We are told by almost every economics commentator in the main stream media that the markets panicked because, on 23rd September, Kwasi Kwarteng failed to explain how the government would fund the increase in spending implied by putting a cap on energy prices and reducing taxes.
Kwarteng’s fiscal statement was unusual. Kwarteng understood that national debt would increase but seemed unbothered by that fact. When questioned about this, Kwarteng dismissed it as an issue of little consequence. Effectively Kwarteng was dismissing the previous 12 years pre-occupation with the size of the national debt. It was politically naive to do this without realising the political forces that he was taking on. The high-priests of the national debt, the Bank of England, Office of Budget Responsibility and the Institute for Fiscal Studies, made clear their outrage.
When subsequently challenged how the government would fund its increased spending, Kwarteng’s courage failed him. He did not have the courage to say that it would be funded in the same way as Furlough and, indeed, all government spending is funded, by borrowing from the Bank of England.
UK government spending is always financed in the same way. The Bank of England creates the requisite amount of money and puts it in the government’s account. The government then spends the money and the private sector is wealthier by that amount. And national debt has gone up by that amount. When spending into an economy, the UK government does not need to worry about where the money is coming from. It should worry about whether the spending will have inflationary consequences because it may be competing with the private sector for resources. If it finds that it is competing with the private sector for resources, then it can use taxation to reduce the private sector’s spending power. The role of taxation is not to raise revenues. It is to remove spending power from the private sector so that the state has access to resources previously used by the private sector.
Issuing UK government bonds (Gilts) has nothing to do with funding government expenditure. There’s a case for saying Gilts should not be issued. However, at present the government does issue Gilts with a value broadly equal to the difference between its spending and tax revenues. Whether the private sector wants to buy these bonds or hold or sell previously acquired Gilts will depend on its perception of the movement of inflation and/or the bank rate. Market behaviour after Kwarteng’s statement suggests they were hoping for something from him that might limit inflation or the bank rate. ‘Markets’ did not believe Kwarteng’s trickle down fantasies. They assumed continued low growth and an ailing British economy. Inflation would have a bad effect on the return on gilts and a high interest rate would also diminish their value. Hence the move to sell Gilts.
The government’s decision to issue Gilts is unconnected to its funding needs. A primary role of Gilts in the UK is to allow pension funds meet their liabilities with riskless assets. The government can, if it wants, control the yield in both primary and secondary Gilt markets. Unlike the Japanese government, the British government chooses not to do this.
This realisation of the true nature of government spending had become clearer during the pandemic. Sunak increased national debt by £300 billion. Taxes did not go up. Inflation did not go up. Kwarteng seems to have naively assumed that his spending would be financed in the same way.
Kwarteng’s fiscal statement was both economically illiterate and politically unwise. It was economically illiterate to suggest that growth would come from lower taxes for the wealthiest people in the society and a reduction of regulations. It was politically very unwise to increase the spending power of the wealthy at a time when most people are experiencing a drop in living standards due to war in Ukraine.
Jeremy Hunt’s decision to increase the corporate tax rate by 6% and not to lower the personal income tax rate is a clear signal that the state wants resources currently being used by the private sector. One may well ask for what purpose. Is it to spend into the NHS or the war in Ukraine?
As we go to press it has just been announced that Rishi Sunak will be the next Prime Minister. Sunak and Hunt are cut from the same cloth as George Osborne. They believe that the size of the national debt is an important statistic. Sunak had little interest in Johnson’s levelling up agenda and often suggested that his tax increases would not be matched by equivalent increased government spending. Rather, his tax increases would be used to reduce the national debt to get the economy into a better state to deal with the next crisis. That would lead to increased unemployment which is hardly a recipe for winning the next general election. Tories in the red wall seats will view Sunak’s election with some nervousness.
There is also the war in Ukraine. This has created a massive increase in energy prices and a broader increase in the cost of living. Workers are mobilising to defend their standard of living. This will add further to the inflation.
The Bank of England is tasked with controlling inflation. It can do little about imported energy prices. It can stop workers from defending their real standard of living by creating unemployment. The purpose of increases in the bank rate is to force the working class to accept the drop in their standard of living implied by the war in Ukraine. Sunak will support that.
The NATO war in Ukraine and the weakening of Russia and Europe has been a main project of British politics today under Johnson and Truss. The Labour Party will raise no objections to that project since it is also an ardent supporter of that war. It is unclear whether Sunak will be equally ardent. But have no doubt he will be cutting public services to control the national debt. And Labour will struggle to disagree with him.