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03/10/2022: This weekend's APEurope Correspondents' Pool Workshop consisted of a review of the government mini-budget entitled, "The Growth Plan 2022" and what can be expected from the OBR evaluation. The workshop reviewed the reasons that the OBR will be challenged to provide a precise and transparent evaluation of this policy proposal to an acceptable standard. The reason is that it is apparent that the Treasury in producing this mini-budget did not follow a structured decision analysis and due diligence procedure. This is particularly the case because the emphasis of this mini-budget on growth and productivity.

In the meantime Kwasi Kwarteng delivered a speech this afternoon at the Conservative party conference in Birmingham, attempting to justify his mini-budget, minus the 45p tax reduction. We add a follow up comment on his speech.

This article was delayed because the workshop covered a vast amount of information on inflation and economic models and we faced the challenge of reducing this to a digestible summary. Nevit Turk, the Senior Economics Correspondent of APEurope assisted us in this preparation.

When a policy is geared to "growth" it is essential to distinguish between nominal and real growth. Nominal growth is measures by the quantity of funds in circulation whereas real growth measures the rise in sustainable purchasing power on the population. Usually nominal growth has no implications with respect to prices whereas real growth is usually associated with falling prices and/or rises in the purchasing power of wages.

Economic growth is an economic development concept of change which is characterized by rising enterprise productivity and a rise in the levels of income distribution. In macroeconomic terms this change translates into an improving balance of payments in goods and rising purchasing power across all income level groups.

Baseline productivity is the improvement in physical processes measured as the amount of physical output compared with inputs and productivity growth signifies rises in output for the same input or more for less. Productivity contains a mechanical component and an evolutionary component. For example whereas a skilled operators can use a technology to achieve a specific output, starting with a newly installed equipment it takes time for operators to reduce mistakes, waste and time to complete processes. During this time taken to attain a good level of practice there is an evolution in unit costs downwards, often referred to a the "learning curve".

The confusion built into the mini-budget is the notion that by expanding disposable funds this will result in a rise in demand and create economic growth. This was an argument put forward by Milton Friedman but Nicholas Kaldor pointed out that this was the wrong way round. Kaldor's point was that demand for funds results from corporate decisions to invest in expansion that is productivity-based and therefore counter-inflationary in terms of unit costs.

For any process the following critical variables govern the volume of production of salable output: Cap is the throughput capacity; Cu is the capacity utilization; Ta is the time allotted to production in a 24 hour period; Y is the yield of salable output, thus production is given as:
Production = Cap.Cu.Ta.Y

Production has a recipe of inputs including quantities of variable inputs (v), labour (l) and energy (e) and therefore the costs are the sum of the products of each input time the unit price:

Cost = vpv + lpl + epe

Unit costs are total costs divided by production, therefore unit costs are as follows:
(vpv + lpl +epe)

Energy prices are rising as a result of extreme prejudicial decisions under UK foreign policy linked to the support of sanctions against Russia and recently the attack on the Nord Stream gas pipelines.

Sustainability of growth requires lowering unit costs on a sustained basis as well as setting prices to penetrate the market. The lower the relative prices the greater the gain in work force/consumer real purchasing power and real economic growth.

Any rises in money injection in the economy even at average or rising interest rates is likely to result in a rise in purchase of high end assets whose prices will rise as a direct result of market manipulation. This will affect land, domestic and commercial real estate, arbitraged commodities and corporate shares as well as some derivatives. The state of the pound has been one of general decline meaning that capital equipment and tools that are mainly imported will rise in price. As a result the maintenance of throughput capacity will be associated with rising overhead costs.
This type of expansion in output results in relatively lower unit output prices and therefore generates increased demand as a result of the relationship between relative unit price reductions and rises in physical demand for goods and services. Therefore the notion of raising disposable incomes as a way to secure real growth is incorrect. To summarize, companies that secure growth in productivity generate real demand on the basis of a sustainable rising real income of work forces/consumers. On the other hand, raising disposable incomes through grants and subsidy, puts a temporary amount of cash in people's pockets but does nothing for productivity or sustainable real growth. Indeed, this approach is not sustainable.

The economist Hector McNeill reviewed a production function model applied by the OBR based on a well-known Cobb-Douglas production function which has been around for over a century. It was first structured by Philip Henry Wicksteed (1844-1927) and elaborated by Charles Cobb (18751949) and Paul Douglas (1892-1976), McNeill has developed several equivalents of this production function since 1968 to explain locational-state concepts in natural resources, ecology and to climate change as well as simulate real economic growth in his work on the real incomes approach.

McNeill's main reservation with the model published by the OBR, is that as the model stands it is unable to discriminate the contribution of different supply side production enterprises to real economic growth. This can be calculated fairly precisely based on a segmentation of sectors into enterprises with good, average and poor practice, where practice is a measure of productivity based on unit costs achieved. This measure is of relevance because unit costs are the baseline benchmark that establish how feasible unit prices map over the purchasing power of the full range of constituent disposable incomes. This in turn can generate a map of production feasibility (profits) against volumes of output transacted.

Based on a model which accounts for different enterprise practice levels, McNeill showed that over the next decade, starting next year, the sustainable physical productivity and real growth rate for the country could be 0.5% rising to around 2% by 2033. However, the achievable income generation in terms of profits, wages and overall demand will be severely hampered by the underlying inflation situation with respect to energy.

The sort of detail missing from the OBR version of the CB production function is reviewed in the box on the right. This requires embedded functions containing arrays of the UCi according to practice and then the transition curve that provides the value of gains in productivity achieved according to the "learning curve". This is a common applied operations research method to project productivity gains.

The main item in the mini-budget is a subsidy to households to reduce the burden of rising energy bills. Some politicians has stated that this will reduce inflation by about 5%. This is simply not true. It will provide a temporary alleviation for families but the underlying structural inflation will remain the same, represented by the difference between the open wholesale market for gas and petroleum and the cap. The result of our foreign policy decisions has been to support and impose sanctions of Russian gas, thereby weaponizing Russian gas even during the period Russia still offered gas on long terms contracts at significantly lower prices. The most recent destruction of Nord Stream pipelines will severely impact Germany but also result in energy prices rising further with the risk of the UK running out of necessary supplies this winter. This means UK manufacturing will face an absolute reduction in energy sources and the government, already generous subsidy for families and businesses, totalling £60 billion, being outpaced by market events. In other words the baseline inflation will continue to rise meaning that the Bank of England will raise interest rates. Already, calculations concerning mortgage premiums, indicate that the benefits arising from the energy subsidies will be more than canceled by the rise in Bank of England interest rates. SDAG estimate that this could result in at least 150,000 families losing their homes due to repossession over the next two years. This would be a repeat of the experience under the Thatcher government. An event that lost the Conservatives the election in 1997.

On the afternoon of 03/10/2022, the Chancellor gave a speech which was rousing and helped mould the Conservative attendees into perhaps believing in the mini-budget.

Removing the 45p tax band reduction was hardly a rounding error. However the £40 billion non-funded tax cuts and the efficacy of the £60 billion funded subsidy remains in serious doubt because none of these decisions will tackle inflation caused by energy prices. Kwarteng seems to believe in the Rostow "Stages of Economic Growth", published in 1960. However, he does not appear to have studied the final phases of hegemonic cycles which typically end in financial crisis and inflation cause by excessive injections of money. The United Kingdom entered this phase following the 1973 OPEC rise in international petroleum prices causing stagflation. A run of monetarism and increasing financialization resulted in the 2008 international financial crisis. It is odd how Conservatives have a bad habit of blaming Labour for the international financial crisis in 2008. Under the Conservative government it is conveniently overlooked that the Bank of England exacerbated this economic decadence with 12 years of quantitative easing in 2008 up until 2022. This not only sustained austerity and intentionally ran down public services, but also reduced real wages and real investment and increased income disparity by enriching those who the Conservatives refer to as "innovative entrepreneurs" and "job creators". However, most growth was not real growth emanating from innovation but it was purely nominal growth based on asset bubbles generated by banks and hedge funds flooding the asset markets to increase their bonuses and shareholder value. Employment was maintained only by an increasing number of extremely low paid jobs.

The exacerbation of the situation under quantitative easing was the result of bank and hedge fund executives preferring to "invest" in assets as opposed to supply side productivity enhancing ventures. This was the reason why asset holders and traders wealth rose multiple times during this period while the majority saw their real wages fall and food bank services grow. Therefore, these institutions did not contribute to national real growth or innovation in an effective manner. Kwarteng's intent to remove the banker's bonus cap is a blatent way of pleasing executives in these institutions by handing more money to a small number of exectives to gain more than the whole 45p band group would have gained by the reduction to 40p. Thus Kwarteng's inaction on the banker's bonus cap, while gaining nothing for the national economy, will ensure generous contributions to the Conservative party war chest and media spin, ready for the 2024 general election.

This is such an unashamed and obvious ploy that it represents a continuation of the lack of ethical standards so typical of this government under the last prime minister.

Because of the nature of the OBR production function model and the range of so-called supply side reforms/actions, the OBR will have to make a range of assumptions concerning the contribution of these to raising productivity to dampen inflation. This will be no more than guesswork. It will be difficult for the OBR to produce a credible projections for this mini-budget; it will be interesting to see what they come up with.

The many routes that money flows can take, as was demonstrated under quantitative easing provided the evidence of why the Quantity Theory of Money had to be replaced by the Real Money Theory (RMT). However, the RMT undermines the whole monetarist money volume price assumptions as a critical firmament of monetarism. Thus the flow on money in the economy does not just find accountancy in the average prices of goods and services, but finds expression in all other factors including assets, overseas offshore flows and savings. The government understood that inflation needs to be brought down first in order to provide time for productivity to improve. However, the energy costs subsidy has no connection to productivity and for this reason will create fiscal gap for which there is no effective productivity compensation. It would seem that the "supply side" actions might have impacts in a few years time but their trajectory remains indeterminate.

The only economic theory and policy propositions that secure short term price reductions linked to sustainable productivity increases is the real incomes approach's Price Performance Policy.

In a follow up contact, Hector McNeill was asked his opinion on the current state of affairs. He stated,

"The proposals are what one might expect from the out of date proposals in the booklet, "Britannia Unchained" of which Truss and Kwarteng were authors. The Bank of England's quantitative easing sustained austerity for 10 years and now post-Covid-19 it is very clear that Kwarteng wishes to strip down the state in another dose of austerity. This is bound to mean cut backs in public services and welfare. This is a strange combination of ideological arrogance and extreme naivity because this will kill the Conservative party and will not work out, given the trends in the strategic energy balance-linked inflation.

Although it is the unfunded aspects that worry the markets, the funded energy subsidy is in fact the most significant in terms of risk because this will, along with all other measures, do nothing at all to reduce inflation.

What is more than obvious is that those concerned have not caught up with fundamental changes in economic theory and derived policy instruments. As a result the Bank of England continues to have no instruments to control inflation without throwing the country into a depression and stagflation. The Treasury and Chancellor still imagine that growth is the result of demand generated by monetary injections. A very serious confusion between nominal and real growth persists. The correct buzz words are circulating and they peppered Kwarteng's presentation, but this only creates the danger of the assembled interpreting statements as containing a profound and relevant significance for the country when the reaity is quite the reverse. However, the sign of this is that no one, so far, has been able to define the timing of the results of all of this or describe the mechanisms whereby these policy decisions will improve the wellbing of the constituents of this country

References for further reading:

Why monetarism does not work
Why the Bank of England Cannot solve the cost of living crisis
The constitutional crisis created by monetary policy
Monetarism & The Cost of Living - BSR Special Report