The future of the British government hinges on one thing – and it isn’t Partygate

The catchphrase “it’s the economy, stupid” from Bill Clinton’s successful 1992 presidential election campaign seems jarringly out of place in today’s politics. Britain’s Westminster bubble is totally fixated on Partygate and Boris Johnson’s political future.

But beyond the bubble, there is the prospect of a European war in Ukraine; Covid is still with us even as restrictions are shed – and the future of the British government (and others like the Biden administration and the Macron presidency) still hinge on what happens in the economy.

There is always some economic uncertainty, but current conditions are exceptionally difficult to read. The nature and persistence of inflation is much debated and unclear, as are the policy remedies. Supply chain disruption may ease or may worsen, depending on events in China. The Ukraine war, if it happens, will have major consequences for energy markets, especially gas.

Governments and central banks are struggling to understand and to respond appropriately to the highest inflation for 30 years. Consumer inflation in recent weeks – year-on-year – has been around 5 per cent in the UK and the Eurozone, 7 per cent in the USA. These are levels double or more than those considered by central banks to be consistent with their mandates requiring financial stability.

The optimistic view is that there are short-term, one-off factors which must work their way through but will subside: supply chain bottlenecks, especially shipping rates; labour shortages for occupations like lorry drivers; energy costs (with the UK also facing a big hike in heating bills as price controls unwind).

A somewhat less optimistic view is that there is a deeper problem: too much money has been pumped into the economy as a result of the emergency monetary measures of recent years; ultra-low interest rates and the use of QE, the large scale buying up of, mainly government, bonds by central banks.

Inflation matters. The German government is obsessed by the risks of inflation spinning out of control. Other leading countries know that even single-digit inflation can have painful consequences. Those workers with fixed salaries or unable to bargain for higher wages suffer a real cut in their pay. Savings deposits, which attract very low interest payments, fall in value.

Pensioners, who have been protected over the past decade by the “triple lock”, may face short-term cuts in their income because of time lags in uprating or because price increases – especially in home heating bills – hit them disproportionately. Continued asset inflation widens inequality and creates barriers to home purchase.

In what were seen as “normal” conditions before the financial crisis, central banks became adept at managing interest rates to keep economies on an even keel. But when interest rates start from being zero (negative in real terms), small upward adjustments will have little effect. And big increases will have traumatic effects on those households and businesses which are dependent on variable-interest borrowing.

These include many poorer people already struggling to service expensive overdrafts or consumer credit, and many small businesses who have been relying on expensive loans to see them through Covid. There is also potentially a very damaging effect on emerging economies that borrowed abroad (in foreign currency, notably dollars) and could now be forced into severe debt problems preventing their recovery from Covid-induced recession.

An even trickier issue is how to unwind QE. Quantitative Easing is a new economic mechanism, and no one is entirely sure what will happen when it goes into reverse. A previous attempt in the USA to phase out QE produced what was called a “tantrum” as bond prices fell sharply, threatening a serious financial crisis.

If central banks administer the equivalent of cold turkey, the risk is that asset markets will collapse. There is a good deal of nervousness that sharply falling share prices and house prices could then undermine consumer and investor confidence, pushing us back into recession.

The orthodox economic response to this dilemma is to combine a tightening of monetary policy (raising interest rates) with a relaxation of fiscal policy (increasing spending). But that is much easier said than done. After President Biden got his first stimulus package and an infrastructure bill through Congress, he was unable to persuade all his colleagues – let alone the opposition – to vote through his Build Back Better legislation. One reason was a fear that he was overdoing the fiscal stimulus and feeding inflation.

On this side of the Atlantic, the chancellor is now fixated on reducing the large fiscal deficit and keeping public debt below 100 per cent; indeed, his reputation for fiscal management within his own party depends upon it.

But the pressures on Rishi Sunak demonstrate just how difficult it is to steer a steady fiscal course. Tax and spending decisions are highly political and cannot be sub-contracted, like the setting of interest rates, to “experts”. The chancellor decides. The government, as well as opposition MPs, is clamouring to cut the 5 per cent VAT on energy and remove the pending increase in national insurance charges – there are, however, few suggestions from these MPs as to which other taxes should be raised instead.

To keep up to speed with all the latest opinions and comment sign up to our free weekly Voices Dispatches newsletter by clicking here

Sunak is having to tread a very treacherous path, bearing in mind that there may soon be a leadership contest for which he is a frontrunner. Assuring his party that he can cut taxes, spend more and impose tight fiscal discipline – and then deliver all three – is probably beyond the capability of a mere mortal. His one crumb of comfort is that his opposite numbers in the USA, Germany and elsewhere are wrestling with the same problem.

But there are bigger, long-term problems stacking up: an ageing population and declining labour force; the stuttering of the Chinese growth machine; Brexit; trade protectionism, “decoupling” and “national security” interventions sapping economic efficiency; the costs of zero-carbon transition; and clamour for fairer distribution of income and wealth.

Meanwhile, a particularly clever Covid virus is probably working out how to create a new round of global economic as well as medical havoc. It is how governments deal with these challenges – rather than passing scandals – which will dictate who gets re-elected and who is thrown out of office.