For those who think globalization is dead, they should consider the crisis of confidence confronting UK Prime Minister Liz Truss. At a time when the U.S. and European Union have made fighting inflation their top policy priority, Truss is taking a very different posture by trying to encourage economic growth.
Soon after Truss assumed office last month, Chancellor Kwasi Kwarteng announced a “mini budget” that called for 45 billion pounds of tax cuts. The measures included abolishing the highest marginal tax rate of 45 percent, dropping payroll taxes, freezing taxes on corporations and temporarily subsidizing energy consumption. Collectively, they represent the biggest British tax cuts in decades, and the budgetary gap will be financed via increased borrowing.
The financial markets’ response to the news was overwhelmingly negative: The British pound plummeted to a record low of $1.04, 10- year gilt yields soared above 5 percent and 50-year maturities lost a third of their value in four days. The tumult raised concerns that it could spawn financial instability, which rippled through global markets.
The Bank of England (BOE) subsequently took emergency action to stabilize markets, announcing it would buy long-dated gilts “on whatever scale is necessary” to restore order. This action has helped calm markets for the time being, with the British pound rebounding to $1.13 and 10-year gilt yields easing to 4.2 percent.
What is highly unusual is the criticism it has drawn from policymakers outside the UK. The International Monetary Fund warned that the British government should reconsider its proposed tax cuts. Former U.S. Treasury Secretary Larry Summers called the tax cuts “utterly irresponsible” and claimed they could lead to contagion globally.
Amid this, the Wall Street Journal editorial board has come to the government’s defense, claiming that the economy’s malaise is “the culmination of 12 years of big-government conservatism from successive Tory Prime Ministers.”
However, the Journal’s senior market columnist, James Mackintosh, offers a different perspective. He views the UK as the “canary in the coal mine” that shows the pain other countries could face in an era of high inflation and rising interest rates if their policies are extreme.
There are two fundamental problems with the government’s policies.
First, the emphasis on economic growth is inappropriate given domestic and international economic conditions. Inflation in the UK currently is running at a rate of 10 percent and is likely to rise further as Russia’s squeeze on energy supplies continues into winter. Meanwhile, unemployment is unusually low at 3.6 percent, and the government’s budget deficit stands at nearly 7 percent of GDP. If the mini-budget were enacted, the deficit would increase further and place added upward pressure on gilt yields.
This situation would pose a problem for the Bank of England. It has been raising interest rates gradually to counter inflation by draining liquidity from the financial system via sales of government bonds. If it were to change course and purchase government debt to limit the rise in bond yields, this action would increase the money supply and add to inflationary pressures.
Second, the government’s action is out of step with the posture of the Federal Reserve and the European Central Bank, which have made fighting inflation their top priority. Until recently, the weakness of the pound was benign as it did not adversely affect British stocks and bonds. But if investors were to lose confidence in UK policies, a full-blown crisis of confidence could ensue in which weakness in sterling would force the Bank of England to tighten policy more aggressively.
The UK government’s priority, therefore, should be to curb inflation and to steady the British pound.
This not only makes economic sense, it may also be a way for the Conservative Party to align itself with the electorate. According to a poll taken by The Economist before the mini-budget, only 49 percent of voters agreed with the notion that growth does more good than harm. Also, by a margin of 53 percent to 16 percent, those surveyed agreed that “the government should spend more on health care and pensions, even if that means spending less on infrastructure and science.”
The big unknown is whether Truss’s growth agenda may already be “damaged beyond repair” as The Economist contends. The British government has been accused of fiscal recklessness, because its plan was not reviewed by the Office of Budget Responsibility, an independent watchdog.
One concession the government has made is to rescind the tax cut for the wealthiest. But this will barely make a dent in the looming budget deficit. The government, therefore, will have one more chance to influence investors when the chancellor unveils new rules for fiscal responsibility in late November.
Faced with this prospect, Prime Minister Truss would do well to follow the lead of Margaret Thatcher, whom she admires.
When Thatcher assumed office in 1979, her over-arching goal was to end two decades of UK economic malaise in which sterling was perennially weak because of high inflation. Thatcher was prepared to allow interest rates to rise sufficiently to break the inflation psychology even though Britain experienced a painful recession in the early 1980s. This strategy ultimately succeeded in setting the stage for more sustainable growth. It should be the government’s objective now rather than to make a quick dash for growth.
Nicholas Sargen, Ph.D., is an economic consultant for Fort Washington Economic Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books, including “Global Shocks: An Investment Guide for Turbulent Markets.”