Rachel Reeves had nothing to say. Faced with the huge uncertainties of war in the Middle East, we need a promise of growth and an assurance of competence. There was, alas, little of the first and nothing of the second. Indeed as she spoke, one of her key points – that the Government was cutting the cost of funding the national debt – was undermined by what was happening on the financial markets. When the markets closed on Monday the key borrowing rate, the yield on 10-year gilts, was 4.3 per cent. By the time she sat down it was over 4.5 per cent.
That’s not her fault. It’s a fact that higher oil and gas prices will push up inflation worldwide and that will make it harder for central banks, including our own, to cut their interest rates. The corresponding yield on US treasury notes also rose, though by a smaller amount, to 4.1 per cent. But it demonstrates how irrelevant what Reeves was saying is to the challenges the economy faces. The truth is that quite aside from being a humanitarian catastrophe, war destroys wealth not just directly in the region but right across the world. As an open economy the UK is particularly vulnerable. A frank chancellor would acknowledge that we will be poorer as a result of what is happening.
The economic impact of war comes in three waves. First and most obvious are the direct blows, in this case higher oil and gas prices, the cost of the disruption to trade flows, the freezing of investment projects and so on. The longer the conflict the greater the damage. So in this case a spike in oil and gas prices, while uncomfortable, is manageable provided markets can return to some sort of normality within a few weeks. But if the war continues through the summer the effects become progressively more grave. The northern hemisphere uses a lot of gas in the winter and needs to stockpile supplies.
Transport and tourism is especially vulnerable for obvious reasons, with the Gulf states a key airline hub. While governments in those places can give support in subsidies and loans, they cannot really do much to help the millions of small and medium-sized businesses that are likely to go under if tourism collapses. Taken together, travel and tourism are the world’s largest industry, accounting for more than 10 per cent of global output – and much higher in many relatively poor countries. For the entire Middle East this is an utter disaster.
There will also be knock-on effects that may be hard to foresee. Thus in the first few months after Russia’s invasion of Ukraine, one particularly severe blow came in agriculture: food prices shot up, leading to a humanitarian crisis in Egypt and other parts of Africa.
Next – and this will take place progressively over many months – there is the impact on business and investor confidence. The world has managed to create, for better or worse, an extremely efficient economy, with countries and regions specialising in areas where they have a cost and competitive advantage. Efficiency, though, has led to vulnerability. The most extreme example of this is silicon chips, semiconductors. More than 90 per cent of the most advanced computer chips are made in Taiwan, and the country has more than 20 per cent of the world’s total semiconductor manufacturing capacity. There is an obvious “what if?” question about a possible Chinese attack that hardly bears thinking about.
The war in Ukraine has led to businesses everywhere rethinking their supply chains to make them more robust. But diversifying comes at a cost. New suppliers have to invest in manufacturing facilities, and to do that they need the contracts that will give them assurance of profitable demand. Now we have an even higher level of insecurity, most dramatically so in the Gulf states, but actually anywhere where there are political tensions. Consumers have to pay more for products and services for the foreseeable future as a result.
The third wave is the impact on government finances, and this is where Rachel Reeves seems in denial. They will need to spend more, maybe much more, on defence. That has to come out of other spending, or from higher taxes. On paper there is a third option of borrowing more, but the new forecasts here of our budget deficit show barely any decline in for the next three years, and they may not be credible anyway. And of course this is not just the UK. Every government across the world will be forced to spend more on security. This is not simply about increasing the defence budget, though that will be a big part of it. It will be much wider than that.
So we need public finances that will be robust in the face of uncertainties. If that means higher taxation, then we need a chancellor that will be honest about that. We certainly need higher growth, which means encouraging the businesses that will deliver that rather than loads more costs onto them. And we need a thoughtful government that takes responsibility for its actions rather than one that keeps blaming everything on the previous lot.
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There’s a huge element of make-believe about the OBR’s numbers for growth and borrowing because no one really knows what will happen to growth and the budget deficit next year, let alone five years into the future. It is required to make these projections and does so perfectly well within the constraints placed upon it. But I worry that too much is being loaded onto it and that its authority is waning as a result.
The indicator I look at most to see how trusted the UK is as a reliable manager of the its own finances is the gap between the 10-year gilts yield and that on 10-year US Treasury notes. Yesterday, the gilt yield went above 4.5 per cent in trading, but came off in late afternoon. The US yield started trading at 4.05 per cent before pushing above 4.1 per cent. So the gap is around 0.4 per cent. On my quick tally that is one of the widest it has been since Reeves took office. Aside from that brief period when Liz Truss was PM, our yields have been below the US for most of the previous decade. So while it is unfair to blame her on everything it does look very much as though Labour is less trusted on finance than the Tories.
The question – and I find this a tough one – is whether the decline in the authority of the OBR is also partly responsible. Could personalities be part of the problem? I was an enormous admirer of Sir Alan Budd, who got it off the ground, and of Sir Robert Chote, who established its credibility, but somehow it does not seem to have retained that status. Things have not been helped, of course, by that leaking of the forecast last autumn, though I gather the OBR itself was not entirely to blame.
And the delay in appointing a new head seems almost a deliberate slight. Richard Hughes resigned at the beginning of December last year, but they didn’t start recruiting until 20 February. It is almost as though the Chancellor says she will abide by the OBR’s judgements, but wants to downgrade the institution.
I do understand from an impeccable source that she was very upset when told by the OBR that her borrowing plans would increase the cost of financing the deficit. She “did not like that at all”. So maybe she resents the OBR and is kicking them as a punishment. This is not good. We ought not to have to pay so much to fund the national debt, and downgrading the OBR is a terrible signal to the markets at a very bad time.
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