It may have been less than three weeks since the government’s mini-Budget but the analogy of choice now needs to be moved forward by a decade. At first the fiscal package was reminiscent of the Conservative chancellor Anthony Barber’s disastrous “dash for growth” in the early 1970s but the situation is rapidly becoming more akin to the French Socialist François Mitterrand’s 1983 abandonment of his initial programme in the face of hostile financial markets.
No Budget in postwar British history has prompted as vicious a market reaction as that of 23 September. Investors and analysts had been braced for an expensive, and necessary, energy price freeze and had expected the new government to cancel a planned rise in corporation tax from 19 per cent to 25 per cent and to reverse the recent National Insurance increase. Those tax changes would have cost around £30bn a year, but the government went much further: stamp duty was cut, the basic rate of income tax reduced from 20p to 19p and the 45p rate on earnings over £150,000 was abolished (altogether amounting to £45bn of tax cuts).
It was the substance of the budget which spooked markets as much as the style. There were no estimates of cost or forecasts from the Office of Budget Responsibility. The government’s fiscal rules, which are meant to ensure financial probity, were suspended with a vague promise to reveal new ones in 2023. Liz Truss and Kwasi Kwarteng, the Chancellor, spoke of rejecting the old orthodoxy of the Treasury, sacked its permanent secretary (Tom Scholar) and even appeared at times to question the role of the Bank of England. Over the weekend that followed the budget the government briefed friendly newspapers that more tax cuts would follow.
The measures unveiled three weeks ago were the largest set of tax cuts at any fiscal event since 1972. Back then Barber, Ted Heath’s chancellor, faced an economic outlook uncomfortably familiar to modern policymakers; inflation was high even as growth slowed. The result was the short-lived “Barber boom”, which overheated an economy already running above capacity and quickly gave way to a Barber bust.
The crucial difference with 1972 is the existence of an independent, inflation-targeting central bank. In the nine months before the mini-Budget the Bank of England had increased its base interest rate from just 0.1 per cent last December to 2.25 per cent to try to reduce the pace of price rises. Financial markets anticipated a rise to 4.5 per cent by next summer. After the budget, they priced in a rise to 6 per cent. Investors concluded that Kwarteng’s tax cuts would further fuel inflation, forcing the Bank to impose higher rate rises to offset the stimulus.
This, combined with worries over a higher supply of British government bonds, known as gilts, as borrowing increased forced a rapid adjustment in the debt markets. The price of gilts fell sharply, pushing up the yield – or interest rate – on them (the rise was the highest in any monthly period since 1957). This caused serious issues for some large pension funds which had staked borrowed money in these markets, forcing the Bank of England to intervene in an attempt to safeguard financial stability and, in its words, prevent a “fire sale” dynamic.
The Bank’s bond-buying programme is due to end tomorrow (14 October). Even after this intervention, the cost of new government borrowing looks set to be around 1.5 per cent higher. As a direct consequence of the mini-Budget, the interest on a new fixed two-year mortgage has risen above 6 per cent.
No plan for growth can survive contact with crushing interest rates. The U-turns have already started. Just four days after the Budget the government announced that a medium-term fiscal plan – complete with forecasts and cost estimates from the OBR – would be brought forward to 23 November. Ten days after the Budget the abolition of the top rate of income tax was abandoned. That took the total size of the tax cuts down to £43bn. As the market pressure – and ever louder grumbling from Conservative MPs – continued, the fiscal plan was brought forward once again to 31 October. The new permanent secretary of the Treasury, James Bowler, is an old insider rather than the previously much touted option of an outsider. Having castigated the OBR, the Treasury and the Bank as part of a failed consensus over the summer, Truss and Kwarteng are now hugging them close and hoping to use them as a shield against financial markets.
Changing the style, although helpful, will not be enough without changes in substance too. There is no appetite among either Conservative MPs or the general public for the kind of spending cuts required to reduce the UK’s debt-GDP ratio while keeping the tax changes. The 45p reversal will be followed soon by the abandonment of other tax cuts. This is Mitterrand but from the other side of the ideological spectrum and at a faster pace. His initial programme, upon winning the French presidency in 1981, included mass nationalisation, wealth taxes and a higher minimum wage. Market pressure on both the franc and French government bonds forced the tournant de la rigueur, or “austerity turn”, of 1983 (public spending was cut by 44 billion francs and taxes were increased by 40 billion francs). This time around it is a tax-cutting programme that has failed to convince the markets. The political fallout will be painful.