The Queen of wishful thinking

This week, we will see some important announcements from the Chancellor and the OBR. Most prominent of these will be Rachael Reeves’s so-called Spring Statement, which is, in effect, an update on the Labour government’s fiscal policy and her most important announcement since last October’s budget. This will be a difficult moment for the Chancellor because it is likely to show that as a result of higher spending and slower growth since last summer, caused in my view by her negative economic rhetoric and by the damaging measures announced in the budget, the government will have less fiscal headroom than it had planned for which will result in the need for “spending cuts”. In fact, these will not be cuts as such, but lower increases in spending than had been budgeted for last October. The OBR is likely to add to the Chancellor’s discomfort by lowering its economic growth forecasts and, consequently, creating more fiscal headaches for the government in the future.

This is a difficult moment for the government, too, because its fiscal plans are unravelling because growth in the economy has stalled. And growth is, of course, the key. Without it, none of the government’s promises are deliverable, whether on defence, incapacity benefit, foreign aid, climate change or anything else. And it is on this subject that I find myself in complete agreement with the Chancellor and the government. The government must do all it can to enable the economy to grow more quickly. Where I disagree is in the execution of this objective. Nothing the government has done since it came to power has helped the economy deliver that objective. Indeed, I would argue that what it has done has made growth harder to achieve and by implication, the MPC and the OBR agree with this position it appears.

Whilst I recognise the limitations of government policy to do many of the things that politicians promise, on this subject it is far from helpless. Many policy options available to the government would liberate the economy and deliver growth. I have made several suggestions in previous blogs that I believe would do just that. The problem, of course, is that political dogma, will, and timidity get in the way and prevent politicians from doing obvious things that could help the economy grow more quickly.

Whilst this is extremely frustrating, all is not lost. There are other things that can mitigate institutional stupidity. I want to write about the things that I think will unfold in the next 18 months and deliver what I have been writing about for months now: a better growth outcome in the UK than consensus expects.

But before doing that, I wanted to make a few points about the economic context we are now confronted with in the UK.  Having done that, it will be more obvious what policymakers will need to do to help the economy deliver better growth, at least for the next two to three years.

Let’s start with tax and government spending and how both have evolved since the start of the pandemic in early 2020. The two charts below and the attached table clearly summarise what has happened over the last five years and, importantly, show what is expected to unfold over the next five (according to the OBR forecasts from the October 2024 budget, which will be updated on Wednesday).

I have written many times before about the damage inflicted on the public finances by the pandemic. What I have paid less attention to is what has happened to the tax share of GDP, which will have increased over this whole period (to the end of the decade) by 5.5% from 37% to 42.5%. As for the very substantial increase in government spending as a proportion of the economy, 2% of the 5% increase from 2020 to 2025 is due to higher debt interest reflecting the increase in outstanding debt from the pandemic, the cost-of-living crisis and higher interest rates (which I will return to later).

However, to return to the core issue of growth, if anyone is in doubt that high taxes stifle growth, the following data shows a clear negative correlation between the level of taxes and economic growth worldwide. Here, the data is standardised IMF data to enable consistent comparisons between different countries.

I suspect that the Chancellor wouldn’t like these charts very much (I don’t think she is a Woodford Views subscriber), and neither would the PM, but whether they like them or not, they need to learn from them. High taxes are not compatible with high growth, and so, by clear implication, neither is high government spending.

One other key relationship is especially relevant to this issue: the relationship between investment and growth. These two variables have a very strong positive correlation, as you can see from the charts below. More investment as a percentage of GDP is highly correlated with faster growth.

If the Chancellor was looking for ideas for her next budget, here’s a really good one. Policymakers need to create an environment in which businesses are incentivised to invest more, and of course, the public sector should look to do the same, but one would hope for things that make a positive difference to the economy rather than expensive vanity projects like the high-speed rail link between London and Birmingham. Unfortunately, the UK has a long and poor track record on the investment share of GDP in both the public and private sectors. But that could change with the right tax incentives for example.

Less than nine months into this government’s five-year term, it is clear that its fiscal strategy is in tatters. But worse, its growth agenda seems to extend only to talking about it and maybe even wishing for it, but not doing anything that will make it a reality. Although this is disappointing, I am not altogether surprised, which begs the question I was asked today: How can you be more positive about UK economic growth?

The answer is that I still expect over the next 18 months and possibly beyond that period, as inflation continues to fall, that there will be further significant cuts in interest rates from their current 4.5% level to potentially below 3%. This will help catalyse a shift in UK household saving behaviour and lead to higher consumption growth. This shift will be assisted by ongoing healthy levels of real income growth, combined with a stable labour market. The following charts, I hope, will help to show why this is possible and why it is so obvious that rates are too high here in the UK. (I still expect three more cuts this year in May, August and November)

First, I wanted to show you data on the UK saving ratio and how it compares with the US, then show what much higher levels of saving in recent years have done to household balance sheets and cash flows and finally show a comparison of deposit and loan growth in the UK. After seeing this evidence, I hope you will conclude that interest rates are too high in the UK and need to come down quickly, especially against a backdrop of high and increasing levels of taxation. By way of comparison, in the EU, which has similar levels of inflation (excluding the budget effects), rates are already down at 2.5%.

First, a comparison of UK and US saving rates as a percentage of disposable income. By implication, if UK rates were to align with those in the US, there would be a massive boost to UK consumption growth.

Saving has been very high since the pandemic. This chart shows how large “unplanned” saving is in the UK relative to a normalised 5.5% saving rate since Q4 2019 (by the way, this ONS data is very reliable, unlike some series I could mention). To put this into context, total “unplanned” saving of £376bn is approximately 13.2% of UK GDP.

These next two charts put this saving into a balance sheet and cash flow context. The first chart shows how household bank deposits have changed dramatically over the last 15 years from a negative £300bn to a positive (deposits bigger than loans) £300bn. In other words, a £600bn swing, or 21% of GDP.

This next chart puts this saving boom into a cash flow context. I have shown this before in a previous blog, but it still surprises me to this day. Effectively, what it shows is that because deposits are now so much bigger than loans (including mortgages), higher interest rates have actually boosted household cash flow, not eroded it.

Finally, the summary chart shows how high interest rates have distorted normal saving and borrowing behaviour in the UK economy. It shows that while rates have remained so high, households have saved more as they seek out higher returns on those savings. Conversely, household borrowing has remained muted, resulting in deposit growth outstripping loan growth by a factor of between 4 and 5x since the end of 2023.

This combined evidence, I think, paints a very clear and compelling picture of the imbalance between savers and borrowers in the UK caused by excessively high interest rates. This needs to change quickly if the UK is to avoid an unnecessary and prolonged period of economic stagnation. It should also be obvious to policymakers as well that against a high and increasing tax burden in the UK, there should be a compensating low-interest rate environment. High taxes combined with high interest rates would undermine even the strongest economies, and that is, in effect, what we have in the UK.

Therefore, my message to the MPC would be to please stop fighting the last two years’ war on inflation and start helping the economy deliver more growth now and in the next two years. My guess is that Rachael Reeves should be doing exactly the same thing. Talking about growth or more wishful thinking will do nothing to deliver the outcome we all want. Actually doing something that makes it achievable might.