Article 10

 Any commentary that attempts to take a positive view of the outlook for the UK economy right now is likely to be met with a howl of derision.

“What have you been smoking?”, I was asked at a recent conference when I ventured such a view, for it is indeed much easier to make the contrary case. On the face of it, things look grim. The world economy is plainly slowing fast after its post-pandemic surge, and the UK is widely forecast to be bottom of the Group of Seven class this year for both growth and inflation. The latter, moreover, is proving stickier here in Britain than elsewhere, and will almost certainly require a further steep rise in Bank Rate, and possibly an outright recession, in order to bring it back to the 2pc target.

The Bank of England meanwhile estimates that only around a third of the effect of rate rises to date has yet been felt in the real economy, with much of the rest due to filter through over the year ahead as cheap fixed-rate mortgage contracts expire and have to be refinanced with the more expensive ones now on offer. For many households, then, the cost of living squeeze is about to get worse, not better. This does not presage well for an economy where household consumption is around two thirds of total expenditure. On top of everything else, we have a policymaking elite which seems to have almost wholly lost its marbles. While the incumbent Conservative Government considers the imposition of price controls, Labour proposes to ban all new North Sea oil and gas development.

These are not the policies needed to inspire confidence in an already deeply disillusioned business community, weighed down as it is by rising taxes, the teething problems of Brexit, and increasingly oppressive levels of regulation. What hope is there for the required surge in productivity-enhancing investment, where again Britain is bottom of the G7 club, with this kind of destructive policy-making? Not much, you might reasonably conclude. It’s not much of a selling point for the Government going into the election if, after 14 years in power, all you can say is that you are slightly better than the alternative.

All three mainstream parties are locked into what Sigmund Freud called “the narcissism of small differences”, the idea that the more people coalesce around a shared view, the more likely it is that they will engage in mutual ridicule and condemnation. Culture wars are far more likely to define your politics these days than serious policy, the latter of which seems largely becalmed in dismal sameness. The broad direction of travel on tax, spend, net zero and much else besides is barely contested. Given the backdrop, how could there possibly be any grounds for optimism? Well here are a few.

Huw Pill, the Bank of England’s chief economist, rightly got it in the neck recently for saying that people just had to accept that they were poorer. “If the cost of what you’re buying has gone up compared to what you’re selling, you’re going to be worse off,” he said. “So somehow in the UK, someone needs to accept that they’re worse off and stop trying to maintain their real spending power by bidding up prices, whether higher wages or passing the energy costs through on to customers.”

This was not just an ill-judged thing to have said; it is also untrue. Britain’s terms of trade have indeed turned violently negative over the past two years, mainly because of much higher imported energy and food costs. But to assume that this is a permanent adjustment cannot be right. Commodity prices are now declining steeply, partially reversing the external price shock. It will take a while – and obviously a big drop in the rate of inflation – before real wages start rising again, but it is almost inevitable that eventually they will. That point should be reached at some stage next year.

Rising interest rates are making sky-high house prices a lot less affordable, mortgage deals are being pulled right left and centre, and some estate agents complain of a housing market as depressed as it was at the height of the pandemic. Even so, supply constraints and a still very tight labour market continue to make an outright house price crash, which would indeed by very bad for the economy, seem unlikely.

Instead, a long, slow adjustment relative to incomes can be expected, with far less severe consequences for the rest of the economy than the violent corrections associated with the last two major UK recessions. To these two pluses – the prospect of resumption in real-wage growth and a comparatively benign housing market adjustment – can be added an improving outlook for the public finances, enabling some kind of pre-election giveaway in next year’s Budget.

In this regard, high inflation is very much a double-edged sword, for it has significantly added through indexation to both entitlement spending and debt servicing costs. But what it also does is quite dramatically amplify the effects of fiscal drag. The Chancellor froze income tax thresholds for five years in the Autumn Statement last year, with the effect that it draws ever more people into the tax system for the first time, or into higher tax bands, as wages rise.

One of the consequences of the relatively high inflation we see in nominal wages at the moment is to put rocket boosters under the revenue-raising power of this stealth tax, nearly tripling the amount that it brings in from the £8bn originally projected by the Office for Budget Responsibility for 2025/6 to £22.4bn. By the end of the fifth year it could be double that, depending on what wages do in the meantime. This is money that could be applied to tax cuts while still staying within the Chancellor’s admittedly not terribly challenging fiscal rules.

It is also a bit of a con, since any such tax cut would only be to give back what the Chancellor is already taking away through fiscal drag. The optics will nevertheless be those of the bad times drawing to a close, and of careful husbandry of the public finances finally paying dividends. In addition, it might enable the Chancellor to shift from a contractionary fiscal stance to a mildly stimulative one. All this may seem like clutching at straws when set against the fierce economic headwinds that currently assail the UK economy.

Voters are an unforgiving lot, and they won’t easily be persuaded that the reality of Britain’s economic position right now is actually a good sight better than might be expected given the extraordinary confluence of three negative shocks in a row – Brexit, the pandemic, and the surge in energy prices.

You have to wonder why sometimes, but the UK economy is seemingly a lot more resilient than it looks.