The British economy’s relative decline has been scarred by a sequence of events that will come to be seen as historically important. The financial crisis laid to rest our notion that it was sufficient to build a national plan on a burgeoning City of London. The referendum on Brexit told us that openness to European trade and migration alone did not allow our economy to deliver sustained increases in prosperity across the country. The pandemic has further exposed the need to redevelop our public provision of health, social care and transport, and to reconsider how we raise the revenues to finance that. It is not the state’s duty to replace private sector activity and impinge on its plans unduly with taxes. But the state—local and national—does have an obligation to support and enable the private sector to generate jobs and prosperity across the nation. In that it has repeatedly failed.
As we reach the end of 2021, we are emerging from the Covid cloud, albeit gingerly. Some restrictions may yet return; certainly, the threat of that happening will continue to affect household and business confidence. Economic activity is facing a persistent negative supply shock, which means that we cannot produce the same quantity of goods and services without prices rising. Those who have saved money during Covid are now looking to spend it—but if there is a shortage of goods, they may be better off holding on to the savings rather than driving up prices further.
It is yet unknown how quickly these disruptions to domestic and global supply will sort themselves out, and how quickly households will return to their usual tendency to save. If we think the disruptions will iron out by Christmas and consumers will continue to spend liberally, we might well think that our problems are behind us. However, if we think that disruptions will persist and firms and households will hold those savings as a precaution, we may face economic stagnation.
Indeed, the UK’s current supply problems may well persist, and they may also be exacerbated by Brexit, which has reduced the pool of labour, decreased levels of firm investment and contracted the size of our traded sector. Of course, less well-off households have faced a squeeze for more than a decade now, predating Brexit, which has primarily resulted from an inability to address our productivity shortfall—our long-term supply constraint. We are in a bad equilibrium where supply and demand meet each other at a low-skill and low wages point, where growth remains low.
But our problems are not insurmountable. Prompt and consistent interventions by the state to support training, labour mobility and housebuilding could alleviate some of the costs of adjustment to that high-wage, high-skill economy for which the government yearns.
Structurally, there are large shortfalls in the amount of capital available to firms—human, physical and otherwise—in many parts of Britain. The government needs to address these with a prolonged period of regional regeneration that asks hard questions of our system of local government and delivers domestic finance to support the establishment of local centres of international excellence. Funds from the new National Infrastructure Bank (NIB) should help fill the gap left by the European Investment Bank, but it is early days, and the scale of the government’s ambition for the NIB may not match that of the task at hand.
The supply shortfalls can only be offset by years of investment in public services. Yet given negative real interest rates, there is also now a serious inflation risk that requires tighter monetary policy. If inflation nears 5 per cent in the coming months , that will surely risk a sustained escalation in inflation and wage expectations. particularly as firms seek to mark-up the prices of their products after the Covid crisis. Failure to act soon may lead market participants to conclude either that the Bank of England’s preferences for output growth have trumped those for price stability—which should be its primary goal—or that the Bank’s balance sheet may not be able to bear considerably higher policy rates. We have proposed a way of unwinding Quantitative Easing without exposing the Bank of England to large losses or potentially dislocating gilt markets with large-scale and lumpy redemptions and hope that the Monetary Policy Committee will take note.
It is becoming clear that over the past ten years, we have adopted the wrong mix of monetary and fiscal policy—the former being too loose, and the latter being too tight. It is time to rip up our sheet music. Fiscal policy should promote public investment and the buildup of national assets, while monetary policy should concentrate on restoring interest rates to levels that will incentivise firms and banks to deploy their capital productivity. Start again.
