Up? Watch the Capital budget.

While both candidates will no doubt pay verbal homage to the notion of levelling up in the weeks ahead, actions matter more than words. The thing to watch is the government’s capital budget.

With Johnson, whoever wins will likely instinctively favour a smaller state than the current PM. But delivering that in practice will be extremely tricky. Higher than expected at the time of the last spending review inflation already means that departments face a real terms squeeze. And that’s before one considers the pandemic related backlogs and pressures. The one area I can see where some form of economically meaningful cuts can be made is public sector investment.

That would not be great news for the UK in the long run but the new government may find the space for a few more tax cuts more useful that investments which will take years to show any benefit.

A levelling up strategy without a more generous capital budget though becomes a place-making strategy about band stands, nicer higher streets and hanging baskets. A good thing for the state to do (making places nicer is worthwhile policy!) but not an economic agenda.

The government is going to be weaker.

I think one under appreciated aspect of this leadership race in terms of its economic impact is that whoever is Britain’s next Prime Minister, they are going to start out in a much weaker political position than Boris Johnson. Johnson received the support of 51% of his MPs in the last ballot of the 2019 leadership race. This week Sunak, the winner, wracked up under 40% and Liz Truss just 32%. Whichever wins will have the lowest baseline of support amongst their own MPs since Iain Duncan Smith in 2001. And unlike Johnson, neither will be able to claim a ‘personal mandate’ from a general election win.

The next Prime Minister will be operating with a lower starting total of political capital and find tough decisions far harder to force through their party. At a time when Britain faces a difficult economic outlook and tricky decisions to make, this is hardly ideal.

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1. I find the logic of this very strange. Either public sector pay is part of the toolkit for handling inflation, or it isn’t. I note for much of the 2010s, when inflation was too low there were few calls from Conservative ministers to raise public sector earnings growth to try and push inflation up. More generally it seems a more sensible approach to set public sector pay to meet the recruitment and retention needs of public services rather than as a tool of macroeconomic policy. Holding it down now is unlikely to make much of a difference to wage-setting in the 80% of the labour force working in the private sector whilst hitting the quality of core public services