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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
“UK business activity shrank for the first time in more than a year, according to a closely watched survey, as the private sector warned that confidence in the Labour government has been badly hit by last month’s Budget.” This was the opening of a story that appeared in the FT on November 22 2024. It raises the important question of whether “confidence” even matters for economic performance.
To answer it, one needs to distinguish the notion of confidence from the direct impact of a policy. Thus, in this story, Chris Williamson of S&P Global is quoted as saying that “companies are giving a clear ‘thumbs down’ to the policies announced in the Budget [on 30 October 2024], especially the planned increase in employers’ national insurance contributions”.
Yet this might have little to do with any loss of confidence. It might mean that companies were rather confident that higher taxes on employment would lead to higher costs, higher prices, lower employment and lower profits and, if so, that they were sure to be contractionary, in the absence of a powerful offset. One offset might have been a fall in borrowing costs as taxes rose. In practice, as the Office for Budget Responsibility noted at the time, prospective borrowing increased. Not surprisingly, then, yields on 10-year gilts costs rose 268 basis points from before the Budget to December 19, a bigger rise than in any G7 member, apart from the US.
Yet confidence might still matter. Indeed, it is certain to do so. After all, as Nobel laureates George Akerlof and Robert Shiller pointed out in their 2009 book Animal Spirits, people are not rational calculating machines. We are intensely emotional.
Frequently, however, we can still analyse the economy as if that is not a problem. The relatively mechanistic analysis of what a tax increase — such as that in the Autumn Budget — could do would be good enough. Yet there are crucial exceptions. These mostly occur whenever “radical uncertainty”, the title of a 2020 book by two British economists, John Kay and Mervyn King, becomes the main issue. Moreover, there are two circumstances in which such uncertainty does become dominant in determining what will happen: the first is one of severe macrocoeconomic instability, such as a financial crisis; the second is one of weak long-term growth.
In both cases, a crucial variable is what John Maynard Keynes called the “propensity to invest”. Investment is where “animal spirits” have to come in. After all, any decision to invest is a bet on an uncertain long-term future. The past two decades have demonstrated just how unpredictable that future can be. It hardly looks less unpredictable today. Just consider what might happen politically, geopolitically, strategically, economically or environmentally.
Moreover, as Keynes stressed, investment is likely to be depressed for years if the economy ever falls into a slump. This is why, in my view, post-financial-crisis fiscal austerity was a mistake. It is a part of the reason why growth in the UK and most other European economies has been weak ever since.
Yet now, above all in the UK, where, as I pointed out on November 25, net investment is exceptionally low, depressed animal spirits threaten the investment on which future economic growth depends. Unfortunately, data suggests that confidence is rather low. A noteworthy example is an “economic confidence indicator” published by the Institute of Directors early this month, which shows business confidence at levels close to those of 2020, at the height of the Covid pandemic, or immediately after Russia’s full-scale invasion of Ukraine in 2022. Not dissimilarly, the Confederation of British Industry reported on December 2 2024 that “Private sector firms expect activity to fall in the three months to February 2025 . . . This marks the first time this year that expectations for growth have been negative.”
The danger, then, is that measures taken by the government to raise taxes and tighten regulation, notably of the labour market, will not merely increase uncertainty about the future, but, worse, actually increase the certainty that the economy will go on stagnating. Both of these effects must undermine trust in the future. That then risks launching a vicious downward spiral, in which poor confidence undermines animal spirits, weakens investment, slows demand, undermines innovation, and so shrinks the growth of productive capacity.
At the level of rhetoric, the government does emphasise the priority of economic growth. It is right to do so. Nothing is going to work without it. But it needs to understand that growth depends on the confidence of business in that growth. This is the confidence most likely to induce business to seize risky opportunities. Thus, in every decision, the government must ask itself this question: will it make business believe more strongly in a better future, or not?