My column for Conservative Home on hitting an economic bullseye with a three arrow approach
Updated: Oct 25, 2021
My column: Time for a three arrowed policy approach
I contributed this column to Conservative Home and it appeared on their platform on Monday, 18th October, 2021. It appeared to land well, based on the positive feedback I received on it. I contributed in my position as senior fellow at Policy Exchange.
How the Government can hit an economic policy bullseye,
There is an opportunity for a reset of UK economic policy. The fact that public debt is at a high level and that the Bank of England has engaged in unconventional monetary policy points to one direction for the government to go in: a supply-side reforming agenda, with levelling-up at its heart.
At Manchester recently, it was sometimes said that the government was in need of a coherent economic policy. Perhaps a tad unfair, but it suggests there is a great opportunity to outline that policy now. Here I propose a three arrowed approach.
Too much of the present economic debate in the UK is downbeat. Instead of seeing 2016 as the trigger to redirect our economic agenda, the vote to Leave the EU has led to a near exclusively negative view about what lies ahead. The danger is that such a view becomes self-fulfilling.
Likewise, despite high transition costs, the green agenda and ambitious move to net zero by 2050 should incentivise innovation and go hand in hand with economic growth.
It should be noted that the current challenges are not unique to the UK, as the global economy has been hit by two major shocks in a short space of time: the 2008 financial crisis and the pandemic.
While the pandemic will trigger change, with more redundancy built into supply-chains and a shift in the way some people work, as we emerge two pre-pandemic trends are likely to be dominant.
Pre-crisis drivers will return
One is the shift in the balance of global economic power to the Indo Pacific, which stretches from India in the west to the US in the east. The Foreign Secretary’s reach in this direction is helping the UK deepen trade and economic ties, while Policy Exchange’s Indo Pacific Commission has highlighted the huge opportunities.
The second is the digital and data revolution. Thus, the increased government focus on science and innovation makes sense. This, though, might merit a change in the architecture of Whitehall to ensure that innovation is not subsumed into incumbent departments.
Of course, we must not overlook our cultural and creative base. Ahead of the pandemic – as the 2017 Bazalgette Review of the creative industries showed – our creative sector was generating jobs at twice the pace of the rest of the economy. We need to build on this too, as it adds to the magnetic pull of London and to the UK’s soft power reach.
To appreciate the scale of the opportunity picture three numbers: 31, 62 and 102. These relate to the size of the world economy, measured in trillions of dollars. At the beginning of this century, the world was $31 trillion in size. Hard to imagine, but big. By the time of the global financial crisis it had grown to $62 trillion, and next year, despite everything, the International Monetary Fund sees the world economy reaching $102 trillion in size.
While the ability to reposition ourselves in this growing global economy is an opportunity, let’s realise the challenge. Ahead of the 2008 global crisis the UK’s trend rate of growth was around 2.25%, implying the economy doubled in size every 32 years. By 2016 this trend rate of growth had decelerated to around 1.2% and remains low, meaning it takes 60 years to double the economy’s size and that living standards take much longer to grow.
Leaving the EU should provide the UK with more opportunity, but we have not yet articulated that global vision in the best possible way, hence the need for a three-arrowed policy approach.
The first arrow of policy should be a supply-side revolution focused on all the “I’s” of innovation, investment, infrastructure and incentives, with the latter requiring lower taxes and easing regulatory burdens where sensible to do so. In turn, this will boost incomes and reduce inequality. A mindset change is needed, and this can only be driven by empowering businesses and people, incentivising entrepreneurs, and by a vision that is led from the top.
When he was Mayor, I outlined to Boris Johnson, how the UK had the potential to become the largest economy in western Europe within a generation. But delivering upon that potential means addressing our productivity shortfall, hence the importance of investment and upskilling.
FEED for levelling up
Levelling up follows naturally from this. This complex, and all-encompassing, topic can best be captured by the acronym FEED.
F is for Finance. Banks do not lend in scale to small business. The gap between the needs of small firms and the finance provided by banks was christened the Macmillan Gap as long ago as 1929. By 2019, in response to its Future of Finance Report, the Bank of England said this gap was then a mammoth £22 trillion. Addressing this finance shortfall is critical, as the private sector is the engine room of the economy.
E is for empowering local decision makers – the Ben Houchins of this world, who know exactly what is needed in their local areas and how to play to their region’s strengths such as with Net Zero Teesside Project and developing the freeport. Not solely top-down policy directed from Whitehall.
E is also for enterprise – while the government can use its policy levers to facilitate levelling up, it cannot do all the work itself - the private sector needs to play a significant role.
D is for Diffusion. A technical term, which captures that the gaps to be addressed by levelling up are not just across regions, but within them too. There is a long tail between the best and others within cities and regions. The same goes for opportunities too. Hence the government’s welcome focus on housing and education, including vocational skills, as stepping-stones to success.
The second arrow is restoring fiscal credibility. A necessary proactive fiscal policy has seen the debt to GDP ratio reach 100 per cent. This is large and the focus should be on reducing this ratio, not on arbitrary fiscal rules that are unlikely to stand the test of time, like their predecessors. Don’t panic. After the war this ratio was 250 per cent and it fell, gradually, helped by a focus on a pro-growth strategy.
Currently the margin of error on official projections of the budget deficit are huge. Recognising this can create the room to push back against the pressure to hike taxes.
Many economists say trend growth is low, thus more of the budget deficit is explained by structural and not cyclical factors, and thus taxes must rise to close this structural budget gap. If it was cyclical then the gap could be closed by a rebound in growth. It is like being in a hole and digging deeper, as the weak growth trajectory forces pro-cyclical fiscal policies, with taxes up, or spending squeezed, which in turn dampens growth and then feeds the desire for higher future taxes, on income, housing and wealth.
During the pandemic the fiscal assistance provided by The Chancellor was impressive and welcome. Now, we are in a transition phase to stabilise the fiscal dynamics. Avoiding further taxes and ensuring a supply-side agenda to deliver growth is essential to help ensure this.
The third arrow is the need for monetary and financial stability. This is a huge challenge, meriting a rethink of the Bank of England’s mandate, possibly moving to a money GDP target – a policy that Lord Jim O’Neill and Sajid Javid have joined me in advocating. Currently close to zero interest rates mean financial markets are not pricing for risk.
Moreover, since the start of this year, despite recovery and higher inflation, the Bank of England has engaged in excessive Quantitative Easing, so much so that the biggest buyer of government debt is a non-commercial buyer: the Bank of England. It means bond yields do not reflect demand and supply. In turn, inflation has crept higher and now financial markets have reacted, which in turn will add to the pressure on the Bank to react. Instead of draining liquidity earlier this year when the economy was rebounding, it is now having to contemplate tightening when energy prices are rising, incomes are being squeezed and growth momentum may slow.
The next few months may become more challenging as oil prices soar, costs, taxes and inflation rise, and supply pressures persist. The current energy crisis reflects many influences, including the reluctance of previous governments to make long-term decisions, such as developing nuclear. If anything, this highlights the case for having a forward-looking pro-growth economic vision now.
It is vital for the public to understand the context around this agenda and the challenging transition phase that the economy is going through. They also need to see the vision ahead.
There is a need for a reset, and it involves three arrows: monetary and financial stability; restoring fiscal credibility; and a supply side agenda, with levelling up and FEED – finance, empowering, enterprise and diffusion – central to this. Policy needs to deliver a bullseye on each!