Markets are nervous and they are right to be. The government has announced a huge, open-ended package of energy subsidies expected to cost over £100 billion but that could cost over £200 billion if energy prices rise and stay high. At the same time, the Bank of England is making large losses on its QE bond-holdings as government bond prices fall as an automatic result of current and future-expected interest rate rises – by some estimates costing potentially another £200 billion.
This leaves a possible £400 billion hole in the nation’s finances. The government says it will spell out how that will be paid for in November. From a policymaking perspective it makes good sense to wait until then because the plans will depend crucially on how much long-term growth can be raised (and the government is setting out how it intends to do that over the next few months) and how energy prices, the Russo-Ukraine War and the continental energy rationing schemes go.
But in the meantime markets are naturally nervous. They worry about inflation. Furthermore, as interest rates rise this will expose a series of imbalances, obsolete regulation and other technical issues that have been created by over a decade of near-zero interest rates. The pension funds nearly going technically insolvent earlier this week was just the first of those (and the government will have to decide if it needs emergency regulation to change the pension funds’ rules before the Bank of England’s temporary liquidity scheme expires in a fortnight). Later there will be issues with mortgage repayments, with securitized mortgage obligations, with outstanding commercial property rents and a whole series of others.
Maybe the answer is that we should do less – or at least do less via the taxpayer
But aside from these technical matters probably best left mainly to regulatory and monetary authorities, is there anything Liz Truss and her Chancellor can do in the short-term? Here are two key things that might make a difference.
First, a key problem with the energy package is its open-ended scale. In a tweet on Thursday the Chief Secretary to the Treasury, Chris Philp, boasted that the UK’s energy support package involves around twice as much taxpayer support for energy prices, relative to GDP, as the schemes of our European neighbours affected by much the same crisis.
Well, maybe the answer is that we should do less – or at least do less via the taxpayer. Closely connected to the issue of the energy package’s sheer scale is that there is no clear way for the government to withdraw from it if energy prices do not fall. Are we to believe that if energy prices are still leading to household bills of around £3,500 in 18 months’ time, the government will remove all its support at that point and leave households to adjust, with just a few months to go to a general election?
One way the government could circumscribe its exposure here is the following. It could say that after some date (say, in 6 months’ time) the basis for capping the wholesale price will switch from the taxpayer to energy utility companies, with those companies permitted to recover the cost through higher future regulated energy bills. And any loans those companies have to take out in the short run to cover the scheme will be guaranteed by the government.
The energy companies themselves offered such a scheme a few months ago, but Truss’s team opted to place the whole burden on taxpayers instead of future billpayers. Maybe that made political sense for the first few months of the scheme but if it drags on the fiscal impact could be huge and it would be better and more natural for energy costs to be recovered via energy bills.
A second thing that should be done now is to set short-term inflation targets, so as to reassure markets that the answer here will not ultimately be for the Bank to inflate away the government’s debts. These should be set for 2023 and 2024 and at credible, achievable levels expressed in terms of CPI excluding energy costs. Something in the region of 4 to 6 per cent in 2023 and 2 to 4 per cent in 2024 should be feasible.
These two measures will not by themselves solve everything. The government will still need to spell out a detailed plan in November. But they may buy the government enough time to do that.
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