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  1. Economy
23 May 2022

Five ways the government failed to shield the UK from inflation

For all the Tories’ attempts to blame the Bank of England, Britain’s unique exposure to the crisis is caused by government policies.

By Will Dunn

Late last month the European director of the International Monetary Fund, Alfred Kammer, presented its regional economic outlook. The report predicted that the UK, which already has the highest inflation in the G7, would experience persistent high inflation through this year and next year, and would experience the lowest real GDP growth of advanced European economies.

“They have the energy price shocks of the Euro area… and at the same time, they are dealing with what we see in the US — the tight labour market, the demand pressures and the pressure to increase wages… This is the worst of the two worlds,” Kammer said.

This is not, as some in the Conservative Party would have us believe, entirely the fault of the Bank of England. If the Bank had simply printed too much money through quantitative easing (QE), then other economies such as the US, the Euro area and Japan, all of which printed even more money, would be looking at higher inflation than the UK. The Bank estimates that 80 per cent of the above-target inflation in the UK is caused by external factors, mainly global energy prices and disrupted supply chains.

Britain’s unique exposure to stagflation (low growth and rising prices) is caused by government policies that have focused on efficiency, creating a “just-in-time” economy, a system with no slack to accommodate global volatility. A wide range of policies have contributed to that.

Leaving the EU

The latest ONS trade data shows that in the first quarter of this year the UK recorded the largest trade deficit since modern record-keeping began in 1997. Britain imported £25.2bn more in goods and services than it exported, and £10bn of this was our widening trade deficit with the EU. The added costs of exporting from the UK to the EU now include extra paperwork, physical inspections and higher tariffs on some products. Meanwhile, the pound’s relative weakness compared with the Euro makes imported goods more expensive.

Whatever your views on the political merits of Brexit, it has come at a stagflationary price. If it costs businesses more to sell goods abroad and more to import goods to sell in the UK, they’ll have tighter profit margins and slower growth, but prices will still go up.

Running on fumes

Most of the inflationary pressure faced by households and businesses is derived from the high cost of energy, and there are a number of policy choices that have made this particularly severe for the UK.

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In 2015 the government withdrew onshore wind and solar power from the subsidy scheme, which appeased the Tories’ rural backbenchers but caused a seven-year halt to the development of new power technologies that would have given the UK cheaper energy.

Two years later, Centrica — the owner of British Gas and the UK’s largest domestic energy supplier — decided it would be cheaper to close the Rough facility, a depleted gas field in the North Sea that had made up 72 per cent of the UK’s gas storage. Other suppliers warned that this would cause prices to become more volatile, and the Energy and Utilities Alliance, the trade association, called for a parliamentary inquiry but the government responded that the closure would “not have a material bearing” on energy prices.

The Rough facility was old and expensive to maintain, but it was also important because Britain is highly dependent on gas, which provides 85 per cent of the UK’s central heating and more than half of its electricity. The UK’s gas storage to consumption ration is a tenth of the EU average, making the UK highly dependent on imports and any further price shocks.

Playing the property market

For many years, governments have aimed to boost one type of inflation — the perennially overheated housing market — because homeowners erroneously believe that higher house prices benefit them (in fact the opposite is true: falling house prices benefit almost all homeowners). Surging rents are a waste in terms of economic growth, because they increase spending on businesses that don’t use that money to employ more people or produce more goods or services. One of the reasons the UK is so exposed to the cost-of-living crisis caused by inflation is that, with the highest rents in Europe, many people in the UK spend a high proportion of their income on housing.

This is the result of government policies; for many years, tax breaks actively encouraged people to become landlords, while schemes such as Help to Buy, which has lent £20bn to people who, according to the National Audit Office, mostly didn’t need any help buying a house, have artificially inflated demand.

In addition, the UK’s old housing stock is among the least energy-efficient in Europe, as a result of policy decisions to slash or replace energy-saving subsidies. And because property developers favour greenfield sites, which are cheap and easy to develop but don’t have public transport, most new housing is dependent on car use. Rises in the cost of fuel for heating and transport are therefore felt keenly.

Failing public health

As one of the Bank’s rate-setters noted in a speech this month, 4.4 per cent of the working-age population are “outside the workforce and do not want a job because of long-term sickness”. Since the end of 2019, 320,000 people have left employment due to long-term health problems. The impact of a decade of austerity on the NHS is clear in human terms — the UK has some of the lowest cancer survival rates in the world — but this also plays out in the economy because fewer employees leads to a tighter labour market, which puts upwards pressure on wage expectations.

Again, the UK is unusually exposed to this risk. Across the EU, countries are employing more people than before Covid, whereas the UK’s employment recovery is the worst in the G7.

An unfair economy

The hawkish case for addressing inflation with steep rises in interest rates is that it would give investors more confidence in the pound, improve exchange rates, make exports worth more and imports cost less. The problem for the Bank is that without fiscal policy to support the people most exposed to such hikes — people on low incomes — the cost-of-living crisis will get significantly worse. Once again, the UK government’s ideological commitment to the market over the state makes this country an outlier: the UK has some of the highest levels of income inequality in Europe, and in-work poverty is at the highest level on record.

This leaves the UK stuck in a trap of the government’s own making, with the Bank forced to choose: more inflation, or more poverty?

[See also: Inflation is hitting the poorest hardest]

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