Liz Truss and Kwasi Kwarteng, the new Prime Minister of the United Kingdom and Chancellor of the Exchequer, are gamblers on a large scale. According to the Institute of Fiscal Studies, the two-year energy package drafted by Kwarteng on September 8 is likely to cost £100 billion (4% of gross domestic product) in the first year alone. The total cost could be up to £150 billion. In addition, permanent tax cuts of more than 1 percent of GDP are expected to be announced later this week. Perhaps worst of all, as Paul Johnson, director of the IFS, points out, “The lack of an official idea of a cost estimate was extraordinary and very disappointing.” I would call it “terrifying”.
Such an energy package was necessary, for reasons I explained two weeks ago. Rising energy prices are the result of a Russian war against Ukraine. It was necessary to protect the British people and the economy from the immediate consequences. Moreover, I argued, the increase was too great to be able to cope with only targeted help. In the short term, there should be price controls, coupled with additional financial aid for the households hardest hit by what would still be very large price increases.
So, what’s wrong with what Kwarteng has done, other than not even trying to tell the world what it might cost?
First, it’s too generous. Under the plan, energy prices for the average household will be capped at £2,500 for two years from October this year (compared to £1,100 before the crisis). If targeting the more vulnerable had been more generous, the price cap could have been set at, say, £3,500, still below projected cost of £4,586 as of January 1, and almost certainly higher later on. This would have been more affordable and also a sharper incentive for energy efficiency.
Second, too much of the cost falls on public loans. The government bears all the costs of lowering prices, rather than imposing price controls on domestic energy producers, as I suggested. In addition, it does not raise additional taxes on unexpected gains or on those who can afford more. Instead, I argued for a temporary ‘solidarity levy’ on wealthy taxpayers, which would have been fully justified in such circumstances. Higher taxes on the wealthy have historically helped pay for war.
Third, the package is poorly targeted, given that it has failed to increase taxes on the wealthy or increase support for the less fortunate. Admittedly, according to the IFS, the gain from the bailout package is 14 percent of the household budget for those in the lower decile and only 5 percent for those in the upper decile, because the former spend much more of their income on energy. But in cash, the highest decile will receive about £2,000 each, against £1,600 for the poorest. According to the Resolution Foundation, the richest households gain more than twice as much in cash as the poorest, when you add in the likely rollback of Rishi Sunak’s changes to national insurance. Moreover, the latter will be hit even harder by the increase in energy prices relative to their income than the former.
Fourth, this package is unsustainable. Suppose energy prices remain this high for more than two years. What would the government do then? In fact, that point is likely to come even sooner, as the planned enterprise support package expires in six months. If the crisis lasts that long, the government should raise prices, better target aid and raise taxes. It should be drafting its follow-up plan soon.
Finally, the combination of massive fiscal easing with low unemployment, high inflation and a weak exchange rate creates significant macroeconomic risks. According to the Resolution Foundation, the package has the advantage for the Bank of England of cutting measured peak inflation by about four percentage points. That was probably part of his purpose. But it seems likely that the Bank of England will believe that the increase in demand will offset the gains from lower headline inflation and set interest rates higher than would otherwise have been the case.
Whether the impact of such a combination of easing fiscal stance with tighter monetary policy would also push the exchange rate up will depend on the main impact on confidence in the UK. Unfortunately, the new growth target, this fiscal easing, and the expected decision to implement permanent tax cuts, resemble one of those “growth streaks” that have inflated this economy (and many others) in the past. This is a risk the country cannot afford, especially given the risk aversion in the current global economy and the aftermath of Brexit.
The UK is not the US. The foreigners who fund it must believe that it is run by sober and responsible people. With inflation rising and fiscal easing, the UK is now in court. It is Kwarteng’s duty to avoid being found guilty.
martin.wolf@ft.com
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