First impressions count, especially when it comes to economic policy. UK Prime Minister Liz Truss and Finance Minister Kwasi Kwarteng last week announced a fresh start for the country with a big shift in fiscal policy — and hit the ground face first. Their plan has crashed the pound, wrecked the government bond market, and destroyed the Bank of England’s efforts to tighten monetary policy.
After such a disastrous start, repairing the damage might be beyond them.
In one way, the financial markets’ reaction to Kwarteng’s mini-budget has been excessive. The plan was poorly designed, for sure, but a plausible forecast (before the market mayhem, that is) would have deemed the tax cuts and spending increases affordable. Projected deficits and debt weren’t outlandish by prevailing standards. Economists had been debating the case for fiscal relaxation; until a few days ago the view that this is no time to be fussing about public debt was respectable, albeit wrong.
The problem is the broader context — and Truss’s determination to ignore it.
The UK faces numerous challenges, any one of which would strain the most competent of governments and risk scaring investors. The new administration is untested in economic affairs. Truss took office after an extended period of political turmoil, defeating Rishi Sunak for the leadership in part by opposing his commitment to fiscal orthodoxy. Britain’s inflation problem is more serious than most because of the economy’s unusually heavy dependence on gas. And the UK economy is uniquely burdened by the immediate impact and unfinished business of Brexit.
A little reassurance was therefore indicated. Truss needed to show she understood the gravity of these problems and would work toward solving them. That would have been challenging, no doubt, because it meant turning her attention from the excitable Conservative Party members who elected her and addressing everybody else — especially investors, who from time to time hold the fate of governments in their hands. Instead of offering reassurance, she stuck with campaigning.
She and Kwarteng ostentatiously set aside the immediate economic challenges and presented a plan that put heavy stress on the longer term. Tax cuts and fiscal incentives to promote investment and enterprise are well and good, if intelligently designed. But for now long-term growth prospects are mostly beside the point. As if to underline her disdain for fiscal orthodoxy, she also suspended the procedure for letting the Office for Budget Responsibility, Britain’s independent fiscal watchdog, review the proposal.
The budget compounds the short-term challenges by cutting across the Bank of England’s efforts to fight inflation. Additional fiscal stimulus forces the central bank to raise its policy rate even more. The sharp fall in sterling, another symptom of collapsing confidence, is a further complication. It too pushes inflation higher, again calling on the BOE to tighten further. Suddenly that’s not so easy: Alarm in financial markets also raises long-term interest rates, turning attention to the solvency of private debtors (including holders of floating-rate mortgages).
These surging cross-currents make the central bank’s task all but impossible. This week, amid extraordinary turbulence in financial markets, the BOE reversed itself in the space of a day, promising to buy as many long-term government bonds as required to restore order — in effect, resuming the quantitative easing it had been planning to reverse.
Recall that during her campaign Truss had raised a question over the Bank of England’s operational independence, saying that its mandate might need to be changed. So you could say she’s consistent: Her views on central-bank independence are as heterodox as her thinking on independent oversight of the budget. The attention to detail is no less impressive: Whatever she could do to make investors anxious and the BOE’s job harder, she has done.
On Brexit, her approach is closer to outright indifference. Repairing economic relations with the European Union, as far as that’s possible, should be an overriding priority. The consequences of a breakdown of trade hardly bear thinking about — and the war in Ukraine offers the chance of a reset, because it has shown the need for European solidarity. Yet the prime minister still seems to think Brexit is going to plan, that it’s only a matter of time before the EU sees sense and surrenders to her demands on trade between Northern Ireland and the rest of the UK.
Add all this together, and investors’ alarm over UK prospects no longer looks extreme. Maybe Truss is chastened. But beginnings this bad are hard to reverse. Staying the course won’t work, because the course she has set is doomed. And abrupt U-turns can make things worse: Incompetence plus panic is more frightening than incompetence. Is it too soon to ask whether the Tories need a new leader?
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