This article was originally published on 12 September 2022. On 1 October 2022, the new Ofgem energy price cap came into effect. This article has been republished in light of the latest news.
In October 2008, a financial analyst at JP Morgan wrote a piece in the New Statesman titled: “And still the Chancellor borrows”. In it, he bemoaned the “madness” of an increasingly unpopular party trying to keep itself in government by kicking aside “fiscal responsibility” by dramatically increasing government borrowing, only to hand it to an amoral industry. “We are happy to believe in markets in the good times. When times are bad, we run to the state,” he wrote.
The writer was of course Kwasi Kwarteng, who is himself now Chancellor and is doing exactly the same thing in the same position. Last week, Liz Truss announced that the government will cap energy bills for consumers at £2,500 per annum for a typical household for two years, and will apply a similar discount for businesses for six months.
This plan provides a vital and very significant reduction in the cost of energy and in doing so the government expects it to reduce inflation by as much as four-to-five percentage points. But this is a short-term effect that comes at an immense long-term cost. It commits the UK to borrowing an unknown and unlimited amount from financial markets, at an elevated rate, in a manner that will produce higher inflation, and higher interest rates, for years to come.
The effect of this can already be seen in financial markets, in which inflation-linked securities change price according to how much the people buying and selling them expect inflation to rise or fall.
“Longer-term inflation expectations have not fallen much,” said Janet Mui, head of market analysis at Brewin Dolphin. “The market believes that one year ahead, inflation [in the UK] is going to fall, but five to ten years ahead, inflation is expected to stay elevated. So the lower inflation compared to previous forecasts is a very near-term thing that the market is expecting due to artificially suppressed prices, and in fact the market is worried about longer-term inflation implications.”
This concern comes partly from the fact that because the energy price cap is paid for by new government borrowing, rather than new taxation (such as a windfall tax), it commits the UK to borrowing as much as it takes. The cost of the plan has been estimated at £100bn by the government and £250bn by others, but the truth is that the UK will have to pay whatever the difference is between the wholesale cost of energy and the new price cap. Because wholesale prices can, as we have seen, rise exponentially, the UK’s borrowing is effectively unlimited.
It gets worse, however, because government debt – when raised from financial markets – is not all created equally. Committing to borrow an effectively unlimited sum from financial markets means committing to sell an effectively unlimited number of government bonds, or gilts. That makes those gilts cheaper. As bonds get cheaper, their “yield” (the return the lender receives) increases. The UK’s new borrowing to finance the energy cap will be issued at current market levels, which Mui believes will make the country’s new borrowing costs “very high”.
But this is not the only financial market in which Britain will have to pay more. Ballooning debt and a large trade deficit affect the value of the pound – now at a 37-year low – which makes imports more expensive and pushes up prices across the economy. This is an effect we have seen before: researchers at the London School of Economics found that the slump in the pound after the Brexit vote pushed up inflation in the UK by 1.7 percentage points.
Still more cost is added by the fact that the Truss plan not only dents market confidence in the UK, it fails to address the problem of demand.
Stephen Millard, deputy director for macroeconomic modelling and forecasting at the National Institute for Economic and Social Research, explained that “somebody, at some point, has to pay the energy companies to cover their costs”. When the government creates new debt to pay the bill, there will be, he continued, “more money going into the economy… there’ll be more demand for goods and services throughout the economy… and that increase in demand means that inflation will be higher”.
Millard said this will leave the Bank of England little choice but to counteract the demand the government has created. “We’ve got the government spending lots more money, that’s creating extra demand… that pushes up inflation. At the same time, we’ve got the Bank of England saying, ‘We still want to get inflation back down to our target. So we’re going to have to respond in a stronger way, by stamping down on that demand in order to bring inflation down.’”
The use of a blunt instrument – the same benefit for everyone in the country – also fails to address the demand for energy from businesses and consumers. During a global supply crisis, as France is discussing energy rationing and German banks turn off their heating, the UK is giving its wealthy citizens and businesses no incentive to cut back on their energy use.
“If anything, the incentive is to actually use too much gas,” said Millard, “because you’re paying well below the odds for it. And the worry then is that that actually creates a shortage.”
The new energy from fracking and new nuclear power stations will arrive – if ever – in a decade. The only short-term measure the UK has to address the wholesale cost of energy now is to reduce demand for it, by insulating people’s homes, making businesses more energy-efficient and giving those that can afford it an incentive to use less. With such an incentive, many might invest in energy-saving measures; without it, they will wait and see.
In essence, the Truss plan amounts to a quarter of a trillion pounds spent pretending that the past decade of energy policy wasn’t a short-sighted and profligate disaster, and that the recession that we all know is coming will happen to someone else. It may make the economy appear healthier for a while – just long enough to get through a snap election, perhaps – but the price of cheaper energy for all this winter will be a weaker economy for a decade.