Manage capacity to manage inflation

We’ve got a promise to keep. In Chapter 8 we set out the mechanism of inflation and said we’d explain how spending gets matched to capacity. Here it is.

The dinner-table version is that prices rise when something is scarce and lots of people want it. There are PhDs written on the nuances. The dinner-table version is close enough.

No serious economist has claimed sovereign governments can create or borrow money without consequence. The claim here is narrower, and it’s accurate: money created to build what a country physically lacks, at a pace that country can physically absorb, does not behave like money created to chase goods that have inelastic supply.

So the question is what the money buys.

Retrofitted homes. Social housing. Generation and grid. Water that doesn’t leak. Buses and trams that turn up. None of it arrives on next day delivery by Amazon Prime. These are projects measured in years.

Each has at least two costs. Wages and materials. Some also need land.

Land is the simplest. Buying a field consumes no bricklayers and no steel. It transfers a title. Money spent on land changes who owns something. It doesn’t compete for the resources that build things.

Wages are the largest cost in the programme. And wages are paid here, in sterling, and spent here.

Follow the money

A welder on £40,000. Her employer pays £5,250 in National Insurance on top, so the job costs £45,250. Income tax takes £5,486 of her salary. Her own National Insurance takes £2,194.

Before she has spent a penny, the Treasury holds £12,930 of the £45,250 that job cost. Nearly 29p in the pound.¹

Then she spends it. VAT on the shopping. Duty on the beer. The pub pays business rates on the building and corporation tax on the profit, and income tax and National Insurance on the wages of the lad who pulled the pint. Who spends it again.

The Office for Budget Responsibility works on the basis that around 40% of the GDP an investment creates returns to the Treasury as tax.²

One thing about that figure. The OBR is required to forecast on stated government policy — not proposed policy, not plausible policy. It has never modelled the programme in this report, and it will not unless a government adopts it.

That is not a criticism. It is the job it was given. But it means the official numbers describe the country we have, not the one we could build.

Others have modelled it. The Confederation of British Industry (CBI) puts the return on construction spending at £2.92 for every pound. The International Monetary Fund (IMF) finds the effect of public investment builds over years rather than fading, and is strongest where there is slack in the economy – the condition the capacity guardrail exists to create. A worked study of a national retrofit programme put the return at £3.20 of GDP and £1.25 of tax per pound.

Different methods. Different questions. Different answers.³

So take the official one. The OBR’s working assumption is that a pound of public investment produces a pound of GDP. At 40%, the Treasury gets 40p back. The real cost to the state is 60p in the pound, and we own the asset at the end.

A private investor recovers none of that 40p. It was never theirs to recover. That is the whole difference, and it’s why the state can build what the market will not.

Text description for Investing in a retrofit blitz: the multiplier effect

GDP returned per £1 of public investment

• OBR official figure, which the report uses: £1.00
• CBI figure, construction spending: £2.95
• Worked retrofit study, optimistic end: £3.20

Tax returned per £1 of public investment

• OBR official figure, which the report uses: £0.40
• CBI figure, construction spending: £1.25

The point made: the argument uses the cautious figure, and the range shows it isn’t the only one. Source: OBR, CBI/Oxford Economics, Fine Margins, Verco/Cambridge Econometrics, Hostage Nation endnote 65.

Keynes named the leaks

Money escapes the circuit three ways: savings, imports, tax.

Only two of them cost the state anything.

Tax is not a leak from the Treasury’s point of view. It is the return. A private firm loses everything that isn’t its own margin. The state loses savings and imports, and recovers the third at every round, from everyone who touches the money.

Savings we have already addressed. National Development Stock offers ISA and pension savers a secure investment at a fair rate, and puts the money back to work.

Imports are the rest of this chapter.

The supply chain is the argument

Order a million heat pumps from an overseas manufacturer and we have let ourselves down. That money is gone. No cascade, no tax, no wages spent on any British high street.

Build them here and the whole circuit runs.

This is not a call for protectionism. No tariffs. No import quotas. No shelter for firms that can’t compete. What we should offer is a full order book to anyone who can supply, the skills training to build the capacity to do it, and social value clauses that make the work worth having.

“Certainty of demand is the thing British industry has never been given. A firm that knows the orders are coming for twenty years will expand the factory. A firm guessing at next year’s budget will not.”

That hits hardest for small firms. A large contractor can carry uncertainty on its balance sheet for a year or two. A firm of eleven people carries it on an overdraft, and cannot bid for work it might not be able to finance. It is not that small firms lack the skill. It is that certainty is worth more to them per pound than to anyone else, and they have never been given any.

Social value clauses are where that gets fixed. The 2012 Public Services (Social Value) Act has long allowed public procurement to embed clauses for social good – fair wages, high environmental standards. The 2023 Procurement Act takes this further. So we already have the legal powers to break contracts into lots a regional firm can actually bid for. Require apprenticeships. Require the skills and jobs to be created here. And apply the one condition that costs the Treasury nothing at all: everyone in the chain gets paid on time.⁴

Thirty-day payment terms are already legally implied into public contracts and already required to flow down the supply chain. They are widely ignored, because the consequence of ignoring them is a published statistic, and a power nobody uses. Make payment performance a condition of holding the contract, and the smallest firm in the chain stops lending money to the largest.

Why the state can pay more

A contractor is building a wind farm. Two quotes for the fabrication. £750 million from a yard on the Tees. £748 million from overseas, shipping included.

The contractor takes the cheaper one. Of course it does. Two million pounds is two million pounds, and the contractor’s job is to build the wind farm as cheaply as it can.

Run the same decision through the Treasury’s books.

£750 million spent on the Tees returns something in the order of £300 million in tax. £748 million spent abroad returns close to nothing.

The state is around £298 million better off paying £2 million more.

The contractor cannot see that. No private company collects income tax. It sees a price, and it is behaving perfectly rationally in taking the lower one. The failure is not the contractor’s. It is an appraisal system that scores the price of a project and ignores where the money lands.

Of course, this requires the capacity to supply, which is itself dependent upon a clear demand signal. The state’s advantage is real only when it puts workers and machines to work that would otherwise be still. Which is exactly what the guardrail measures.⁵

The real value of work

The £300 million is only the tax. It is not the whole return.

A welder in work is a welder not on Universal Credit – around £11,500 a year for the average household, more where there’s a health element. Council tax support on top. She is less likely to need the NHS. Her town has less crime. Her children grow up in a house with a wage coming in.

And the scarring stops. Someone who gets a trade at eighteen pays tax for forty-five years. Someone who gets three years of app work and then gives up costs the state for forty-five years. The decision runs the same distance in both directions.

The Treasury knows how to count all this. It maintains a database of these costs, and requires a council bidding for an employment programme to use it.

But it does not require anyone to use it when deciding where a wind farm’s steel gets made.⁶

What we owe the world

Britain buys more from the world than it sells, and has done every year since 1984. Recent deficits have run at roughly two to four per cent of everything we produce. Spend heavily at home while that gap stays open and sterling comes under pressure. A weaker pound makes every imported component dearer, including the silicon wafers and cables this programme runs on.⁷

Be fair about it, though. A weaker pound also makes British exports cheaper, and that is supposed to be the adjustment mechanism. Right now it is not working. What we import is mostly essentials – energy, food, components – so when the price rises we pay it, because essentials are essentials.  And when the rate turns in our favour, we cannot take advantage, because in industry after industry we no longer have the plant or the workforce to scale up. Britain gets the loss and misses the gain.

That is not an argument against having a floating currency. It is an argument for rebuilding industrial capacity.

The rate moves anyway

Sterling’s value is not set by the British government. It floats based on market events. A rate rise in Washington. A flight to the dollar when a war starts. A shift in what global investors think of emerging markets, which has nothing to do with us at all. The pound moves, and the price of everything Britain imports moves with it – under any government, pursuing any programme, including doing nothing.

We have seen this argument before in this report. It is the same one made about gilt yields: a price this country depends on, set by people responding to events on the other side of the world.

You cannot make that volatility go away. What you can decide is how much of your national life is exposed to it.

What the money buys

Our programme is aimed at the imports causing the problem. Britain burns imported gas to heat badly insulated houses. Retrofit cuts the demand. A sovereign grid replaces the supply with clean electricity generated here. Cambridge Econometrics modelled the insulation alone and found gas imports 26% lower than they would otherwise be. That is before a single boiler is replaced. That is the trade gap closing, not widening.⁸

There is a second drain nobody mentions. Stop dividend flight. Our water companies, energy networks and airports are largely foreign-owned, and the dividends leave every year, permanently. Building capacity does not fix that. Only changing the ownership does, and the moment it changes, the outflow stops.

Then there is what we sell. Trained engineers, plant that runs at scale, firms clustered around a guaranteed order book – that’s how a country becomes competitive in export markets. Britain does badly in industries where we lost the capacity to compete. Coordinated, long-term investment is the fix.

Be honest about the sequencing, though. We buy the heat pumps before we stop buying the gas. There is a window, some years long, where the imports come first and the savings arrive later. That is not an argument for continuing to import gas. It is an argument for building those supply chains here, now, at the pace the guardrail sets.

“A country that heats its homes with its own electricity, houses its people in homes it built, and moves them on transport it owns is a country that needs less foreign currency. That is not protectionism. It is the difference between weathering the next shock and being hostage to it.”

First we build capacity

Which brings us to the rule that governs the whole programme.

Provide certainty of demand for labour and production. Then train the workers and build the supply chains. Then, and only then, fund the projects, in line with the capacity that exists to deliver them. But where they know that the money will be there when the capacity comes online.

Not a spending total announced in a Budget and dumped into a market overnight. Tranches, released against a measured answer to a simple question: can Britain physically build this yet?

That is what the capacity guardrail is for. Not immunity from inflation. A mechanism for spotting it early and easing off.

The machinery for measuring it already exists, and we set out how it works in Chapter 28, including who assesses capacity, how the skills pipeline is built, and where the engineers come from.