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5 October 2022

How Liz Truss crashed to earth

By waging a culture war against reality, the government has made the UK economy one of the most unstable in Europe.

By Duncan Weldon

Rarely, if ever, has so much financial and political capital been burned in so short a time. On 23 September the Chancellor of the Exchequer, Kwasi Kwarteng, unveiled his so-called mini-Budget. It was anything but mini. Alongside a £150bn plan to cap energy prices for households and firms came a wholesale change in economic strategy.

The fiscal conservatism that had supposedly been the guiding principle of Tory budgets for the past 12 years was replaced by a tax-cutting, ostensibly pro-growth agenda. A planned increase in corporation tax from 19 per cent to 25 per cent was cancelled, a rise in National Insurance contributions was reversed, a 1p cut in the basic rate of income tax was brought forward and the 45p tax rate on earnings over £150,000 was ­abolished. In total, around £45bn of permanent, unfunded tax changes were announced – the largest of any fiscal event since the former Conservative chancellor Anthony Barber’s ill-fated 1972 Budget.

Kwarteng’s mini-Budget provoked a ­deeply negative reaction not only in financial markets – where interest rates on government debt have risen by the highest monthly amount since 1957 – but also among voters and even among many Conservative MPs. Pollsters have recorded Labour leads stretching as high as 33 percentage points – the largest since the Tories’ 1990s nadir.

On 3 October, as a revolt by Conservative MPs – including Michael Gove – intensified, the inevitable U-turn came: Kwarteng announced that the 45p rate would remain (“we get it, and we have listened”). That, though, still leaves £43bn of tax cuts. The abolition of the 45p rate was merely the most inflammatory part of an already combustible package.

The reaction to the mini-Budget from investors appeared to surprise the government. It should not have done so. The basic economics of the UK’s precarious position were obvious. Inflation, at just below 10 per cent, is alarmingly high. And while that headline rate reflects high energy prices and Vladimir Putin’s invasion of Ukraine, these are not the sole factors. Core inflation, which excludes volatile energy and food prices, stands at more than 6 per cent, a figure the Bank of England believes reflects a tight labour market short of workers and domestic inflationary pressures. In a bid to return inflation to its 2 per cent target, the Bank had already increased interest rates from just 0.1 per cent last December to 2.25 per cent before the mini-Budget.

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The Bank was, in other words, stepping on the macroeconomic brakes in order to slow demand in the economy and reduce inflation. The Chancellor’s decision to hit the accelerator, pumping money into the economy via tax cuts, left UK policy looking profoundly incoherent. Financial markets correctly surmised that if the government was fuelling consumer demand, the Bank would have to go further to offset it. The day before the mini-Budget, markets expected interest rates to peak at around 4.5 per cent next summer. The day afterwards, that forecast had reached 6 per cent.

Illustration by André Carrilho

But the market reaction was driven by the style of the announcements as well as their substance. Having already sacked Tom Scholar, the respected Treasury permanent secretary, Kwarteng promised the biggest tax cuts for 50 years without any accompanying forecasts and costings from the Office for Budget Responsibility. He subsequently responded to early market turmoil by insisting that this was just the beginning and more tax cuts would follow next year.

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By 28 September, the situation in the market for British government bonds, known as gilts, had become so worrying that the Bank of England was forced to intervene on financial stability grounds. The government’s debt-funded tax cuts and expectations of faster interest rate rises from the Bank led to a large rise in the yield, or interest rate, that the government pays on gilts, which then caused the price of these bonds to fall.

[See also: Inside Liz Truss and Kwasi Kwarteng’s economic meltdown, with David Gauke and Duncan Weldon]

As prices moved at a pace not seen in the gilt market for decades, serious problems were created for large defined-benefit pension funds. Higher interest rates on government debt are, in the long term, usually positive for pension funds because they imply that the discounted value of liabilities that have to be paid out in the future is now smaller. But many large funds have used complex derivatives to protect themselves against market volatility. As the price of gilts fell, they found themselves forced to raise cash to meet margin payments on these products. By the morning of 28 September, a vicious cycle was developing whereby falling gilt prices resulted in pension funds being pushed into selling gilts, adding to the downward pressure. The Bank became so alarmed that it pledged to spend up to £65bn (or £5bn a day) buying long-dated gilts to end the fire sale of assets.

Owing to the 2008 global financial crisis and the Covid-19 pandemic, we have become accustomed to dramatic interventions by the Bank of England. But never before has the Bank had to act in such a fashion to save a government from its own recklessness. Across September, the yield on ten-year UK gilts rose by 1.3 per cent, the largest increase experienced by any major advanced economy since at least 1987.

Since the mini-Budget, the government’s economic outriders have been forced to fall back on two rather dubious lines of argument. The first is that what has happened in financial markets has nothing to do with the UK government and instead reflects global conditions. There is no doubt that the world economic environment is alarming and that markets are in a febrile mood. Interest rates have been rising across the advanced economies, driving government bonds ­lower. The dollar has strengthened sharply against most currencies, reflecting both the faster pace of interest rate rises in the US and the desire for a safe haven in a crisis (something the dollar traditionally is).

But if the crisis is global, it is becoming more acute in Britain. As Huw Pill, the Bank of England’s chief economist, recently put it, there is a “UK-specific component” to the volatility. The move in government debt prices has been bigger in Britain and the pound has lost value against currencies other than the dollar. That global markets were unsettled even before the mini-Budget was an argument for taking a cautious approach rather than doubling down on a risky fiscal wager.

The second defence is that the adverse market reaction is due to the cap on energy prices (costed at £60bn for the next six months and planned to continue for two years) rather than the tax changes. This is nonsense. The energy price package is certainly costly but, unlike the tax cuts, it is temporary. The long-term impact on the fiscal position is limited and markets are willing to tolerate such interventions. Most European countries have introduced similar measures – Germany, for example, announced a €200bn package on 29 September – without similar market reactions.

The more sophisticated defence of the government’s measures is that they have simply been misinterpreted. Rather than being intended to boost demand and pump more money into the economy, they should, runs the argument, be seen as part of a larger plan to reform the supply side of the British economy and increase its trend rate of growth (to 2.5 per cent a year). By cutting tax rates on income, the government hopes to encourage more people to work for longer and to boost the supply of labour. Not raising corporation tax should, by this logic, encourage firms to invest more. Taken together, a higher supply of labour and more capital would raise the potential output of UK firms.

The problem is that the evidence for tax cuts leading to these kinds of improvements is distinctly mixed. Most firms cite a lack of macroeconomic stability as the primary impediment to them investing more and recent weeks have hardly helped on that front. Even if the tax changes do lead to improvements on the supply side, such improvements typically take years to show up in the data. In the meantime, it is the additional demand from firms and households that will matter most to the economic outlook – and the Bank of England will almost certainly offset that increase with higher interest rates.

Most concerning of all for supply-siders is that the toxic politics of the mini-Budget have destroyed the prospect of meaningful non-tax reforms. Liz Truss and Kwarteng have hinted at changes to planning law to allow more houses to be built and reforms to speed up infrastructure construction. This was always going to be a tough sell to sceptical Tory backbenchers. But by beginning with unpopular tax changes and being forced into an abrupt U-turn over the 45p rate, Truss and Kwarteng have shrunk their already diminished stock of political capital.

We now face a grim battle over public spending. Kwarteng has promised to reveal his medium-term fiscal plan earlier than 23 November. His aspiration is to demonstrate that the government’s debt-to-GDP ratio (which stands at 96.6 per cent) will be lower in five years’ time. That implies large reductions in government spending. The promised £43bn of tax cuts, and an extra £10bn-£12bn in debt interest costs, means ministers will be forced to impose £35bn-£50bn in cuts depending on how the economy performs, heralding another period of austerity. Real-terms cuts to benefits and public sector pay, and sharp reductions to capital spending, now appear likely. All of this will be both economically damaging and politically toxic.

The spectacle of a government led by supposed free marketeers finding itself locked in battle with financial markets and even the International Monetary Fund (which condemned the tax changes) will be familiar to anyone who followed the Brexit debates. As during 2016 to 2020, the right of the Conservative Party is arguing that the Treasury, currency traders, bond market investors and international organisations with three-letter acronyms represent a stale orthodoxy and are simply wrong about the likely economic impact of the government’s policies. But a culture war against economic reality can only take a government so far.

In the case of Brexit, the economic damage played out slowly. Erecting new barriers to trade with your richest, closest and largest trading partner damages the economy over time. Denying the reality of the damage was at least possible. This time things are moving at a faster pace. As interest rates rise and the Tories’ poll ratings fall, the government has been left brutally exposed.

[See also: Liz Truss has failed to seize the moment]

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This article appears in the 05 Oct 2022 issue of the New Statesman, Crashed!