Animal Spirits, Taxing and Borrowing  — Editorial

Kwasi Kwarteng is clearly a believer in animal spirits, or more specifically, the animal spirits of the UK private sector. The term ‘animal spirits’ was used by the economist J. M. Keynes to describe the spontaneous forces of vitality that drive human action.  Apparently these animal spirits have been held back by too much taxing and spending by the UK government.  And that, according to Kwarteng and Truss, is the explanation for Britain’s low growth.

Kwarteng proposes to fix the UK’s problem of low growth by 1) abandoning Sunak’s planned increase in corporation tax, 2) abandoning Sunak’s planned 1.5% increase in National Insurance, 3) ending the cap on bonuses in the city.  The original plan to abolish the 45% tax rate on high earners has been abandoned as we go to press.

Kwarteng will also remove those regulations that he feels are restraining the animal spirits of the private sector.  Incentivised by lower taxes and less regulation, the UK private sector, according to Kwarteng, will resolve the problem of low growth that has bedevilled the UK economy for the last 15 years.

It’s a somewhat bizarre belief.  In the 1980s Thatcher also decided to give the private sector its head by selling off the nationalised industries.  Energy, transport, water, communications were sold off to the private sector.  Local government was blocked from providing social housing.  The results have been spectacularly unimpressive.  Yet Kwarteng wants to once again increase our dependency on the private sector.  

An interesting feature of the fiscal statement is the absence of concern about the size of the national debt.  The national debt is just the cumulative difference between government spending and taxes levied.  Clearly it will  go up under Kwarteng, since Sunak’s tax increases have been abandoned  but no equivalent spending cuts were announced.  Rather, there are large increases in spending to help households pay their energy bills.  

Kwarteng had little to say about the increase in national debt implied by his fiscal statement.  This apparently spooked the markets because his fiscal statement implied massive borrowing from the private sector that could only be achieved if the government paid much higher interest rates.  Indeed, the suggestion was made that the private funds might not be available.   The markets therefore may not believe the ‘animal spirits’ story, fearing instead further degeneration in Britain’s productive capacity.  

This understanding of the mechanics of financing UK government spending is quite wrong.  The UK is a currency creating state.  Once expenditure has been approved by Parliament, the Bank of England (BoE) is legally required to make any payments implied by that expenditure decision.  The BoE simply creates money to finance expenditure approved by Parliament.  Government spending is always financed in the same way, through the creation of money.  Kwarteng does not have to borrow from the private sector to get the funds that he needs to finance his spending plans.

However, by tradition, an institution called the Debt Management Office (DMO) auctions bonds, the value of which broadly matches the difference between what a government spends and what it levies in taxes.  Bonds are auctioned quite frequently, often weekly.  

As an example, the DMO auctioned a bond for £3 billion on 11th January.  So, an investor could buy a piece of paper that promised to give him £100 in 4 years’ time. And each year he would additionally be paid interest on his investment at the rate of 3/8% [about .37%]. That’s 37.5 pence per annum. What should an investor pay for this bit of paper?  There is no risk that the bond will not be repaid since the UK government can simply create the money to repay the bond.  However, there is the danger than inflation may reduce the buying power of a £.  In the auction on 11th January investors, were only prepared to pay £95 for this piece of paper.  So their effective rate of interest, called the yield, was 0.988%.  

That was on 11th January.  By 6th September, as concerns about inflation grew, the yield on a similar UK government bond had increased from 0.988% to 3.18%.  That’s quite nice if you have money that you don’t need to spend.

The existence of the Debt Management Office (DMO), created by prudent Gordon Brown to prove he could be trusted by the rich, is a problem.  It auctions bonds and accepts bids that mean that the interest paid (yield) on those bonds is high.  The best solution would be that the DMO did not issue bonds.  Alternatively, the DMO should put a reserve price on any bonds that it issues.  If the market does not want them at that reserve price, then the government should instruct the BoE to buy the bonds, as they did during Covid.  For the curious,  a full list of gilt auctions can be found here:

This is how Furlough was financed during Covid.  The BoE created the required money.  The DMO issued bonds for a similar amount.  The BoE bought these bonds.  If this is how Kwarteng wants his deficit to be financed, he will have to remind the governor of the Bank of England, Andrew Bailey, that the BoE is wholly owned by the Treasury.  It will be interesting to see how the relationship between the BoE and the government develops.  If Kwarteng is unable to assert the dominance of the government in this relationship he will fail.

There is also the question of the Office for Budget Responsibility (OBR).  The OBR was created by George Osborne who based his entire chancellorship on reducing the size of the national debt.  As a result, Osborne’s austerity program created one of the lowest rates of recovery from the 2008 Global Financial Crisis and was a main factor in the vote for Brexit.  The purpose of the OBR was to independently determine the effect of government budgets on the size of the national debt.

Unlike Osborne, Kwarteng showed little concern in the effect of his growth plan on the size of the national debt.  He is quite right to take this position.  Since the UK is a currency creating state and not, therefore, financially constrained, his only concern should be with the effect of government spending and taxation on the welfare of the UK’s citizens.  If high spending or low taxation increases that welfare then he should not concern himself with the effect it has on the size of the national debt. Kwarteng’s behaviour suggests he believes that the size of the national debt is very much a secondary consideration.  But it is highly unlikely that he would be prepared to publicly state it.

Kwarteng is quite right that it is the effect of fiscal policy rather than the size of the national debt that matters.  However, when his attempt to achieve higher economic growth by releasing the animal spirits of the private sector through lower taxation fails, as it most likely will, Tory attention will, inevitably, return to the size of the national debt.  Taxes will have to be raised or government expenditure will have to be cut.  For a Tory administration, the preferred route will be to cut expenditure.  The ultimate result of this budget may well be further cuts to government benefits and services.

At which point, Labour’s preoccupation with ‘fiscal rules’ and the size of the national debt because of its desire to appear fiscally responsible will fail the working class.  Labour need to realise that the question of importance is whether government spending and taxation is good for the society.  The size of the national debt should not enter into that consideration. Labour Affairs has argued that spending should be directed towards improving localities, focussing on transport, education and skills, the environment and social peace. Labour should also consider investing directly in businesses that have promise. Capitalist investment is more likely to appear if the candidate locality is attractive with a motivated, contented, skilled and well-educated population, who can easily travel to their places of work. If the environment is attractive, managers and their families will be happy to relocate there. Their ‘animal spirits’ are more likely to be aroused by such a policy and the same goes for the workforce.

At the moment, Labour by concentrating on a household view of national finance, has fallen into a trap. They cannot say how they will pay for any proposal without increasing the national debt. But that leaves them with little or no room to make any proposals that might restart growth in Britain’s regions. Their best hope is that the electorate do not notice the feebleness of their position.

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