In this week’s macro update we consider whether the dramatic U-turn by Britain’s new Chancellor has avoided a financial crisis in the UK. We will also look at another sudden announcement – a plan by the German government to cap their energy bills, a plan that is bigger, bolder and more complicated than Liz Truss’s.
Convincing the OBR there is a sustainable plan
Britain’s policymakers face three big problems – high inflation and excessive fiscal and balance of payments deficits. All this against a background of political weakness.
However, let’s begin with the U-turn on the higher rate tax. This will reduce the projected deterioration in the fiscal deficit but it’s small beer. Kwasi Kwarteng put the cost at just £2 billion. He still has to convince the Office for Budget Responsibility (OBR) that he has a plan to put the budget deficit on a sustainable trajectory, despite reversing some of tax increases previously planned. That won’t be easy.
Public finances had already deteriorated even before Kwasi Kwarteng’s ill- judged Budget. His plan to hold spending limits, in cash terms, allowing inflation to squeeze spending in real terms, won’t be easy after 12 years of Conservative government. Trying to cut higher-rate tax in the midst of a cost-of-living crisis has been a political disaster. It makes cutting welfare spending even more difficult. So, persuading the OBR to endorse his plan will be difficult. Difficult but not impossible.
Swings and roundabouts ahead
The first casualty will be public investment. It’s easier to cancel plans to build a new hospital or school than to cut current spending. And there is some good news on public finances. Employment is still rising in the UK and that’s good news for tax revenues and funding unemployment benefits. Admittedly, the pace of improvement had slowed to a crawl, probably because businesses and consumers alike were frightened by the prospect of a huge rise in energy bills this winter. The emergency price cap has eased those fears.
The price cap will also knock chunks off inflation and that means a lower social security uprating and lower payments on indexed-linked gilts. Risks of recession have also been reduced by the massive energy support programme announced by Germany – our biggest export market in Europe.
But Kwasi Kwarteng will also need luck on his side. The plan to limit the average annual energy bill to £2,500 is to be welcomed. It has avoided an estimated increase in household energy bills of £3,000, which would have been unaffordable by many if not most. But it leaves the government with an open-ended bill dependent most of all on the market price of gas. That price is still very high but has been falling despite fears, as yet unconfirmed, of Russian sabotage to supply pipelines. A warm and windy winter not just in the UK and Europe but in Asia too would be helpful.
Germany acts on energy costs
The German government’s bold new plan will help too. After weeks of dithering, I reckon it was Liz Truss’s plan that pushed the German coalition into action. Details have not been finalised but the cost as a % of GDP is at least as big as ours and we reckon it has been calculated to give German households slightly lower bills than their UK counterparts. There is one big difference, it seems that only the first 75% of a bill, as measured by past usage, will be very cheap, with the rest at a much higher marginal price. This will give a big incentive to cut usage and help to bring down wholesale gas prices for everyone, including the UK. A cunning plan indeed.
A huge current account deficit
Lower gas prices would also help with the second big problem in the UK, our massive current account deficit. We’ve run a deficit for decades and the red ink reached a record in the first three months of this year. It improved a bit in the next three months but remains huge. The interest on the interest is growing and it is going to get worse before/if it gets better. We will have a huge bill for imported gas over the winter. We’re also paying £2.5 billion every three months to the EU as part of the withdrawal agreement. Our current account deficit could reach a staggering 10% of GDP over the winter. That will worry the financial markets and the credit rating agencies.
Credibility will be crucial
Any new Chancellor needs to establish credibility with the financial markets. Kwasi Kwarteng has started very badly in that regard. The Bank of England had to step in to stop the circle of doom in long-dated government debt last week and has made it clear that a big rise in base rates in on the way. That brings us to the next crisis for the government – falling house prices. I discussed all this in more detail in last week’s webinar and I’ll be giving an update in our annual client conferences, in Edinburgh on Thursday and London next week. Contact your representative at Columbia Threadneedle for more details.
