John Redwood is an incisive commentator on economics and politics, writing his daily blog on www.johnredwoodsdiary.com. He has led two UK-based international industrial businesses, set up and sold on an investment management company and is a fellow of All Souls College, Oxford.
Sixteen years ago, the Coalition government, with George Osborne as Chancellor, set up a new architecture for UK budgets and economic management. The Bank of England was confirmed as setting the base rate of interest, making independent forecasts of the economy and inflation and regulating the financial stability of commercial banks.
The Treasury had to share information with a newly set up Office for Budget Responsibility (OBR), which has the tasks of costing government policies and programmes and forecasting the impact of government measures and taxes on the economy, debt and deficit. From the OBR’s work, the Government sets itself targets, or fiscal rules, seeking to constrain deficits and to control the level of total state indebtedness. The OBR forecasts how well the Government will do in relation to the rules and usually concludes it will hit the targets.
The government sold this approach on the basis that so-called “independent” bodies, the Bank and the OBR, would ensure discipline so that the country could keep inflation to the target of 2 per cent per annum, and could prevent excessive deficits and debts building up.
The system had some apparent success for the period 2010 to 2019, when government itself sought to keep spending and borrowing under reasonable control. A benign period in world trade, with China greatly expanding its supply of cheaper goods, helped keep inflation down globally, so the Bank’s task was easier.
Many Western countries were knowingly or unwittingly restraining the growth in money and credit as they took a tough stance on commercial banks after the excesses of the banking crash of 2008. It was a period of disinflation after the big build-up in money, debt and credit prior to 2007, allowed by lax bank regulation and poor central banking in the West.
In 2020 Covid struck. The three main Western central banks – the US Federal Reserve, the European Central Bank and the Bank of England – all embarked on creating large sums of money to buy bonds, driving interest rates down to new lows. As an initial response to the collapse of supply through lockdowns, this was helpful.
All three continued with it for too long and on too large a scale, triggering rapid rises in inflation by 2022. The central banks blamed the price rises on the outbreak of the Ukraine war and its impact on energy and grain supplies.
The Swiss, Japanese and Chinese central banks, which did not announce new policies to greatly expand balance sheets to buy bonds and depress rates, presided over much lower inflation throughout this period, showing that inflation was a choice wrongly made by the Western central banks and governments.
No one should be complacent about the dreadful loss of direction in UK public finances and inflation since 2020. In each of the last five years, inflation has spent long periods above the Bank of England’s target, peaking at more than five times the target.
The OBR and the derived rules to keep debt and deficits down have failed, with UK state debt now three times the level in 2010 and surging all this decade. The Conservative government of 2019–24 greatly boosted spending and borrowing to see the economy through the collapse caused by the Covid lockdowns. It had started to rein in spending and borrowing when it lost heavily in the 2024 general election.
On taking office, the Government substantially increased spending, taxation and borrowing in its first two years.
The result is a runaway debt, with interest charges now rising rapidly as the stock of debt increases and as older debt needs to be refinanced at much higher rates of interest. For two years running now, longer-term government borrowing rates have been well above the worst day under Liz Truss.
The Bank of England sets itself up to fail by ignoring money and credit trends. The Monetary Policy Committee, despite its name, tries to forecast the economy based on a view of how much UK capacity there is and how close to capacity the economy is running.
If employment levels are high, it expects higher wage settlements and seeks to offset them with higher interest rates to cool lending and activity. If unemployment is high, it tends to want lower rates to act as a boost.
This ignores the fact that the UK imports a lot, so world prices and wages, rather than UK capacity alone, matter for marginal purchases. It ignores the way that extra money and credit can boost inflation even when too many people are unemployed or UK steel mills and car factories lack orders owing to UK costs and net-zero policies.
The OBR is set up to fail because the fiscal rules set a target to see debt falling as a percentage of GDP only in the third year of the forecast, and to control the deficit only in the third year.
The third year never comes, as it is a rolling target revised each year as a new year is brought in. The Government can comply without ever having to impose the spending cuts or extra taxes that are implied in year three of the forecast.
So what should be done to give the UK a fiscal framework that would encourage low inflation and properly controlled debt? Both the Bank and the Treasury should be set the 2 per cent inflation target, as government needs to do its bit to keep inflation down. Much of our current high inflation is caused by high public-sector wage costs allied to poor public-sector productivity.
Both should also be set a 2 per cent growth target to remind them that growth is a crucial aim and can help keep deficits and inflation under control. More investment can bring more efficient new capacity on stream. Faster growth reduces unemployment and boosts tax revenues.
Neither the OBR nor the Bank is an independent body. The Bank needs permission to buy and sell bonds through the Asset Purchase Facility (APF), receives Treasury payments to offset its huge losses (forecast by the OBR to be £228bn over 2022–33) and has a Governor who reports to Parliament and is appointed on the Government’s recommendation. The OBR works closely with the Treasury, is state funded and has little scope to criticise government policy.
The Bank needs to put money and credit into its models and get better at forecasting and tackling latent inflation. The OBR needs to tell the Government to introduce a control on debt and deficits that is more likely to work than the current failed three-year-out non-targets. The big rise in debt is worrying and will eventually force a major change of policy when the debt becomes unaffordable.