Winners and losers

It’s very hard these days to disentangle economic and market views from the increasingly challenging geo-political events that are evolving at a speed that in my adult lifetime seems unprecedented. Almost daily, established norms are being turned upside down, whether it’s in the UN where Russia and the US together opposed a European-backed General Assembly resolution on Ukraine, or in Germany where the outgoing administration is trying to rush through legislation to increase defence spending by €200bn, or Sir Keir Starmer’s announcement in the House of Commons to lift the UK’s defence budget to 3% of GDP by 2027. It’s all a little bewildering.

The common thread, of course, is that all this activity was triggered by the arrival of Donald Trump in the White House and his radical agenda to shake the US and the world order to its core.

Clearly, what is going on has ruffled many feathers. Established diplomatic and economic norms are being shredded daily, and we are all struggling to adjust to this new disruptive normal. I for one have had to rethink my views about many important issues that I believed I understood and had a reasoned perspective on. I have found this quite uncomfortable as I suspect have many others. It’s almost like going back to school to be told that the things you had learned and relied upon for years were just not true anymore, and that you now had to acquaint yourself with a whole new set of natural laws that governed how the world works.

This process is not helped by the polarised nature of political debates on issues like climate change, energy policy, DEI, immigration, free speech and the overall health of democracy, that now grip all western economies and which are made even more challenging when trust in mainstream media is so low (see below).

Of course, surveys like this have to come with appropriate health warnings for obvious reasons, but the very low level of trust in business, government and the media in the UK is particularly shocking and especially so because there appears to be more trust in these institutions in countries that rank very low in league tables compiled by the World Bank that compare, for example, the ease of doing business across the world. The UK ranks 8th in this series out of 190 different countries, whilst Nigeria ranks 131, Brazil 124,  South Africa 84, and Colombia 67. Clearly, something is going very wrong in the UK, and this urgently needs to be addressed.

The issues I have touched on so far are complex and controversial. Most of them are absolutely fundamental to our future economic prosperity. I want to try to put some economic context around a couple of the most important to highlight some of the critical trade-offs inherent in the policy choices made by successive UK governments. Someone much smarter than me once told me that economics was all about winners and losers, but it is this perspective that is so often ignored in the absolutist debates that surround these controversial but fundamentally important issues.

It is my belief that if governments in the UK trusted the electorate more, and were honest with them about the costs and benefits of different policy choices, they might earn a bit more respect and support from them. They might also then win a larger mandate to do the more difficult things that are so necessary to reinvigorate the UK economy and our democracy. Many of these things will require a level of bravery I don’t see in most of today’s politicians and a determination to take on and dismantle the vested interests in the bureaucracy and establishment that now exert so much control over what happens here. This is a big and gnarly issue, but it is critical to our future prosperity, and I will talk about it in another blog in the near future. For now, I want to focus on the war in Ukraine and on the UK’s energy and climate change policies.

Funding our own defence

So, to the first and one of the most controversial topics we confront today. The war in Ukraine. Aside from the terrible human cost and misery inflicted on the Ukrainian population and economy, the war has also had a significant economic and political impact on Europe and also now on its relationship with the US, for so long the guarantor of its peace and security. Right now, this issue is dominating the global political debate, and in just two weeks, the apparent Western consensus on the war and when and how it would end has been turned on its head.

The bewildering series of accusations, summits, statements, and shuttle diplomacy that was catalysed by Donald Trump’s speech two weeks ago has been hard to keep track of. Trump’s initial statements were shocking, by design, and took many by surprise, and my initial reaction to them was incomprehension mixed with outrage. To me it was clear who had started this war and the idea that Ukraine could or should have pursued a peace settlement over the last three years reminded me of a quote attributed to Winston Churchill from 1940, “you cannot reason with a tiger when your head is in its mouth”.

Trump’s statement, I believe, was intended to shock, but also to catalyse action, not just with respect to the protagonists, but also by Europe’s leaders who have supported Ukraine since Russia’s invasion in February 2022, but failed to develop a credible strategy to help bring it to an end. To the extent that Europe’s leaders had a collective strategy, it appeared to rely on Russia’s explicit defeat either diplomatically through its isolation, economically due to sanctions, or on the battlefield. The reality is that none of these looked at all likely and certainly none would have appealed to President Putin.

In trying to understand the motivations for Trump’s intervention and whilst thinking about the failure of Europe to take the lead on pursuing a peace deal, I stumbled again into the Treaty of Versailles, the peace treaty that marked the end of the First World War. In fact, by coincidence, my son was studying it in preparation for a history exam.

Ultimately, this treaty was a disaster for Germany, Europe, and the world. Europe’s insistence on Germany accepting the “war guilt clause” effectively paved the way for unaffordable reparations, the surrender of territory (it had taken from France in 1871) and the effective humiliation of Germany. Germany had to print money to pay the reparations, which led to hyper-inflation and the collapse of the economy, the rise of Nazism and of course the most devastating war in human history twenty years later. Interestingly, the US objected to the treaty's terms, which they had wanted to be based on Woodrow Wilson’s 14-point plan focused on rebuilding and recovery. The president signed the treaty, but the US Senate rejected it, and the US also never joined the League of Nations, which it had proposed as an idea to avoid future conflicts.

As an aside, Germany did start the war by urging its close ally, Austria-Hungary, to invade Serbia, which it knew would trigger a wider conflict after the assassination of Franz Ferdinand.

As I read all this, I was reminded about history not repeating itself but rhyming, and I think that I began to better understand the motivation for Trump’s shocking intervention. I am not suggesting he is a student of early 20th century history, but, maybe naively, I do believe there may be method behind the US’s disruptive intervention in the debate about the war in Ukraine. A messy, compromised peace is better than a grinding attritional and unwinnable war that could always lead, unpredictably, into a wider conflict. And as much as Ukraine has been clearly and gravely wronged by what has happened over the last three years, the lessons of history on how to make peace are clear, and especially pertinent to a country like Russia and a leader like Putin.

Of course, appeasement is not the answer either. A flawed, weak and hasty peace, without appropriate security guarantees would inevitably lead to a potentially even more damaging conflict later. So, whilst the events of the last few weeks have seemingly turned the world order on its head, and the most recent, in the Oval Office, have both shocked and appalled all but the most one-eyed observers, they have at last awakened Europe’s leaders to finally take responsibility for their key role in helping to bring about an appropriate peace in Ukraine and to back it up with a robust and appropriately funded defence strategy that is not any longer completely dependent on US funding, manpower and equipment.

This, of course, then raises all sorts of related issues about how this additional bill can be funded.  From a UK perspective, the government’s announcement that the UK will commit to raising defence spending to 3% of GDP by 2027 has clearly won some brownie points in Washington and thrown the gauntlet down to the rest of Europe’s political leaders. In the short term, this increase in spending will be financed by cutting the UK’s overseas aid budget, but the additional burden from 2.5% to 3% will have to be funded from elsewhere. Defence experts suggest that even this spending level will be inadequate to cover the additional costs of delivering the peacekeeping mission along the Ukraine border with Russia (and Belarus) and the need for Europe to rearm and modernise its capability and deter future Russian aggression.

And so, the UK government bumps into the trade-off debate again. If we are at the limits of what we can borrow as the government tells us, and we need to increase spending on defence, we have some interesting challenges to confront. Either the government cuts spending elsewhere, increases taxes again, or gets serious about enabling the economy to grow faster. This is the trade-off I would have liked the PM to have addressed, and of course, my preference is that the government does what it can to facilitate higher growth. Unfortunately, and as usual, the how do we pay for it messy compromise question was left to another day.

Climate change and energy policy

This is another huge issue confronting the world, and Donald Trump's arrival in the White House has also completely shaken it up. Not that we should be surprised. He has been explicit about his scepticism about man-made climate change for a while and his desire to maximise the output of the US fossil fuel industry. Ultimately, his industrial policy to reinvigorate the US’s manufacturing base also pivots significantly on a cheap energy strategy.

This of course stands in stark contrast to the energy policy and climate change perspective of the current UK government and indeed, its predecessors. The UK has led the developed world in reducing its carbon emissions, which have halved since 1990, ahead of any other G20 country. Many will applaud this achievement, including Ed Milliband, the new Secretary of State for Energy Security and Net Zero, whose Clean Power Action Plan sees 95% of electricity generation in the UK coming from zero carbon sources by 2030 and a further very significant reduction in the UK’s carbon emissions. However, the trade-off is that the UK now has the most expensive electricity in the world (see below) for business and the fourth most expensive for households. This is a direct product of the significant subsidies and grid costs associated with incentivising private sector companies to invest in building renewable generation capacity here in the UK, (subsidy costs are recouped through consumer’s bills) and in part the requirement to back that intermittent renewable infrastructure with despatchable, largely gas fired power capacity.

Another direct result of this energy policy is that we now have an electricity infrastructure in the UK that is heavily dependent on imported power via interconnectors because of renewable energy intermittency. This means that when the sun isn’t shining, and the wind isn’t blowing, we must import power via interconnectors with Europe. However, because of capacity constraints with those interconnectors and the now limited capacity of our gas-fired and dispatchable power infrastructure, we have very little margin for error when renewable generation is low and demand is high (a potentially frequent event during winter). This creates a vulnerability to potential blackouts on dark, cold and still winter days when we have to rely on up to 20% of our energy needs from imports at peak demand. Indeed, this winter on January 8th we came perilously close to disruptive localised blackouts when we had spare capacity of just 1% of demand.

So, whilst we may lead the world in our decarbonising efforts, we should not be surprised that there are trade-offs from this policy choice. For example, energy-intensive industries will struggle to justify being in the UK because of the very high cost of electricity and in direct contrast to Sir Keir Starmer’s ludicrous claim that the UK will be a powerhouse in the AI revolution, no data centre operator would ever contemplate coming to the UK in preference to the US for example, where electricity costs are more than 70% lower.

Our energy policy agenda has also left the UK’s generation infrastructure perilously short of spare capacity in situations when winter weather leaves our renewable fleet unable to generate much power. If the UK’s nuclear or gas-powered fleet had just one outage during these sorts of stressed scenarios, we would see localised blackouts, which would create further incentives for energy-intensive businesses to move abroad.

It appears you can have a “carbon free” energy economy with consequential very high costs, or you can have a low cost, but more carbon-intensive energy system in which both old and new technology businesses want to operate, but you can’t have both, despite the protestations of people like Ed Milliband who want us to believe that renewable energy is fundamentally lower cost than other non-renewable forms of generation. The truth is that across the world, there is no evidence to support this claim (see below).

The UK’s energy policy choices have already had worrying consequences for the economy, but now that the US has explicitly chosen a different, low-cost energy path which other economies will inevitably follow, the risks attaching to the UK’s determined and unilateral rush to carbon neutrality will have even more worrying implications in the future. Maybe this is something the country wants, but it is surely time that the consequences of this policy choice were made explicitly clear to the electorate rather than the frankly deceitful rhetoric we hear from the government, which on the one hand says that growth is its number one objective, but at the same time is implementing an energy policy that makes it impossible to deliver.

Conclusion

Again, this blog has turned out to be rather longer than I had expected, and I have clearly meandered to this conclusion, but I hope, if you have got this far, that you can see why.

In summary, if the UK economy is to deliver the financial means to allow the UK government to pursue its policy goals on climate change, energy security and defence, to name just a few, it must grow. Unfortunately, current policy priorities, particularly the UK’s energy policy, make that impossible to deliver. To be clear, the UK has prioritised carbon reduction over living standards and growth. As long as we continue down this path, we will continue to de-industrialise our economy and lag behind peers like the US. This may be a choice the country wants, but surely it is time that those who govern us were honest about who wins and who loses from these fundamentally important decisions.