Given the many political and market events of the past week it is difficult to know where to start.
It may be useful to look at the UK economy as an overinflated balloon. The balloon has been reduced in size by Covid, demographics, people leaving the workforce and other issues such as Brexit. At the same time, low interest rates and quantitative easing have pumped more money into the balloon – the Bank of England now holds almost £600bn of government debt, up from 0 in 2008, and over £200bn of that additional borrowing was added during Covid.
This has left us with a constricted balloon that has been pumped up with money and this is putting the economy at significant risk of bursting. That pressure inside the economy is most obviously measured by the increased rate of inflation.
The economic and political discussion is around what needs to be done to relieve the pressure and reduce the risk of the balloon bursting.
The first thing you can do is try to deflate the balloon, this can be described as the monetary approach. This means taking money out of the economy by increasing interest rates, reducing government spending, increasing taxation or a combination of all three.
The second thing you can try to do is increase the size of the balloon. A number of factors have the effect of constraining the economy. Trying to remove these constraints could, in theory, allow the economy to grow and reduce some of the inflationary pressures. This is what the current government is calling supply side reforms.
The final issue the government can try to address is productivity. Increased productivity can increase the capacity of the economy to grow without increasing demand for restricted inputs, primarily labour. You can view increasing productivity as having the effect of condensing the air within the ballon and decreasing the outward pressure.
The current government is focussed on the supply side reforms to relieve the pressure. The battle they are going to have with the markets is that the markets believe only the first solution, tightening monetary policy, is going to be effective.
If the government just tinkers with policy then they risk squeezing the balloon in one place while increasing the risk of it bursting elsewhere, this is what we’ve seen over the past week.
Simply tinkering with reducing taxes without other reforms just increases the risk of inflation and interest rates having to go up, driving up mortgage rates and pushing the economy over the edge.
The government appears to have quickly but belatedly realised this, and we can now expect them to work on a raft of measures focussed on the supply side.
The primary factors that are constraining the UK economy are a shrinking workforce (fewer people working), skills shortages amongst those who are working, internal constraints to trade such as burdensome regulations, external constraints to trade such as trade barriers, and specific demand and supply imbalances such as housing and energy supply. This is the list of issues the government is looking to address.
We have some hints as to what the government is looking to do:
They will try to encourage people back into the workforce, likely through benefit and tax reforms.
Rhetoric on immigration also appears to have changed. The easiest way to reduce skills and labour shortages is to increase immigration. This is an interesting one to watch for a change in policy, and in effect over the last couple of years we’ve seen ramped up rhetoric and policies such as Rwanda on the one hand, while at the same time the government has been steadily easing some barriers to immigration, such as those for foreign students.
They are clearly looking to scrap some regulations, most obviously through investment zones. Reviewing and rewriting large swathes of regulations is difficult and time consuming. At the same time, simply scrapping regulations across the board is risky, as there will likely be significant unintended consequences. They are therefore taking the expedient path of scrapping regulations in specific geographic areas through the proposed Investment Zones, and seeing what happens.
They will try to increase housing supply. Policy here lacks specifics. This is something the government has been trying to do for years through a number of policy initiatives, most of which have failed. Housing supply is important to economic growth because you want a flexible and mobile population who can go to where the jobs and growth is. Property ownership is also an important economic motivator in creating a sense wealth (we can argue whether that is a good thing for productivity).
Perhaps the biggest behind the scenes shift in policy over the last week has been towards external trade barriers. One of Truss’s first conversations as Prime Minister was with the Irish PM, stating a desire to work more constructively with the Irish government and the EU to solve the Northern Ireland issues. In addition, Steve Baker, an ardent Brexiteer, has signalled a change in tack and even some humility in wanting to now work more closely with the EU. There is a chance that this signals a willingness to work on trade deals with the EU, however more likely is that the government wants to solve the Northern Ireland issues in order to smooth the way for a trade deal with the US. The US government has made it clear that there is no chance of any trade discussions while the UK rhetoric on the Northern Ireland protocol remained so hard-line.
Finally the government is looking to solve the energy supply and demand issues by increasing investment in fossil fuels. I don’t expect this policy to last without further shifts on renewable sources. Primarily because as good as fracking or North Sea exploration may sound, it’s just not feasible. No company is going to take a risk on investing in fracking in the UK when that investment would be unlikely to survive the next general election.
The government does not have much time to show that these policies can work before the markets again see interest rate and spending cut expectations rising. That is a huge challenge.
The Challenge for us in Wales is that a lot of these issues are not in the sole gift of the UK government and require consultation and legislation from the Welsh Government and Senedd. The Welsh government has its own views on many of these issues. It is clear some fundamental change is needed, our hope is that Welsh businesses have a significant voice in the discussion.