The challenges facing the new Prime Minister

Paul Johnson

Hello and welcome to this episode of the IFS Zoom In, I’m Paul Johnson director of the institute for Fiscal Studies and really pleased to be back podcasting again after the summer break. I’m joined today to talk about the many, many challenges facing our new Prime Minister by Ben Zaranko and Xiaowei Xu, two senior economists here at the IFS. Xiaowei is an expert in everything labour market and inequality, while Ben knows pretty much everything there is to know about health economics and the public finances and public spending.

So, over the next half hour or so we’re certainly going to be discussing energy bills and inflation, we’re going to be looking at the challenges on the public finances and spending on public services, we all know what’s happening in the health service and elsewhere at the moment. But we’ll also be looking at challenges facing the new Prime Minister, one who wants growth, urr but in a world where we’ve got an incredibly tight labour market, what we might do, what she might do to improve productivity, and where things like 30 billion odd worth of tax cuts might or might not fit into all of those, all of those problems.  

So let’s start at the beginning through, of course the first thing that Liz Truss is going to face is this huge increase in energy bills, rising next months from just under £2,000 for an average house hold to about three and half thousand pounds a year for a n average household, expected to go up to £5,000 in January and remember this is all up from not much more than a £1,000 a year just twelve months ago. We had then chancellor Rishi Sunak come up with the £30 billion package of measures increases in spending and the National Insurance cut through to May, but that no longer looks anywhere near sufficient to deal with the scale of the problem that we’re facing. And it looks like what we’re going to end up with is a holding down of energy bills, possibly roughly at their current level of about £2,000 for the average household, a cost over a couple of years, a cost we can’t know because we don’t know the cost that gas is going to be, but probably in the region of £100 billion over the next year or two. Which is a staggering amount of money, a lot more even than we spent on the furlough scheme during COVID.

So, Ben perhaps you could say something about why you think we’re looking at such an extraordinary intervention in the market as to keep prices down rather than more of what we had before, £400 off everyone’s energy bills, £300 for all pensions, £660 for everyone’s on means tested benefits, that was, that felt three or four months ago like the natural response to an increase in the cost of living, but it no longer does.

Ben Zaranko

I think it’s because the scale of the problem has got even worse and is now on such a monumental level that the pervious sort of targeted approach where you had money specifically ear marked for recipients of working age benefits for example, and those who were just a little bit richer perhaps getting much less, giving the scale of the rise in energy bills now, the problem just extends much further up the income distribution to a larger number of households. And if you are to target specific groups, there will be some people that fall through the gaps and do perhaps live in a large house with lots of children with not much insulation, who are really going to be feeling the pain, and that targetted approach wouldn’t do much for them. Which comes back to the problem of this limited database, that we just don’t know who can afford to meet this challenge and who can’t. And so we can’t specifically target support to those who absolutely need it, leading to this blunter, much wider spread approach of perhaps just freezing bills which means that everybody get support, including some who don’t need it, but it means that people don’t fall through the gaps in the same way and that trade-off is something that the government is seemingly now willing to make, I don’t know if you agree with that Paul?

Paul Johnson

I broadly do, I mean as I’ve been saying, I think it’s a dreadful policy, but a dreadful policy we may have no choice but to implement. And I call it dreadful because it’s incredibly poorly targeted and a lot of money will effectively be paid to people like me who can perfectly well afford to pay a higher energy bill. But probably more fundamentally, it will mean that there’s a much reduced price single, people will presumably use more than they would have otherwise done, including people that are relatively well off that could have cut back a bit. And it must increase at least the danger that we’ll end up being rationed by quaintly rather than price. In other words we may have blackouts or periods when we can’t use the energy. But this is, Xiaowei of course part of a much wider cost of living crisis, inflation heading up to wards 13% according to the Bank of England, possibly rather more, so that’s what’s happening to prices, but what’s happening to incomes? Are incomes keeping up with those big increase in prices?

Xiaowei Xu

No, incomes aren’t keeping up. So have seen high nominal wage growth by pre pandemic standards, however those wage increases have not kept up with the 10/13% inflation that we’re facing. Wage growth has differed across the distribution, and we’ve actually seen a higher wage growth at the top of the distribution than at the bottom, which is likely to reflect the fact that you know its those higher waged, higher skilled people that have the bargaining power to press for wage increases that match inflation. Now for people who are not in work, of course, living standards have not been keeping up with inflation either, and that’s because benefits rise by a lagged measure of inflation. So, benefits in April went up with the measure of inflation last September, which was of course much lower than inflation in April, which was again much lower than inflation today.

Paul Johnson

And that’s, in a surprising way perhaps, that picture that you’re describing, distributionally, is different to what we’ve seen for at least the last ten or indeed fifteen years, in that at the moment we’re seeing the highest earners doing best, and actually a widening in the income distribution, which we haven’t seen for quite some time. It’s really only the top earners that are keeping up with inflation, everyone else is falling behind. But what I think is really worrying politically as well as economically, is that the, that earnings have still barely returned to their pre-financial crisis level. So, this isn’t a drop in living standards after what we saw in the 1990s and the 2000s and indeed the 1980s of a period of increased living standards and then dropping, this is a period of complete stagnation and then dropping.

Xiaowei Xu

Exactly so we’re approaching this crisis after a decade of stagnation, so lots of households are in a poor position to bare the shock to begin with. On the distributional consequences it’s also worth noting that not only are the poorest households facing the smallest increase in incomes, they’re also facing the highest rates of inflation. And that’s because the inflation we’re facing is driven by energy costs and also food process, and these are things that poor households spend a larger share of their incomes on. So, we know that overall inflation is projected to hit 13% in October, but actually we think that the poorest fifth of households are going to face an inflation rate of 18%, compared to 11% for the riches fifth.

Paul Johnson

That’s a really important piece of context here for the new Prime Minister, of course she’ll be dealing with the immediate consequences but those immediate consequences are in the context of a decade and more of very poor growth, and that’s going to make the next year or two even more difficult for households to cope with. But then it’s also going to make it more difficult for public services to cope with. Public services are clearly going to have to cope with increased energy bills, but also, they’re going to need to respond to this higher level of inflation in terms of what they pay the teachers and nurses and civil servants and so on.

Ben Zaranko

Absolutely, just as households are squeezed by higher energy prices, higher food prices, higher fuel prices, so too are schools, are hospitals, are prisons, and so on. Its fair to say I think that the rate of inflation facing a hospital is likely to be lower than that facing a household, partly because energy which is you know, which is really driving inflation, represents a much smaller share of hospitals budgets than it does for households. But what really stands public services apart from households is that whereas the public sector pay bill is about the third of all spending on public services, it obviously doesn’t feature in a households budget. And what’s happening in a pay bill is that it’s going up by a lot less than inflation. We’ve had pay announcements so far over the summer in the region of four or five percent for most public sector workers, that’s considerably below inflation which is already at 10%, projected to go higher. But importantly that pay award of four or five percent is above what was budgeted for, when public services had their spending plan set out last year. And so they’re having to meet these additional costs of paying their workers more, and they’re not getting any extra cash from the treasury, which means they’re having to squeeze other things, you see headlines sometimes of schools cutting back on how many teaching assistants they have, or not buying new text books, maybe it’s you know a hospital perhaps not being able to setup the new diagnostic hub they were hoping to because their pay bill is simply rising too fast. That is forcing difficult decisions for public services. One of the key choices for the new chancellor this autumn, is whether they want to provide any more money to public services, to lessen the difficulties they’re facing, to take the edge off that trade off, but that will of course mean spending more than they otherwise would.

Paul Johnson

And I suspect we haven’t seen the last word on public sector pay either. You’ve talked about four or five percent pay increases being more than what was budgeted for, but of course that’s in the context of inflation at 10% and rising as you say. So, that is another five percent plus real pay cut for teachers, nurses and so on, and they’ve not exactly been doing well over the last decade either?

Ben Zaranko

Absolutely not, so one of the reasons why we’re facing the possibility of widespread strike action across the public sector and beyond is that lots of these workers who are now being asked to accept a lets say 5% real terms pay cut, lots of them are earning less than they did a decade ago, particularly less than someone doing their job did a decade ago. So experienced teachers have always seen real terms pay cuts of eight or nine percent even before this year, nurses in the region of about eight 8% on average in England. Doctors, consultants have seen their pay fall by more than 10%, might be twelve or thirteen percent so another 5% cut on top of that, that hits the living standards of these people and ultimately could threaten the government’s ability to attract, retain, motivate the skilled public sector workers it needs to operate public services and deliver things like clearing the NHS backlog, levelling up primary education, fixing social care, all those things are going to be harder if you can’t recruit the people you need to actually achieve those things.

Paul Johnson

So, my guess is that we’re going to have to see bigger pay rises, if not this year, then next year, it seems to me at least implausible that we’re going to be cutting another five or ten percent off the real salaries of all of these groups, and a lot of them for reasons that are entirely understandable are clearly considering strike action. So, we’re looking at potentiality a significantly higher pay bill, we’re looking at, as we know the pressures on NHS waiting lists and ambulances and so on, we’re looking at the still backlogs of the justice system, problems catching up with COVID in the education system. You might not want to put a number to this Ben, but I would be surprised if we get away, or the new chancellor gets away with lets than another £30 billion on public service spending in the next couple of years?

Ben Zaranko

I think you’d get away with less, I think to broadly compensate departments for the higher inflation they’re facing, including the cost of higher than expected pay awards, you’re perhaps looking at maybe in the twenty billion mark for next year and beyond. That’s a permanent spending increase. Now that figure could end up being higher, depending on what happens to inflation and energy bills and pay awards and so on. But its, thirty billion is completely in the realms of possibility, particularly if you wanted to stick to all the governments objectives on public services. It’s possible that the new Prime Minister and government will roll back from some of those, perhaps be less emphasis on the levelling up agenda, for example. Perhaps they’re willing to accept longer timetable for clearing the NHS backlog, and paring back those public service objectives is one way they could as the UK, to deal with being a poorer country, which is what we are in the process of becoming. And so, it’s possible that you know if you want to achieve less with public services, you can spend less on then, that is one possibility for the new government.

Paul Johnson

I’m going to bet you a fiver ben that in 2024/25, spending will be at least £30 billion more on public services than currently planned. So, we’ll come back to this podcast in a couple of years and see whether that happens. Not least because there’s going to be an election in 2024.

Ben Zaranko

Is that £5 in todays terms or?

Paul Johnson

That a very good question.

Ben Zaranko

I’ll take you up on that.

Paul Johnson

Let’s take a fiver in 2024. So Xiaowei, Ben has talked about some of the issues in the public sector labour market, and pay has fallen pretty precipitously over a decade in the public sector and is failing again. And the private sector things haven’t been quite so bad, but they’ve still been pretty bad, but we’re facing a slightly different issue in both public and private sectors at the moment, which is that there just seems to be a lack of workers around.

Xiaowei Xu

Yeah, so the labour market is extremely tight at the moment by historical standards, basically there’s been an exodus of workers over the pandemic, first because of older people leaving the labour market, many choosing to retire early, and second because of EU workers leaving over the course of the pandemic and then not returning back, presumably because of Brexit, so we have lot of sectors that are very dependent on EU migrants, things like hospitality for example are better depending on the constant inflow of EU migrants, we see that the people that have left over the pandemic have not been replaced by new waves, and as a result the labour force is just much smaller than it was before the pandemic. Added to that a quick recovery on labour demand, what we’re seeing is an incredibly tight labour market.

Paul Johnson

And that creates all sorts of challenges because we’ve got high inflation, we’ve got the Bank of England projecting a recession, or at least zero or slightly negative growth over the next year, year and half and yet we’ve got this extraordinarily tight looking labour market. Now into that mix, it appears the government wants to pour a very large amount of money. Understandably to support people’s living standards through supporting energy bills, but also big tax cuts relative to plans, and as we’ve just discussed almost certainly more money going into public services.

Xiaowei Xu

Exactly, it’s difficult to see how that would not be inflationary, as Ben said the UK is simply a poorer country as a result of the energy shock, the UK is an energy importer so therefore a rise in energy prices means that we’re all poorer in the medium term, so it’s not possible for the government to simply compensate everyone for the loss in the form of a price cap. I think, you know, unless there’s tax rises to offset some of this, there will be more inflationary pressure, which would then just put pressure on the Bank of England to raise interest rates in response.

Paul Johnson

It’s a really difficult economic situation I mean, genuinely isn’t something that we’ve faced since the 1970s, a period where you’ve got potential recession and quickly rising prices, we’ve had some periods of, we’ve had some difficult periods since then, but not periods where those two things have been going hand in hand. Now the Prime Ministers response to this, and it’s a traditional one from all Prime Ministers and chancellors when they take office, is to say, “we will grow our way our of these problems.” And indeed, growth would solve you know most of the problems that we face from an economic point of view. And lack of growth, certainly lack of growth per captia has been the fundamental issue that we’ve suffered from the last decade. So, any thoughts on how we might go about getting a bit of growth Xiaowei?

Xiaowei Xu

Well absolutely we want more growth, I mean everyone wants more growth, but yeah, as you say, the question is how we go about getting more growth. And so far, you know one of the main things that have been proposed is cutting NICs, which you know I wouldn’t be surprised if it had some small labour supply response, but I really don’t think that that can be the main policy to get growth going in the economy again. We know that the labour market is tight at the moment, we’re at historically very high employment rates, there’s really not that much scope to cut taxes and therefore pour more people into the labour market, I think. And so, you know, if you can’t get growth by increasing the number of people working, then you have to increase productivity and it’s really unclear how cutting NICs would solve the productivity puzzle in the UK. We know that productivity in the UK has been sluggish for a long time now, we had this period of stagnation since the 2008 recession, and that’s really the underlying cause of a lot of problems in the UK, like the lack of living standards growth.

Paul Johnson

And that absolutely is the fundamental issue, we’ve not had productivity growth, you don’t have productivity growth you don’t have economic growth, you don’t have increases in peoples wages and standard of living, and I really hope the new chancellor the new Prime Minister has a good plan for growth that goes well beyond tax cuts, tax cuts generally speaking are better than tax increase, we all, none of us particularly like paying tax, but as you say, tax cuts can be helpful if they increase labour supply well, labour – we’re already you know struggling with a very tight labour market, and they do risk at least somewhat increased inflation and therefore a response from the Bank of England. If we’re really looking at growth, we need to be looking right across the waterfront, we need to be looking at the planning regime, which of course the government has backed down from reforming for political reasons, we need to look at a tax reform, something that’s always very difficult, we need to look at doing something much more serious with our education system and don’t forget, that spending per pupil on education is no higher today than it was twelve or thirteen years ago, quite astonishing when you compare that for example with the, something like 40% increase in spending on health over that period. We had a long period of reduced spending on infrastructure investment, and that’s of course is going to be, in the long run, problematic for growth. There are a whole serious of, and let’s be honest about this, Brexit won’t be helping growth either. So, there’s a whole serious of things that for a decade and more governments have failed to do to move us forward towards a higher growth economy, and lets hope this government does something to change that, but it’s certainly not going to be straight forward.

Ben Zaranko

I think we should also remember that Xiaowei talked about the proposed cut to National Insurance, which I think is fair to say isn’t an especially growth friendly tax cut, but they’ve also promised not too increase the rate of corporation tax, which with current legislation was scheduled to go up 19-25%, cancelling that rate rise is, I think it’s fair, a much more growth friendly growth policy than the NICs change, so I think that is perhaps indicative of where the focus may be.

I think the big question here is who much you can really move the dial with relatively small tax changes around the edge and given that the UKs rate of growth comes from a cumulated stock of machinery, buildings, skills, human capital, intangible capitol, you know annual change in one particular tax is unlikely to really shift that. If you’re more optimistic then you might say, well we’ve been falling behind not just countries in Europe, but countries further afield like America or south Korea and say maybe there’s scope for us to do more catch up if we can just fix whatever you think is holding us back. But I think that the real question is whether you can really achieve a big change in the UKs trend growth rate, particularly in the short term, and whether you should be underpinning your public finance plans based on such a hope and such an assumption which may not turn out to be true.

Paul Johnson

It’s always risky to assume growth when it may not turn up. I think one of the things that is really difficult for politicians, and in terms of the political cycle, is that it is genuinely possible for governments to affect our growth and out living standards over a long period of time, but it really does take a long period of time. The impact of the lack of investment in the early 2010s, is being felt now in terms of our living standards. The impact of a very poor planning policies for decades is being felt now in terms of our housing costs and our living standards the impact of failing to get our education system right is being felt now. But if you changed all of these tomorrow it would be at least a decade until we really began to feel the impacts and things that really can make the difference tomorrow are probably not sustainable because they mean pushing money into the economy, making us feel better off, a bit of a sugar rush in the short run, but a hangover in the longer run. So, we really do need to look for long term growth strategies, not things that are just going to be supporting us over the next year or two. Politicians of course want to be going to the electorate at a point where things are doing, are doing particularly well.

We probably need to start to bring this to an end. One thing Ben I wanted to talk about slightly more probably, issues around some of the risks to the public finances. We’re seeing big increase in spending on debt interest for example, now a lot of that’s driven by higher inflation, one of the things that been noticeable in recent months has bene an increase in the underlying yield on debt, on government debt, we used to be, I mean a year to two ago, we used to be able to borrow virtually for free, for free. We’re not paying something like 3% on non-index, non-inflation linked debt. How big an issue do you think the huge COVID debt that we’ve inherited is going to be, and how big a problem is going to be paying back the very large amounts of additional debt we are inevitably going to be taken on over the next year or two, likely to be?

Ben Zaranko

I think it’s difficult to say with any degree of certainty, given how uncertain the economic outlook is, but I think it’s likely to be a slow burn, so yes were seeing an increase in the cost of borrowing for governments and increase in gilt yields, that takes a while to feed through to debt servicing costs, because of the relatively long maturity of UK government debt, though we should also remember as well that currently debt servicing costs are extremely low, by historic standards even despite the big increase in the level of debt, the fallen interests rates has meant that servicing that debt has actually been extraordinarily cheap.

The challenges that that may be about to change, we may be heading into a world where interest rates start to turn something more into what we used to think of as normal, and the incoming government seems to have decided that its one thing to borrow for a temporary support package to help households get through a very difficult winter, it’s another thing to decide you’re willing to structurally, permanently borrow more to for instance cut corporation tax, cut national insurance and increase defence spending to 3% of GDP. If you so all those things and decide you’re going to borrow much more, precisely at the moment when its going to become more expensive to do so, that does potentially spell higher spending on dept interests going forwards, we would be left more exposed to changes in interests rates which maybe on the horizon, particularly still given the current state of easing has on the public finances, and so you might be able to square a circle by achieving higher growth rate and making all these problems go away. But if you don’t, I’d think you are taking a bit of a gamble with the public finances.

Paul Johnson

Yeah, and one of the things that don’t know what’s going to happen to it but I saw a chart just yesterday of the sterling/ dollar, sterling/ euro exchange rate it goes down overtime but it’s been going down quite a lot more recently, and I think one of the lessons from this is that political instability breeds economic poor performance, and one of the things I think we need from our government, whichever flavour, is a degree of policy and political stability and certainty around our institutions. If you lose that you also lose the capacity to borrow on the interventional markets at relatively low rates.

Xiaowei Xu

I think political stability is also really important for encouraging the sort of investment we need to drive up productivity. So, we know that the UK lags other countries like France, Germany, the US, in terms of levels of R&D spending, we know that business investment lags other countries, but that gap has especially widened after the Brexit referendum. Probably as a result of that doubt that’s been created. Now, we know that we’ve had a period, a long period of political instability in the UK now, Liz Truss would be the third prime minister since 2016, and there’s been a lot of stop/ starts on industrial strategy, and other policy priorities. So, I think having that long term outlook and that period of political stability would be really important to boost productivity as well.

Paul Johnson

Yeah, I think you’ve lost count Xiaowei, she’ll the fourth Prime Minister since 2016.

Ben Zaranko

On that point about the sterling/dollar exchange rate, what’s particularly striking about last months is it happened at the same time as like the return, of like gilt yields have been going up, and in quote unquote “normal times,” what you might expect is if UK yields are rising faster than other countries, which is what’s happening, you may expect more money to flow into the UK and if anything the pound to strengthen. In fact we’ve seen the opposite, it does raise at least questions of whether markets are taking fright at some aspects of the UK’s economic outlook, and I think that just as important as you say is whatever policy reforms are doing in the background is some degree of stability, confidence in institutions, and making sure that the UK is an attractive place to invest and to you know and to live and I think that’s something that we really would benefit from.

Paul Johnson

Absolutely, well perhaps we should leave it at that point. And I think what we’ve identified here is that Liz Truss faces two sorts of problems really, one is to stabilise things in the short run, there are a lot of big, short run problems that we as a country are facing, at which obviously the biggest and more urgent is dealing with the cost-of-living crisis and the spike in energy prices. But portably even more important for the long term is that there are whole series of underlying long term challenges that need to be addressed about the productivity for the economy about the stability of our finances and to some extent, resulting from our political system that we need to bolster the institutions and we need to think very hard about what we’re doing about planning, competition, education, infrastructure investment and so on and so on. And so, what I think we’re looking for over the next few months is that combination of stabilising things in the sort run and putting in place a feasible and credible strategy for the longer run.

So, we will leave here and leave it to the new Prime Minister and her new chancellor to sort a lot of that out as we get on with the rest of our lives. Thanks ever so much for joining us we’re going to continue to provide fresh analysis of the challenges facing the UK economy and the new government as we head into the autumn. To se all of our analysis, do visit www.ifs.org.uk. And to further support our work please consider becoming a supporter of the IFS for as little as £5 a month. Each donation helps us to respond to policy announcements as they happen. You can find out more about the link the episode description.

See you next time.