Liz Truss became prime minister promising to shake things up and she has certainly done that. In less than a month, the new government has sent interest rates soaring, crashed the pound, torpedoed the property market, made recession inevitable and left her party on course for a defeat of epic proportions at the next election. Not bad for starters. The encore will have to be good to match the debut performance.
As the economist Mohamed El-Erian has noted, the mayhem since Kwasi Kwarteng’s mini-budget was more typical of the stuff that happens in developing countries than in rich, developed nations.
A full-blown emerging market-style crisis still looks a long way off because, unlike a troubled emerging market, the UK has its own currency and can in the last resort print pounds to cover its borrowing.
But the UK is running both a whopping trade deficit and a big (and growing) budget deficit, and relies on investors to finance them. Truss can dismiss criticism of her plans all she likes, but the fact remains that last week’s events have made the UK appear a much riskier place for those investors, who are now demanding higher interest rates to take a punt on the UK.
So, while some stability had returned to currency markets by the end of last week, with the pound back to around the levels it had been before Kwarteng announced his tax changes, this has come at a cost. Bond yields – effectively the interest rate the government pays on its new borrowing – have risen sharply. “In effect the UK now has to offer much higher returns to global investors to sustain the same currency value that prevailed, with much lower rates, before the announcement,” says Krishna Guha, of the investment banking advisory firm Evercore.
The government has tried to argue that the UK is not alone in facing higher interest rates or currency weakness. This is true, but does not explain why the pound briefly reached a record low against the US dollar last week. Nor does it pass muster as a reason why the Bank of England was forced into an emergency programme of bond buying to prevent a run on UK pension funds. These were the results of blunders by Truss and Kwarteng.
To be sure, global interest rates have been rising all year, but this should have made the prime minister and chancellor more cautious about announcing a package of unfunded and unaudited tax cuts without squaring off the markets first. It was not as if Truss and Kwarteng were not warned; they were, but chose to ignore the advice they were given both by officials and by outside experts. The decision to go ahead without any form of scrutiny from the Office for Budget Responsibility was especially reckless.
The upshot is that the mini-budget will have precisely the opposite results of those intended. Truss hit out at Treasury orthodoxy and abacus economics, but now both are back with a vengeance. Whitehall departments have been told to make efficiency savings, and the Treasury has made clear it has no intention of reopening last year’s spending round, even though the settlements agreed now buy less owing to higher than expected inflation. It looks highly likely that state benefits will not be raised in line with inflation.
And if Truss had any thoughts of exerting more control over the Bank of England following its failure to prevent inflation reaching a 40-year high, those plans have been abandoned after last week’s Threadneedle Street pension fund rescue. “The government has managed to make the Bank of England look good, which is some achievement,” one leading economist says.
The squeeze on public spending is one reason why Truss can kiss goodbye to hopes that her mix of tax cuts and supply-side reforms will boost growth in the months ahead. A more important factor will be higher interest rates.
The day before Kwarteng’s mini-budget, the Bank raised interest rates by half a percentage point to 2.25% – deciding against a bigger increase because it thought the UK was in recession. As it happens, an upward revision to growth in the second quarter means the economy is not actually in recession, but the respite is certain to be brief.
Huw Pill, the Bank’s chief economist, has warned that “significant” increases in interest rates can be expected at the next meeting of the monetary policy committee at its next meeting, and the financial markets currently expect official borrowing costs to keep on rising to 6%.
Make no mistake, if the Bank does push rates anywhere close to 6%, it had better be prepared for a colossal recession. Already last week there were signs of trouble ahead from the mortgage market, where more than a thousand home loan products were pulled by lenders watching what was happening to bond yields and the expected path of official Bank of England rates.
Many home buyers have taken out mortgages at high multiples of their incomes in the belief that permanently low interest rates will make them affordable. That assumption now lies in tatters, and floating rate mortgage holders and those whose fixed-rate terms are coming to an end face huge increases in their monthly payments. The supply of new buyers will quickly dry up. House prices will fall.
The irony is that the first budget of a supposedly pro-growth government has made recession more, not less, likely. The government can introduce supply-side reforms in the months ahead, but if interest rates stay high to placate jittery investors, the trend growth rate will be lower, not higher. Britain’s economic history is scattered with budgets that have quickly unravelled: Kwarteng’s is in a class of its own.