Merlin Weekly Macro: Hunt’s electioneering Autumn Statement
Merlin Weekly Macro: Hunt’s electioneering Autumn Statement
The Jupiter Merlin team discuss the Autumn Statement, which helps position the Tories for the next election. But are Sunak and Hunt ducking the big issues?
“The budget deficit has emerged as a central focus of concern in public policy debate, attracting anxious attention from a variety of constituencies. The left now raises the spectre of enlarged deficits in opposition to the increasingly audible calls for tax reduction, while the right continues to cite the same threat against new government spending initiatives. In either case the (usually implicit) presumption of ill effects from a sustained deficit is an underpinning of the argument. The economic consequences of government deficits—usually alleged to be either inflationary (in the sense of raising prices), or deflationary (in the sense of depressing investment and hence economic growth), or both—today appear with unaccustomed urgency in discussions of hitherto unexciting policy issues.” *
Apposite in the context of this week’s UK Autumn Statement delivered by the Chancellor, Jeremy Hunt. With equality and wealth redistribution at its ideological core, Labour’s natural inclination is to eschew tax cuts (though with a trap laid by the Tories, and not to scare off potential voters, politically Labour finds itself boxed in to saying it would not reverse the tax cuts once implemented, though it explicitly would reverse the abolition of the pension lifetime allowance announced by Hunt earlier this year, and in a case of straightforward discrimination Labour is determined to levy VAT on private school fees and to burden such establishments with business rates). The Tory right-wing insists that public sector reform is the prerequisite to prevent burgeoning deficits and explosive debt accumulations.
Apposite in the context of this week’s UK Autumn Statement delivered by the Chancellor, Jeremy Hunt. With equality and wealth redistribution at its ideological core, Labour’s natural inclination is to eschew tax cuts (though with a trap laid by the Tories, and not to scare off potential voters, politically Labour finds itself boxed in to saying it would not reverse the tax cuts once implemented, though it explicitly would reverse the abolition of the pension lifetime allowance announced by Hunt earlier this year, and in a case of straightforward discrimination Labour is determined to levy VAT on private school fees and to burden such establishments with business rates). The Tory right-wing insists that public sector reform is the prerequisite to prevent burgeoning deficits and explosive debt accumulations.
An electioneering Autumn Statement: desperate times, cynical measures
Hunt has reduced employee National Insurance by two percentage points and introduced a new raft of tax incentives to encourage business to invest in capital expenditure. In a flatlining economy, the prospective total take on income taxes next year net of this week’s reduction in the NI rate will still be £7bn greater than last year. It depends on your perspective whether what he has announced represents a tax ‘cut’ or merely offers a little light relief from what will still be appropriated by a rapacious Treasury.
But as we have discussed many times in these columns, the central problem with the UK government finances is debt. £2.6 trillion of government borrowings is the equivalent of the size of the economy, and in 2023/4 at £95bn it will cost £50bn more to service in interest charges than in 2018/19. That and the fact that, in the persistent absence of public sector reform, the Treasury remains incapable of producing anything other than budget deficits in an unbroken history stretching all the way back to the Millennium.
A year ago, emerging from the wreckage of the brief but destructive debacle that was Trussnomics, the newly appointed Hunt declared that the country faced “eye-wateringly difficult challenges”. In January, laying out his prime ministerial stall, one of Rishi Sunak’s five pledges for 2023 was “to reduce the debt”; with only five weeks of 2023 remaining that is a pledge that will not be met (given how long it takes to effect such measures and to produce a tangible result, it was a foolhardy promise to offer up in the first place). At the Tory conference in October, Sunak doubled down and insisted that he would be the first prime minister in 30 years not to “duck the big issues”. Earlier this week, bounced by other political events over which he had lost control, in an unscheduled speech to deflect from the Conservatives’ domestic difficulties, among other subjects he repeated his pledge to cut government debt, but over the medium term.
Confronting “eye wateringly difficult challenges”. Not “ducking big issues”. Pious pledges and leaky promises and an inescapable appointment with the electorate. A very stubborn 20pt deficit for the Tories in the polls against Labour; a Reform UK party with momentum behind it and with an 8% share, a naturally rightward-inclined break-away constituency with just enough support to do considerable damage to the Conservatives’ prospects; a prime minister with a 22pt negative approval rating; and 14 months maximum to the election. Desperate times call for desperate measures. Solution: chuck the dog a bone and keep it happy with a tax ‘cut’. See how it goes and maybe keep another in the coat pocket for the Budget in March, a last pat on the head and hope it doesn’t bite the hand that feeds it. That was about the level of sophistication and imagination behind this week’s thinking.
Whatever the political expediency, and however welcome at a personal level in restoring a few pound notes to those who earned them, does cutting taxes now make strategically sound economic sense?
But as we have discussed many times in these columns, the central problem with the UK government finances is debt. £2.6 trillion of government borrowings is the equivalent of the size of the economy, and in 2023/4 at £95bn it will cost £50bn more to service in interest charges than in 2018/19. That and the fact that, in the persistent absence of public sector reform, the Treasury remains incapable of producing anything other than budget deficits in an unbroken history stretching all the way back to the Millennium.
A year ago, emerging from the wreckage of the brief but destructive debacle that was Trussnomics, the newly appointed Hunt declared that the country faced “eye-wateringly difficult challenges”. In January, laying out his prime ministerial stall, one of Rishi Sunak’s five pledges for 2023 was “to reduce the debt”; with only five weeks of 2023 remaining that is a pledge that will not be met (given how long it takes to effect such measures and to produce a tangible result, it was a foolhardy promise to offer up in the first place). At the Tory conference in October, Sunak doubled down and insisted that he would be the first prime minister in 30 years not to “duck the big issues”. Earlier this week, bounced by other political events over which he had lost control, in an unscheduled speech to deflect from the Conservatives’ domestic difficulties, among other subjects he repeated his pledge to cut government debt, but over the medium term.
Confronting “eye wateringly difficult challenges”. Not “ducking big issues”. Pious pledges and leaky promises and an inescapable appointment with the electorate. A very stubborn 20pt deficit for the Tories in the polls against Labour; a Reform UK party with momentum behind it and with an 8% share, a naturally rightward-inclined break-away constituency with just enough support to do considerable damage to the Conservatives’ prospects; a prime minister with a 22pt negative approval rating; and 14 months maximum to the election. Desperate times call for desperate measures. Solution: chuck the dog a bone and keep it happy with a tax ‘cut’. See how it goes and maybe keep another in the coat pocket for the Budget in March, a last pat on the head and hope it doesn’t bite the hand that feeds it. That was about the level of sophistication and imagination behind this week’s thinking.
Whatever the political expediency, and however welcome at a personal level in restoring a few pound notes to those who earned them, does cutting taxes now make strategically sound economic sense?
“Who will rid me of this troublesome debt?”
Regular readers of these columns will know we have rehearsed ad nauseam a monetarist point of view to challenge the lazy Keynesian economic orthodoxy. At the risk of boring you again: fundamentally we believe in the capitalist principle that the state works for you, rather than the socialist point of view that you work for the state. The public sector is a necessity but it essentially recycles taxpayers’ money and any contribution to wealth generation is either a by-product or at the margin, not the core. Markets are more efficient allocators of capital than governments, economic wealth and progress are created and driven by the private sector. Lower rates of taxation empirically drive higher tax receipts in a growing economy. To create wealth should be lauded, not despised. But these are not individual concepts existing in separate silos; they are deeply and conditionally inter-meshed in a homogenous system, one which moves into disequilibrium when the balances are out of kilter.
At its most simplistic, the Chancellor’s job is straightforward: to raise sufficient funds to meet the government’s budgeted expenditure. Income is derived from taxes; expenditure is a mix of discretionary choices and non-discretionary obligations to maintain appropriate public services. The net is either a surplus which can then be used to reduce any outstanding debt, or to be returned to taxpayers, or it allows options about additional expenditure; a deficit means making choices about raising taxes, cutting expenditure, or plugging the gap with borrowings. A firm grip on knowing where the money is to be spent, how, and to what effect in the context of measurable need is key.
At its most simplistic, the Chancellor’s job is straightforward: to raise sufficient funds to meet the government’s budgeted expenditure. Income is derived from taxes; expenditure is a mix of discretionary choices and non-discretionary obligations to maintain appropriate public services. The net is either a surplus which can then be used to reduce any outstanding debt, or to be returned to taxpayers, or it allows options about additional expenditure; a deficit means making choices about raising taxes, cutting expenditure, or plugging the gap with borrowings. A firm grip on knowing where the money is to be spent, how, and to what effect in the context of measurable need is key.
‘r-g’: when an academic theorem is unstitched by reality and a flawed premise
There is a simple economic theorem, ‘r-g’, that says that so long as the rate of interest ‘r’ is lower than the rate of growth ‘g’, then funding government deficits with borrowings to invest in that economic growth is a rational strategy. The theorem is supported by the logic that if the debt can be funded sustainably at a lower rate of interest than the economic growth rate, then both are good for the deficit/GDP ratio which mathematically falls. What is not to like?
And therein lies the catch. Two catches, in fact: 1) ‘investment’ presupposes a positive rate of return which differentiates it from operating expenditure which has none; all too often governments confuse the two and money disappears into a bottomless hole to minimal benefit; and 2) in a system trying to avoid excess inflationary money supply, capital is a finite resource and investors must weigh up not only the pros and cons of individual projects but also the opportunity costs of investing in one rather than another (the theory of “crowding out and crowding in”); it is no foregone conclusion in the ‘r-g’ assessment of funding deficits that the increased borrowings (and therefore the cumulative debt) will actually deliver growth.
Consider the eurozone. The European Central Bank pursued a continuous programme of QE from December 2015 to July 2022. Over that period its balance sheet increased three-fold from €2.75 trillion to peak in 2021 at €8.5 trillion. Over those 7 years, even allowing for the almost symmetrical collapse-and-recovery of the 2020/21 pandemic period, GDP growth struggled to exceed 1.25%pa. Every marginal euro of debt issuance obeyed the law of diminishing marginal returns, tending to zero; it is what economists describe as a ‘failure of the transmission mechanism’ in which frictional inefficiencies prevent money that is tipped in the hopper at the top being able to percolate down to the bottom to stimulate demand in the real economy. The money gets stuck (and in this case created universal asset price inflation). Bear in mind for all this period eurozone deposit rates were negative, and latterly bond yields too, where several national governments were being paid to borrow money!
But leaving aside the real world inefficiencies of the zombie economy that are corrosive to growth, the fundamental flaw with the theorem of ‘r-g’ and ‘debt sustainability’ is what happens when the formula reverses. To point out the obvious, when interest rates ‘r’ are high it is because central banks are trying to slow the rate of economic activity, ‘g’. But the real problem, as is also only too obvious today, is that by the time that point is reached, the structural damage is already done. If governments have been less than rigorous in their application of the deficits to fund growth or the deficits have been entirely swallowed up in unproductive public sector expenditure, no matter how cheap the cost of borrowing during that period, that newly increased interest rate is likely to be applicable to a much bigger pile of debt which has been allowed to accumulate in the meantime. The resulting interest charge itself becomes a compounding drag on the economy.
Taking the OBR data released alongside the Autumn Statement: the new GDP forecast for 2024 has been slashed from the 1.7% estimated at the time of the March Budget to 0.6% now; and for 2025 from a projected 2.5% in March to 1.4% in the Autumn Statement. The Bank of England Governor is gloomier: to the questionable extent his crystal ball is any the clearer, he reckons there will be no meaningful growth in the next two years. On the higher-for-longer scenario for interest rates, nobody sees UK base rates falling below 2% (the long-term implied real neutral rate, i.e. the inflation-adjusted rate of interest that causes the economy neither to accelerate nor slow). For the next two years, ‘r-g’ is likely to remain a positive figure which means a negative outcome. With persistent deficits, still the highest tax burden in history but no commitment to a root-and-branch reform of how government spends our money on public services, the OBR sees no appreciable decline either in the sum of our nominal debt or the debt ratio as expressed as a percentage of GDP extending to 2028.
But back to those “eye wateringly difficult choices” about public spending (Hunt) and not “ducking the difficult issues” (Sunak) which have been deferred until after the election: stretch your mind back to 2010 and the inception of the Cameron/Osborne period of coalition Austerity, cancelled formally by the May government in 2017: over that 7-year period, and despite trying to curb public sector expenditure, UK government debt not only did not fall, it increased 70% from £1.0 trillion and 53% of GDP to £1.7 trillion (78% of GDP) with an average base interest rate at below 1%. Today, it is £2.6 trillion, approaching 100% of GDP and the base rate is 5.25%. At what point does someone really grasp the concept: the key to a sustainable competitive growth economy is one that is not fiscally incontinent, it has an efficient public sector which supports the wealth-creating private sector rather than dominating it and sucking the oxygen out of it. There is a logical progression. If the Tories want to put real blue water between themselves and Labour, there is the blueprint. Reinterpreting our familiar TBD acronym: seemingly it is no longer To Be Decided; it is To Be Ducked; because it is Too Bleeding Difficult.
And therein lies the catch. Two catches, in fact: 1) ‘investment’ presupposes a positive rate of return which differentiates it from operating expenditure which has none; all too often governments confuse the two and money disappears into a bottomless hole to minimal benefit; and 2) in a system trying to avoid excess inflationary money supply, capital is a finite resource and investors must weigh up not only the pros and cons of individual projects but also the opportunity costs of investing in one rather than another (the theory of “crowding out and crowding in”); it is no foregone conclusion in the ‘r-g’ assessment of funding deficits that the increased borrowings (and therefore the cumulative debt) will actually deliver growth.
Consider the eurozone. The European Central Bank pursued a continuous programme of QE from December 2015 to July 2022. Over that period its balance sheet increased three-fold from €2.75 trillion to peak in 2021 at €8.5 trillion. Over those 7 years, even allowing for the almost symmetrical collapse-and-recovery of the 2020/21 pandemic period, GDP growth struggled to exceed 1.25%pa. Every marginal euro of debt issuance obeyed the law of diminishing marginal returns, tending to zero; it is what economists describe as a ‘failure of the transmission mechanism’ in which frictional inefficiencies prevent money that is tipped in the hopper at the top being able to percolate down to the bottom to stimulate demand in the real economy. The money gets stuck (and in this case created universal asset price inflation). Bear in mind for all this period eurozone deposit rates were negative, and latterly bond yields too, where several national governments were being paid to borrow money!
But leaving aside the real world inefficiencies of the zombie economy that are corrosive to growth, the fundamental flaw with the theorem of ‘r-g’ and ‘debt sustainability’ is what happens when the formula reverses. To point out the obvious, when interest rates ‘r’ are high it is because central banks are trying to slow the rate of economic activity, ‘g’. But the real problem, as is also only too obvious today, is that by the time that point is reached, the structural damage is already done. If governments have been less than rigorous in their application of the deficits to fund growth or the deficits have been entirely swallowed up in unproductive public sector expenditure, no matter how cheap the cost of borrowing during that period, that newly increased interest rate is likely to be applicable to a much bigger pile of debt which has been allowed to accumulate in the meantime. The resulting interest charge itself becomes a compounding drag on the economy.
Taking the OBR data released alongside the Autumn Statement: the new GDP forecast for 2024 has been slashed from the 1.7% estimated at the time of the March Budget to 0.6% now; and for 2025 from a projected 2.5% in March to 1.4% in the Autumn Statement. The Bank of England Governor is gloomier: to the questionable extent his crystal ball is any the clearer, he reckons there will be no meaningful growth in the next two years. On the higher-for-longer scenario for interest rates, nobody sees UK base rates falling below 2% (the long-term implied real neutral rate, i.e. the inflation-adjusted rate of interest that causes the economy neither to accelerate nor slow). For the next two years, ‘r-g’ is likely to remain a positive figure which means a negative outcome. With persistent deficits, still the highest tax burden in history but no commitment to a root-and-branch reform of how government spends our money on public services, the OBR sees no appreciable decline either in the sum of our nominal debt or the debt ratio as expressed as a percentage of GDP extending to 2028.
But back to those “eye wateringly difficult choices” about public spending (Hunt) and not “ducking the difficult issues” (Sunak) which have been deferred until after the election: stretch your mind back to 2010 and the inception of the Cameron/Osborne period of coalition Austerity, cancelled formally by the May government in 2017: over that 7-year period, and despite trying to curb public sector expenditure, UK government debt not only did not fall, it increased 70% from £1.0 trillion and 53% of GDP to £1.7 trillion (78% of GDP) with an average base interest rate at below 1%. Today, it is £2.6 trillion, approaching 100% of GDP and the base rate is 5.25%. At what point does someone really grasp the concept: the key to a sustainable competitive growth economy is one that is not fiscally incontinent, it has an efficient public sector which supports the wealth-creating private sector rather than dominating it and sucking the oxygen out of it. There is a logical progression. If the Tories want to put real blue water between themselves and Labour, there is the blueprint. Reinterpreting our familiar TBD acronym: seemingly it is no longer To Be Decided; it is To Be Ducked; because it is Too Bleeding Difficult.
A 1978 academic paper and its wider real world relevance today: the US and Germany
* That quoted opening paragraph was written 45 years ago in 1978, authored by Benjamin M. Friedman of the US National Bureau of Economic Research, in a paper drily entitled, “Crowding out or crowding in? The economic consequences of financing government deficits. Working paper No 284”. To illustrate its immediate relevance to the UK today, we simply removed “Federal Government” from “The…. budget” in the first line. The quotation continued: “Several state legislatures have proposed a Constitutional amendment prohibiting the Federal Government from spending beyond its receipts. In 1976 the victorious Democratic (!) (sic) Presidential candidate campaigned on a pledge to balance the government budget by 1980”.
As a historical footnote, that Democrat candidate was Jimmy Carter; he failed to balance the books; the only US budget surpluses recorded in the last half century were in 1998-2001 inclusive under his Democrat successor, Bill Clinton; that they were achieved at all was entirely down to the heavy lifting putting the economy on a sound monetarist footing having been done by Ronald Reagan, a legacy soon squandered. The ‘no deficit’ principle those state legislatures were proposing was enacted, but instead of in America, it was made law in Germany as the Debt Brake law (Schuldenbremse), introduced in 2009 in the midst of the Global Financial Crisis. But if not enacted in America, it spawned a weaker cousin, today’s US government debt ceiling laid down by Congress, the subject of why the Biden Administration for the second time this year is currently confined to fiscal special measures to prevent either the closure of all public services or the US government defaulting on its loans.
And even more pertinently to the discussion in this article, as we highlighted last week, the German government budget having been declared illegal for being in breach of the debt brake referred to above, has now turned into a major political crisis. Could the German Federal government collapse? Quite possibly. What chance politically among a fragile, fractious and fragmented group of coalition members of rapidly producing a new budget that plugs a huge €60bn hole? Will the courts concede that what confronts Germany is a financial emergency and the debt brake is relaxed again (as it was during the pandemic), or will they resist and determine that it is no more than a self-inflicted own goal by the Traffic Light Coalition? Could the debt brake be jettisoned entirely? The political left is pushing hard to have it repealed as an anachronism, an irrelevance and an economic millstone; the courts and the conservatives are all for maintaining a tight fiscal ship for which the debt brake’s preservation is key. In a monetary system of quasi union but with no debt or fiscal union, any permanent rather than temporary dilution in fiscal discipline in Germany as the anchor economy in the eurozone would have significant ramifications for the euro.
Even in the dry world of theoretical economics cooked up by academics nearly half a century ago, old familiar problems are enduring in practice. History does repeat itself.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
As a historical footnote, that Democrat candidate was Jimmy Carter; he failed to balance the books; the only US budget surpluses recorded in the last half century were in 1998-2001 inclusive under his Democrat successor, Bill Clinton; that they were achieved at all was entirely down to the heavy lifting putting the economy on a sound monetarist footing having been done by Ronald Reagan, a legacy soon squandered. The ‘no deficit’ principle those state legislatures were proposing was enacted, but instead of in America, it was made law in Germany as the Debt Brake law (Schuldenbremse), introduced in 2009 in the midst of the Global Financial Crisis. But if not enacted in America, it spawned a weaker cousin, today’s US government debt ceiling laid down by Congress, the subject of why the Biden Administration for the second time this year is currently confined to fiscal special measures to prevent either the closure of all public services or the US government defaulting on its loans.
And even more pertinently to the discussion in this article, as we highlighted last week, the German government budget having been declared illegal for being in breach of the debt brake referred to above, has now turned into a major political crisis. Could the German Federal government collapse? Quite possibly. What chance politically among a fragile, fractious and fragmented group of coalition members of rapidly producing a new budget that plugs a huge €60bn hole? Will the courts concede that what confronts Germany is a financial emergency and the debt brake is relaxed again (as it was during the pandemic), or will they resist and determine that it is no more than a self-inflicted own goal by the Traffic Light Coalition? Could the debt brake be jettisoned entirely? The political left is pushing hard to have it repealed as an anachronism, an irrelevance and an economic millstone; the courts and the conservatives are all for maintaining a tight fiscal ship for which the debt brake’s preservation is key. In a monetary system of quasi union but with no debt or fiscal union, any permanent rather than temporary dilution in fiscal discipline in Germany as the anchor economy in the eurozone would have significant ramifications for the euro.
Even in the dry world of theoretical economics cooked up by academics nearly half a century ago, old familiar problems are enduring in practice. History does repeat itself.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
Authors
Investment Manager, Jupiter Independent Funds/Merlin
Investment Manager & ESG Investment Director, Independent Funds/Merlin
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