Trussonomics abandoned as Britain re-adopts financial orthodoxy

Jeremy Hunt went into Parliament on Monday to bury Trussonomics, not to praise it.

In a knife worthy of Shakespeare Julius CaesarThe Chancellor defeated the right-wing ‘mini’ budget used by Liz Truss to propose £45bn in unfunded tax cuts.

Hunt reversed most of the Prime Minister’s tax cuts intended to boost Britain’s economic growth. He also announced plans for tax increases and public spending cuts in his financial report due Oct. 31, as he tried to reassure financial markets that the government was serious about balancing the books and cutting debt.

Hunt cut Truss’ plan to cap the annual energy bills of all UK households to an average of £2,500 for two years, saying it would end after just six months. And he unveiled a new Economic Advisory Council packed with people steeped in Treasury Department orthodoxy.

A recently deceased senior Treasury Department official said, “Liz Truss took on a battle with economic orthodoxy and orthodoxy won.”

A waterfall chart showing how a sizeable hole remains in the UK public finances

Treasury Department insiders privately agreed that Trussonomics had been abandoned as Hunt attempted to stem the market turmoil that followed the mini-budget unveiled by then-Chancellor Kwasi Kwarteng on September 23.

The acute situation was underscored when the Bank of England launched a government bond purchase program on September 28 to protect parts of the fixed income industry at risk of bankruptcy after gilt yields rose sharply.

Hunt hopes to minimize the damage, limit the depth of the coming recession and bring the UK government’s borrowing costs back to where they were before Kwarteng’s tax return.

There was not a single moment when Treasury officials managed to convince the Truss government that they were steering the UK economy towards the rocks.

Officials had noted with concern rising global interest rates in response to rising inflation over the summer following the Covid-19 pandemic and Russia’s invasion of Ukraine.

In addition, investors have placed a damaging premium on the UK government’s borrowing costs as a result of perceptions of fiscal recklessness under Truss. This premium has been dubbed the “idiot premium” in the markets.

Together, these global and national issues meant that by the time Truss became Prime Minister on September 6, the £30billion room for potential tax cuts or spending increases that existed at the time of the March budget, against UK tax rules, had turned into a void hole in public finances.

But instead of tightening the government’s belt, Truss and Kwarteng added an additional £45 billion in loans for their tax cuts.

The Institute for Fiscal Studies think-tank last week estimated the budget gap at £60 billion, but as markets churned and government borrowing costs rose, it rose to nearly £70 billion.

Line chart of the cumulative increase in 30-year government bond yields since 1 September 2022 (basis points), showing that UK government borrowing costs remain at elevated levels

Treasury officials produce daily estimates of likely forecasts for Britain’s economic growth and public finances, which come from the Office for Budget Responsibility based on the latest prices in the markets – and the figures looked increasingly grim as the ‘idiot premium’ rose. The UK Financial Services Authority will publish its new forecasts on October 31st.

The actions Hunt is taking are aimed at tightening fiscal policy after Truss’ inflationary mini-budget. It should allow the Bank of England to back out of extreme rate hikes and also lower the cost of government borrowing, so fewer tax hikes and spending cuts are needed to balance government books.

With a budget hole of £70bn, Hunt filled £32bn of that by reversing Truss’ tax cuts, but that still left a deficit of around £38bn and so he stressed orthodoxy and more measures to come.

Every 1 percentage point fall in government borrowing costs, both short- and long-term, reduces the cost of servicing debt by £15bn to £20bn a year.

And while the total interest bill for the debt in the medium term from a forecast of about 50 billion government.

By Monday afternoon, Hunt’s steps appeared to be working. Markets were expecting the BoE interest rate to come in at 5.1 percent in August 2023, up from 5.6 percent last week, down 0.5 percentage point. Similar falls in long-dated gilt yields suggested that around £10bn of the fiscal gap could be filled by lower borrowing costs.

That left about £28bn, partly from spending cuts. These are likely to be spread across day-to-day spending on public services, investments, and social benefits for non-retirees. There’s little evidence of how much Hunt plans to raise through tax hikes.

Meanwhile, Hunt introduced an advisory board composed of economists with close ties or former ties to the Treasury Department: Rupert Harrison, who served as an advisor to former Chancellor George Osborne; Karen Ward, who worked for ex-Chancellor Philip Hammond; and two former members of the BoE’s Monetary Policy Committee, Sushil Wadhwani and Gertjan Vlieghe.

Paul Dales of consultancy Capital Economics said Trussonomics was “smashed” even more thoroughly than expected with Hunt’s decision to review the scope of Truss’ energy price guarantee for households, adding that the policy change by lowering government bond yields did so doing would help fill the tax hole.

But he said even without the UK’s self-inflicted financial drama, the global context and tight UK labor market would still have pushed gilt yields higher and put pressure on interest rates.

However, David Page, an economist at Axa Investment Managers, said the fact that yields remained relatively high “reflected the erosion of the government’s fiscal credibility – something you lose faster than you gain”.

Kallum Pickering, an economist at Berenberg Bank, said the government may now be forced to “overcompensate for fiscal discipline to bolster its credibility”.

He added that the risk of very large rate hikes has only diminished because the government now has to be very aggressive with fiscal policy – and the outcome for the economy could be the same, a sharp recession because “they have to overdo it”.

Pickering said austerity measures were the result of Britain’s brief experiment with Trussonomics. Trussonomics abandoned as Britain re-adopts financial orthodoxy

Adam Bradshaw

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