If cutting taxes causes an absolute meltdown in the bond market, bad enough to cost a chancellor and then a prime minister their jobs, and raising taxes puts the UK’s economic forecast into a lonely recession, you might be wondering what the correct choice really is.
Today, we dig into the most boring and basic of economic theory to find an answer to that question. What should the UK government do to get its debt under control without seriously harming the economy (i.e. you)?
The first concept to grasp is that time is a crucial part of economics, and yet it is usually ignored.
Do you remember the claims that Brexit would lead to a short-term hit to the economy, but that over the long term, we’d be better off? Most economic decisions are based on the same trade-off. If you want to improve your lot in the future, you must make sacrifices today.
Saving money is the obvious example. If you consume less today, you can save money, and that’ll make you better off in the future. Your reduced consumption can even be invested in something to make your future even better.
Conversely, if you want to borrow money today, you need to reduce your future consumption in order to pay the debt.
So savings are consumption that will be available in the future. And debt is an expression of how much of your future consumption you have brought forward by pledging it to repay debt.
Hold that thought, because we’ll apply it to the government’s situation.
First though, consider the monetary side of things, which we’ll also apply to the problem which Rishi Sunak, Jeremy Hunt, Liz Truss and Kwasi Kwarteng encountered.
The interest rate in a free market is supposed to be the equilibrium price between savers and borrowers. Of course, we have an interest rate that is set by the central bank, but that is not a natural state of affairs.
At a 2% interest rate, I’d be a borrower and a spender of money. At an 8% interest rate, I’d be a saver and a lender. The market for savings and borrowings in a free market would thus balance at an interest rate of say 5% – the price where savers’ and borrowers’ funds balance.
This reveals something called the time value of money – a key concept of financial markets.
Would you rather have £100 today, or £100 in a year’s time? The answer is obvious. People have a preference for things today.
But how much more would I have to offer you in a year’s time in order for you to accept the delay?
The correct answer, given deposit rates at the local bank, should be around £104. If I offer you any less, you could take the £100 today and put it in a bank deposit for a year, after all.
So, what the interest rate in a free market is really revealing is people’s time preferences – when they want to spend their money.
In a society where people really want to spend money today, interest rates are high. As they were when the baby boomer generation was busy listening to Simon & Garfunkel.
When people are trying to save for retirement, interest rates fall because savings and preparing for future consumption are the key concern.
The issue is that we don’t have a free market in interest rates. We have the central bank controlling them by way of meddling in the supply of loanable money. This creates distortions in the balance between present and future consumption.
By pushing interest rates artificially low, central banks try to stimulate consumption to boost the economy.
But if you believe in the time value of money and time preferences as described above, then what central bankers are actually doing is stealing future consumption and bringing it forward to today. They are tricking would-be savers into buying things.
Another way of thinking about it is that, if central banks create money in order to buy bonds under quantitative easing (QE), this tricks the economy into thinking that there is a huge amount of savings. That, in turn, means that a huge amount of future consumption is being built up. But because that money was just created, not saved, the future consumption will never actually arrive. It is fake future consumption. Nobody had to forgo present consumption for the savings to come into existence.
Of course, eventually, this policy stops working very well. You hit 0% interest rates, inflation spikes and there is no more growth to pull forward in time.
Let’s apply this idea, and the idea that government debt is stolen future consumption, to the UK’s growth and debt conundrum… once I explain the situation we face there.
We have so much debt and government spending that we can’t cut taxes, because the budget will spin out of control. That’s what Truss and Kwarteng found out the hard way.
But if we raise taxes to bring the budget under control, we strangle the goose which lays the golden egg – the economy. It stops growing, as Sunak and Hunt are finding out the hard way.
So, what’s the right policy?
The Laffer Curve is the idea that there is an optimal point in taxation policy, presuming your optimal outcome is to maximise taxation, anyway.
The curve argues that raising taxes generates more government revenue, up until some hypothetical point. Raise taxes any further… and people begin to evade tax, the economy stops growing, people leave the country and a number of other things happen to actually reduce the total tax take. To be clear: at some point, raising taxes reduces tax revenue.
So there is an optimal level of taxation. And trying to find it is important. But the Laffer Curve doesn’t consider the crucial consideration of time.
So, let’s bring in the factor of time. A growing economy eventually pays more in taxes because it grows. If you forgo goose eggs by way of mating, you eventually get more geese, and thereby more eggs. But this growth takes time.
Computer game developers understand this. The player trying to grow their civilisation in the game constantly faces the same trade-offs. They can tax now in order to spend money on warfare or infrastructure, at the expense of strangling the economy. Or they can keep taxes low, grow the economy and thereby end up with a bigger tax base in the future.
So, Truss and Kwarteng’s tax cuts involved short term pain with the promise of long-term gain, while Sunak and Hunt are proposing short-term gain by way of higher tax revenue immediately, but a smaller economy in the future.
Now let’s bring in our understanding of debt and monetary policy from earlier.
Central bankers have completely undermined the trade-off that Truss, Kwarteng, Sunak and Hunt faced by stealing growth from the future with their loose monetary policy.
It’s much the same for government debt. We can’t grow if too much of our future consumption has already been pledged to paying debt.
So… the pro-growth policy won’t work.
Kwarteng’s plan to cut taxes to grow the economy would have worked… but a few hundred billion pounds in debt ago.
Hunt’s plan would’ve worked… provided that he was hiking from a low rate of tax. But we may be beyond the Laffer Curve’s optimal point.
Between the four of them, they’ve tried both options. But the future just has nothing left to give and the British taxpayer doesn’t either.
In other words: time’s up.
In situations like this, governments always try to exert more control over their economies in an attempt to hold things together, rather than letting them fall apart.
That’s why central bank digital currencies (CBDCs) are so high on the agenda now. We need one in order for the government to be able to impose the policies needed to avoid a crisis.
But that could be bad news for investors. Find out why, here.
Nick Hubble
Editor, Fortune & Freedom
