Kwasi Kwarteng’s financial thinking is put to the test

Kwasi Kwarteng made headlines in 1995 when he said the word “fuck” twice University Challenge: The same word echoed in the trading rooms on Monday as the pound faltered in response to the British Chancellor’s new economic policy.

A few years after representing Cambridge University’s Trinity College in the television quiz, Kwarteng wrote a doctoral thesis on early modern monetary policy which gave him an insight into the likely impact of sterling’s fall. At one point on Monday, it fell below $1.04, a record low against the dollar.

Although the currency later rallied, Treasury insiders said UK economic policymakers were “heading for crisis mode”. Kwarteng’s supply-side revolution, including £45 billion in tax cuts funded by massive borrowing, is about to be tested.

The Chancellor said in an interview with the Financial Times on Friday that he had remained “calm” even as the sterling sell-off began. He argued that fiscal stimulus to stave off a recession is not inconsistent with the Bank of England raising interest rates to curb inflation.

“There were two exogenous shocks: the Covid pandemic and Putin’s invasion of Ukraine,” he said. “In this context, it makes perfect sense to have some looser fiscal policy to deal with these shocks.

“On the monetary side, it makes perfect sense for the bank to do what it does traditionally. It’s not a contradiction at all.” The BoE’s independence – including its ability to raise interest rates to protect the pound – was “sacrosanct”.

Some of the economic frontrunners for Prime Minister Liz Truss’ new government have argued that higher interest rates could actually be helpful and are a positive side effect of looser fiscal policy.

Professor Patrick Minford, an academic at Cardiff Business School, was cited by Truss as a leading economic thinker: He has on record said it would be “not a bad thing” if interest rates went to 5-7 per cent.

Gerard Lyons, chief economic strategist at Netwealth, advised Truss and Kwarteng during the Tory leadership contest, telling the Financial Times on Monday: “It is very clear that we need to move away from easy money policies.”

Lyons said it caused a number of problems, including contributing to asset price inflation and inefficient capital allocation. But he conceded that Kwarteng could have managed market expectations better.

“In my opinion, he should have taken into account the feverish state of the markets,” he said, adding that Sunday’s pledge by Kwarteng to cut taxes further added to the uncertainty.

Kwarteng, who holds bi-weekly meetings with BoE Governor Andrew Bailey to coordinate strategy, told the FT: “Markets are constantly moving. It is very important to stay calm and focus on the longer term strategy.”

Kwarteng hasn’t said that he thinks higher interest rates, brought about by looser fiscal policy, would be a good thing: instead, he argues that tax cuts, as part of a broader agenda of supply-side reform, will bring Britain’s growth rate back to levels of before financial crash rate of 2.5 percent per year.

This right-wing economic agenda laid out by Kwarteng, Truss and other Tory MPs in the 2012 tract Britannia unleashedIt has been making the rounds in conservative think tanks for years; now it is government policy.

Indeed, Kwarteng has good political reasons to fear the consequences if the BoE hikes interest rates, leading to large hikes in mortgage payments and directly affecting millions of Tory voters in central Britain. Conservative MPs are already very concerned.

“What’s the point of an income tax cut that puts someone in their pocket £100 a month when their mortgage payments go up by £200 and they pay an extra 30p for their coffee every morning?” asked a former minister.

However, it may be worth paying attention to the introduction to Kwarteng’s book war and goldpublished in 2014, in which he states in the introduction: “Anyone who has discussed taxes and public spending with a finance minister before an actual budget will be aware of how often political considerations greatly outweigh the subtleties of theory.”

However, he has been concerned with some of the economic problems that Kwarteng is facing for some time. His doctoral thesis entitled “Political Thought of the Recoinage Crisis” is a survey of late 17th-century commentary surrounding the decision of William III’s government to reissue England’s coinage in 1695-6.

Modern concerns about rising coffee prices echo the views of Sir Isaac Newton, then in senior positions at the Royal Mint. Kwarteng quoted him as saying that a devaluation-related increase in commodity prices would be “balanced”. [equivalent] a tax on all other estates” and tended to “make the nation weary of war and uneasy under government”.

The historical context of Kwarteng’s analysis makes it difficult to draw many conclusions about his current views: One of the critical monetary issues at the time was the smelting, shaving, or exporting of coins for their silver.

He certainly does not appear to support the position of pamphleteers he quotes, who feared that the then-new BoE’s monetary monopoly would spark another civil war.

But the thesis shows there is a long tradition of comments from his allies over the weekend blaming City Boys speculation for sterling’s weakness.

Kwarteng notes that even then, at the very beginning of the London financial revolution: “Nobody believed that the interests of the goldsmiths and bankers were detrimental to the welfare of the nation as a whole”.