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21 September 2022

The meaning of Trussonomics: prevent a recession, then stake everything on growth

All governments want higher growth but few put the incentives in place to achieve it.

By Gerard Lyons

Since I began reading the New Statesman in September 1979 some recurring themes have been evident in discussion of the UK economy, such as the need for more investment. Another is for fiscal policy to be used more proactively in delivering growth, and not to obsess over the budget deficit, especially when times are tough, as they are today. It is interesting to note these figure prominently in Liz Truss’s plans for Britain.

Her Chancellor, Kwasi Kwarteng, has told the Treasury to adopt a pro-growth strategy. That’s good. The Treasury occupies roles that in other countries are split across government departments. In the UK its role as a finance function supersedes its aim to foster growth.

While all governments may want higher growth, the reality is that few put in place the necessary incentives to achieve it. Kwarteng is not calling for a “go for growth” policy that we have seen before, where the attention is solely on boosting demand. Instead, the focus is on the supply side to boost investment and empower the private sector. It will be unashamedly pro-growth and pro-business. If they cut income taxes, re-index tax allowances to increase in line with inflation, and lower marginal rates of tax, it will be pro-workers, too.

I thought it positive that the immediate policy aim was to prevent a deep recession and protect jobs by fixing energy prices and reversing planned tax increases. Next the challenge is to raise trend growth. I see three features.

One is a supply-side agenda to boost investment, encourage innovation, fund infrastructure and to get incentives right, through smart regulation and low taxes. For example, the UK has £6trn in pension and insurance assets, among others, but not enough of this capital pool is invested in long-term productive investment. This is where reform of Solvency II and other regulations can make a difference.

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Low taxes are a key part of the plan, but not all of it. They are important for rewarding work and encouraging firms to be based in the UK and to invest.

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Politicians often call for a deregulation agenda, yet it does not materialise. It is important to challenge the mindset that regulation is costless. When it comes to the City, an immediate focus of policy, there is an opportunity outside the EU to build a bespoke regulatory agenda for financial services. The aim is to ensure the City is competitive and that it finances UK firms to grow and invest. Amazingly, the Macmillan Gap, identified in 1931, still exists. This is the gap between the finance that firms need and what they receive. In 2019 the Bank of England said the funding gap for small and medium-sized firms was a huge £22bn.

The second pillar is sound public finances. Keynes would be turning in his grave at the UK’s nonsensical fiscal rules. The only rule that merits retention is the one to ensure fiscal discipline: reducing the ratio of debt to GDP, steadily, over time.

Truss has clear fiscal principles: let people and firms keep more of their own money. In time, the debate will likely switch to controlling public expenditure and reforming services. Tax simplification, too, should be embraced – something the Federation of Small Business calls for.

Immediate fiscal easing is necessary to prevent recession. It is non-inflationary because of the nature of our inflation shock. This was triggered by supply-side factors, such as bottlenecks that arose from the pandemic, which were exacerbated by poor monetary policy, not triggered by an overheated domestic economy. And it is affordable: the government is able to borrow cheaply despite the rise in yields. The maturity of our debt, too, is long.

The government has to keep financial markets onside. The UK is not exempt from global trends, which show a strong dollar, and higher bond yields across Western economies. While markets are naturally wary of any new government, especially when rates are rising and debt is high, policy should avoid the biggest threat to the public finances – a deep recession.

The third pillar is low inflation and financial stability. With fiscal policy playing a more important role in stabilising the economy, we need to move away from the cheap money policy that has dominated since the 2008 crisis. It has led to asset price inflation, financial markets not pricing properly for risk, an inefficient allocation of capital and a fertile environment for current inflation to soar.

Last year monetary policy was eased when it should have been tightened. At that time, I highlighted the already evident inflation risk. The economy could have coped with tightening last year but is now far less able to do so. The Bank of England needs to tread carefully as it tightens policy.

Truss has been clear that the Bank will retain its independence to set interest rates. But she should be concerned about the Bank’s self-inflicted credibility gap and poor communications. Hence a review of its remit, commonplace in other countries such as Canada, is long overdue. Diversity of thought, and of background, is needed at the Bank, where each of the four deputy governors used to work at the Treasury.

Liz Truss wants to turn around the Treasury orthodoxy that Britain is a low-growth economy where more of the budget deficit is structural, not cyclical. This thinking wrongly led the government to opt for austerity a decade ago, and Rishi Sunak to hike taxes. I welcome the shift to a pro-growth strategy.

Gerard Lyons is chief economic strategist at Netwealth

[See also: Trussonomics gives Labour a golden opportunity]

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This article appears in the 21 Sep 2022 issue of the New Statesman, Going for broke