01 Dec 2020
27 November 2020 | Jupiter Independent Funds Team
Hold the Press! Official! The UK’s finances are a mess! As if we didn’t know already. This week it was confirmed by the Office of Budget Responsibility that the UK economy is on track to shrink by 11.3% and the projected budget deficit is only just the right side of £400 billion against the Chancellor’s March budget plan of £55 billion; total UK public sector debt now exceeds £2 trillion and is more than 100% of the size of the economy. In the days of yore before the advent of central bank money printing (quantitative easing), those statistics would have added up to the country being bust.
And yet the Chancellor is keen to spend more! In his Covid-delayed Spending Review he earmarked increasing expenditure on defence, health, police, education and employment offset to a degree by a reduction in overseas aid and a public sector wage freeze for all bar the NHS. Incidentally, £4.3 billion is set aside in various guises to help the re-employment prospects of those who have lost their jobs thanks to Covid. It is a big investment in the context of what £4.3 billion could buy: a dozen new fully-kitted-out acute hospitals perhaps, or an aircraft carrier and even some aeroplanes to go with it; but in the context of employment, it is the equivalent of only 9 days’ furlough payments when the scheme was at its peak.
How does he square the circle without heaping more public sector debt on the existing mountain and in doing so increasing the national economic and financial risk? Thanks to the unique circumstances created by the pandemic, the government must be seen to be offering support: anything else would be political suicide. In the context of the debt, fiscal prudence is therefore a balancing act between political expediency and economic necessity.
Nominal debt of £2 trillion is frighteningly high, notably if interest rates go up, however remote that possibility is in the foreseeable future. That would push up the cost of financing, using precious pound notes to service the debt rather than being used more productively in promoting growth, an all-round lose-lose. But if the debt remains constant, as the economy grows the debt/GDP ratio falls, by definition, lowering the financial gearing and with it, reducing risk. That must be a good thing. But ideally, one would also like to reduce the debt itself. That requires managing current income and expenditure to curtail the annual deficit.
While there are many complex mechanisms whirring away underneath, the ability to ‘balance the books’ is reduced to the only two very simple levers at the Treasury’s disposal: one, raise more income through taxation and two, stem the outgoings from the public purse by constraining expenditure. This is where politics and economics collide.
With the experience of cost constraint in the aftermath of the Global Financial Crisis, “austerity”, a term now so politically loaded, is taboo. That is not to say hard choices can be avoided but they are complicated by political promises which limit the room for manoeuvre. On the spending side, all the areas outlined for incremental expenditure above, on top of the substantial green infrastructure projects, HS2 and so forth as part of the political imperative to meet carbon emission targets and the desire domestically to ‘level up’ the North-South divide mean that in an effort to constrain overall expenditure, the remaining spending departments have to take a disproportionate hit.
With regard to income generation, the government made a manifesto pledge not to increase the rates of Income Tax and National Insurance; these two taxes, alongside VAT, are among the biggest revenue generators for the Treasury, so, boxed-in on that front, the Chancellor has to look elsewhere. From that emerges the suggestion that Capital Gains Tax should rise significantly; expect other kites to be flown to test the acceptability of raising further income from Inheritance Tax, the possibility of wealth and mansion taxes, as well as the familiar trope of removing tax-breaks on pension contributions. For many Tories, these are red lines, not to be crossed or surrendered.
As the Chancellor said, ‘our economic emergency has only just begun’; there will be many more debates and divisions about how to restore financial stability. There is no short-term fix. But longer term, the path to sustainable growth is self-evident: a fit, healthy, expanding economy relies upon the wealth creation generated by a vibrant and confident private sector; however supportive the public sector is, economically it largely recycles taxpayers’ money in a zero-sum game. Providing incentives to the private sector to invest, innovate and compete with the best in the world, unfettered by the tangled weeds of over-bearing regulation, determining our own path, must be the sensible way forward. After all, it is half the reason we chose to leave the EU!
It is occasionally fun to play the game of pairing numbers in the easy-come-easy-go environment of government cash flows. Two examples this week. In the UK, Rishi Sunak’s public sector pay-freeze is expected to yield £23 billion over three years; a deficit-reducing cost saving? Not a bit of it! Boris has spent it: his announcement last week of an additional £16.5 billion expenditure over five years for new defence capabilities on top of the CPI +0.5% annual defence budget uplift committed in the manifesto totals £24 billion. Meanwhile in the US, Steve Mnuchin, the US Treasury Secretary, wrote to Fed Chairman Jay Powell asking for the return of $455 billion of unused equity capital set aside to seed the Special Purpose Vehicles employed to buy US corporate debt (extending its emergency QE programme to include company credits as well as US Treasuries, the Fed actually only invested $22 billion in such instruments before market confidence was fully restored). Much like the UK example, there is an amazing symmetry: a freedom of information request made by the Washington Post revealed that, of the total outstanding US Student Loan Book of $1.37 trillion, $435 billion (nearly a third) will be written off as irrecoverable, gone as if it never existed.
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