There will be a risk premium on UK assets as long as Truss is in power

The author is the author of Two Hundred Years of Muddling Through: The Surprising History of the British Economy.

Not since 1976 has a UK government been forced by market pressure to make such an abrupt about-face in fiscal policy. At the time, Denis Healey, the then Chancellor, on his way to the annual IMF meetings, had at least not reached Heathrow airport’s departure lounge until he was summoned back to Downing Street. In contrast, Kwasi Kwarteng had to endure the humiliation of flying back early from the same meetings in Washington, only to be fired on arrival.

No post-war fiscal event in Britain was so brutally and promptly attacked by the financial markets as the September 23 ‘mini’ budget. Investors had expected that a proposed increase in corporate income tax from 19 percent to 25 percent would reverse a recent increase in Social Security contributions. That would have meant about £30 billion worth of tax cuts a year. Instead, the government delivered a package of tax cuts totaling initially £45bn on top of a major energy market intervention. A sharp sell-off in gilts, exacerbated by leveraged pension funds facing margin calls, was enough to trigger a two-week intervention by the Bank of England, which began just days after the budget update.

In order to calm the markets, a promised plan by the Treasury Department to reduce the ratio of government debt to gross domestic product in the medium term was brought forward from November to the end of October. But last week has shown that neither Conservative MPs nor the general public have any appetite for the magnitude of the spending cuts that will be required if the tax changes remain in place. On Friday, after sacking her Chancellor, Truss announced that the increase in corporate tax – estimated at around £18bn – would still take place. With a promised top tax cut on incomes over £150,000 already scrapped, unfunded tax cuts now total around £25bn.

Gilts rallied sharply on Thursday as news of the imminent turnaround began to trickle out of Whitehall. For the bond markets, the turnaround is to be welcomed for a number of reasons. It significantly reduces the government’s borrowing needs in the coming year and, more importantly, should slow the expected pace of Bank of England rate hikes. The Monetary Policy Committee had already raised interest rates from just 0.1 percent to 2.25 percent last December, before the “mini” budget and markets expected it to rise to around 4.5 percent by next summer. After the unexpectedly large tax giveaway on September 23, investors concluded that Threadneedle Street would feel the need to tighten even further to offset fiscal bounty. The expected peak in key interest rates rose to over 6 percent. That should now be reversed.

The stylistic changes are much more difficult to quantify than the changes in content. The negative market reaction to the Truss agenda has been caused, at least in part, by talk of scrapping established treasury orthodoxy, by challenges to the Bank of England’s mandate and by the Office for Budget Responsibility’s lack of forecasting and cost calculations. Jeremy Hunt, Britain’s new Chancellor, is a much more established figure and his appointment is no doubt intended to signal that this government is taking fiscal conservatism more seriously.

But as the saying goes: You can’t put the toothpaste back in the tube. Even if the entire “mini” budget had been lifted, the gilt market would likely not return to its September 22nd level. British policy credibility has been seriously undermined at a difficult time for global markets. The chancellor’s sacking may have provided Liz Truss with a political scapegoat, but the agenda and approach are inseparable from her. As long as she is in office, international investors will impose a new risk premium on British assets.

Counterintuitive as it may sound, tighter-than-expected fiscal policy in this case could actually support growth over a one- to two-year horizon. While businesses would no doubt have preferred a lower corporate tax rate, given the bleak outlook for the UK economy, this is unlikely to stimulate much new investment in the short term. In contrast, the sudden rise in interest rates over the past three weeks has been a clear and present threat to growth.

In the medium term, however, it is difficult to view the events of the past month as positive for the UK economy. With no direct mandate from a general election and only having secured the support of a third of her own MPs in this summer’s leadership elections, the prime minister’s reserves of political capital never looked particularly well-stocked. You are now empty. The chance for meaningful but politically contentious supply-side reforms in areas such as planning, housing and infrastructure is negligible. The default policy will now be drift and the path of least resistance.

Even before this self-inflicted catastrophe, Britain was headed for recession. Inflation was uncomfortably high, real household disposable income fell by the biggest drop in decades, and interest rates rose. The odds that Truss’ fiscal gamble would pay off always looked pretty good. It failed miserably, leaving the economy worse off than it was a month ago.