John Rapley is a political economist at the University of Cambridge and a senior fellow of the Johannesburg Institute for Advanced Study.
Less than two weeks after her government plunged the markets into crisis with a disastrous budget, Prime Minister Liz Truss used her closing speech at the Conservative Party conference to blame the meltdown on a nebulous anti-growth coalition. Channelling her icon, Margaret Thatcher, she said she was not one for turning, and that she would stand by her economic program.
Pressed a week later in Parliament, she insisted that not only would she keep her beleaguered Chancellor of the Exchequer, Kwasi Kwarteng, but she wouldn’t balance the books by cutting spending. But then on Friday, a mere two days later, the inevitable happened. Standing before a podium for an eight-minute news conference, she sacked her chancellor, started rowing back the tax cuts, and acknowledged that her government would have to cut spending.
It’ll probably go down as the day that Brexit met its Waterloo. Once Britain voted to leave Europe six years ago, it set itself on a collision course with markets. Cut off from its largest market, its export-dependent economy suffered badly. With the tax base consequently narrowed, the country needed to find new sources of revenue. At the same time, the need to create new bureaucracies, from border guards to trade negotiators, drove up spending. All told, Britain had to rely on the kindness of strangers to bankroll its adventurism – namely, foreign buyers of U.K. gilts.
How a tax cut for the wealthy almost tanked the UK economy
Ms. Truss had ignored that reality and scoffed at the establishment orthodoxy that did recognize it. While she might now be trying to put out the fire, she has lost all credibility with the markets and the strangers her country so depends upon. The burning will continue.
The previous government of Boris Johnson had a powerful chancellor, Rishi Sunak, who wholeheartedly embodied the orthodoxy of the all-powerful Treasury. Recognizing that Britain could not stay on this path, he raised taxes to support the many spending promises that Mr. Johnson had made when running for office.
But this high-tax, big-state Britain enraged the right wing of the Conservative Party, which had strong allies in the right-wing press. When Mr. Johnson was forced out, they spied their opportunity to install a leader more to their liking.
Ms. Truss had campaigned for the Conservative leadership with a promise to finally deliver the promise of Brexit by slashing taxes, cutting regulation and rolling back the state, implementing the “Singapore-on-Thames” vision beloved of the libertarian think tanks that advised her.
Mr. Sunak warned that such an approach would tank the pound and panic markets and, in any event, would never get past the Treasury nor the independent Office of Budget Responsibility, whose task it was to do the sums.
Anticipating this, Ms. Truss and her chancellor said they’d take on the “establishment orthodoxy” holding Britain back. They sacked the top bureaucrat in the Treasury and shut the OBR out in the cold, saying they would do their own sums. Their goal was apparently to engineer a revolution in expectations and persuade everyone that tax cuts would drive up the growth rate and thus pay for themselves.
Their faith was premised on an economic theory called the Laffer Curve. The problem is, while it’s well-understood that there are thresholds beyond which tax hikes reduce revenues, nobody has ever established a clear correlation between tax cuts and growth, let alone the point at which they might start to work. The Truss-Kwarteng strategy seemed to be that with enough time, if they could just get enough people to share their belief, optimism would return to the economy.
But in their “just-trust-us” boosterism, they neglected those strangers on whose kindness they’d come to rely. Bond investors took one look at the budget and said ‘no.’ Preferring the establishment orthodoxy, they snapped shut their chequebooks. So sharp was the resulting sell-off that mortgage rates surged almost overnight, heralding a collapse in the property market that would kill off any added growth that could possibly result.
The International Monetary Fund then joined other forecasters in knocking down the economy’s expected growth rate. Worse happened when, within days, a liquidity crisis erupted in the pension industry. Given the exposure of foreign investors to British pensions, the risk of a global Lehman Brothers moment suddenly seemed real.
Britain thus found itself not just frozen out of the bond market but isolated among its friends, who worried that the government’s recklessness might damage the fragile global recovery. Mr. Kwarteng cut a lonely figure at the Washington meetings he was attending. Back home in London, Ms. Truss was working frantically to rescue her premiership. After news broke that Mr. Kwarteng had left his meetings early on the last flight out of Washington, gilts rallied sharply. Markets around the developed world joined in.
But no sooner did Ms. Truss announce what amounted to only a partial climbdown, that the rallies reversed. Gilts finished the day back under pressure, dragging other markets down with them. The bond vigilantes still wanted their pound of flesh. They aren’t likely to stop now until Britain puts a “grown-up” back in power and the establishment is fully restored.
And Brexit Britain has just found out what it’s really like to go it alone in the world.