He's fighting the last war - and losing (Christopher Furlong/Getty Images)

October 28, 2021   3 mins

More often than not, economic policy misfires when policymakers find themselves fighting the last war. This happens more often in history than non-economists often appreciate. Rishi Sunak’s budget is a classic in the genre.

Take perhaps the most extreme example: Weimar Germany. In the first half of the Twenties, the young republic was seeing its economy collapse due to hyperinflation caused by the punitive repayments imposed by the victors in the First World War. By lending in American capital markets and buttressing the currency, the hyperinflation cooled. But in 1929, as Wall Street went into meltdown, American capital markets seized up and Germany started to slide into a deflationary depression.

But German policymakers remained fixated by the prospect of hyperinflation. So when they saw turbulence ahead, their default position was to assume that trouble was inflationary, not deflationary. As a result, they slammed the brakes on government spending and led their country into a punishing depression. And we all know what happened next.

Sunak’s budget suffers the opposite problem. Since 2008, we have been experiencing a world of economic stagnation and low interests. Keynesian policy proposals — spending more money — have been in circulation in policy circles all throughout this period. I should know, I was one of the people circulating them. They are perfectly suited to an economy with relatively high unemployment and low inflation.

But today we face exactly the opposite economic problem. Labour markets are so tight that employers are finding themselves being slowly strangled. And inflation is starting to tick up. Bank of England interest rate setters are putting on a brave face in public, telling us that inflation is transient — but seasoned watchers know that they are far more sceptical when they gather around the water cooler.

The problems are relatively straightforward. The lockdowns and the emerging vaccine mandates are unprecedented economic interventions. They cause chaos for businesses who are trying to provide goods and services to consumers. They also cause chaos in labour markets — just look how many workers simply left the UK in the first and second half of 2020. Crucially, these conditions imply a high probability that inflation is here to stay.

And this is where Rishi’s budget comes undone. Dumping spending and increasing taxes in an economy already under inflationary strain is akin to tossing a lit match into a barn full of dry hay. The spending increases will drive further demand for goods and services that businesses are already struggling to supply due to the onerous lockdown and vaccine-related regulations. Meanwhile, the tax rises will be passed on immediately as price rises by companies, as they attempt to defend their already thin margins.

Why is Sunak doing this? Because he is fighting the last war; focussing on what has happened rather than what will happen. His budget assumes that the main resistance on the field is overwhelming tank power — and as his soldiers march forward he will look on aghast as they are bombed mercilessly from overhead. Sunak is being fooled by a non-existent problem while a very real one festers.

It will work like this. The spending and tax rises will enter into the economic bloodstream, placing further pressure on prices. Inflation will accelerate. The Bank of England will take one look at their charter and realise that if they do not raise interest rates, they are going to take the heat for the inflation. So, they will raise those interest rates, the yield curve will invert — meaning short-term interest rates become higher than long-term rates — and the economy will slip into recession. That is how an expansionary budget produces contractionary results.

The worst part of all this is that, if the inflation is being driven by the lockdowns and vaccine policies, the recession will not stamp out the inflation. Instead, the British public will get a taste of both: stagflation — low growth, inflation and unemployment. Just like in the Seventies.

The entire economic debate today is topsy-turvy. Economists have been, for the most part, too cowardly to challenge the overarching public health measures. They recline in their seats, either becoming armchair epidemiologists or simply falling asleep. Poor Sunak looks on his desk and finds a plan written for a world that ceased to exist in March 2020. And the rest of us live with the consequences. La Comédie humaine.

Philip Pilkington is a macroeconomist and investment professional, and the author of The Reformation in Economics