Linchpin takes an initial look at Trussonomics and how the Bank of England might finance the Chancellor’s plans. It seems to combine toxic elements of all the financial crises of the last 50 years, but before passing judgement, we remember the 364 economists who condemned Thatcherism in 1981. We might just be as wrong as they were.
Markets are having difficulty digesting the U.K.’s financial change of course under Truss and Kwarteng. At a first glance, it looks like a repeat of the Barber mini-boom of 1972, which ultimately led to the U.K. going to the IMF for support. Another perspective would be Corbyn’s magic money tree, where money is borrowed and doesn’t have to be repaid. In today’s article, I take a more considered look at what it means in reality.
The ostensible purpose of the tax cuts is to promote higher growth. Behind that lies political timing. The next election is not much more than two years away and cutting taxes ahead of an election is straight out of the political playbook 1.01.
Could the economics work?
Let’s focus on the economics. To stimulate growth, Trussonomics needs buyers for British goods or services. The candidates are consumers, foreigners (whether through exports or inward investing) or the government itself, and none are completely ruled out. Consumers are under the cosh from the rise in energy and food prices, but money in their pockets leaves scope for a bounce-back after years of austerity. Immigration (rich and poor) continues, and immigrants tend to have a relatively high propensity to spend. On the other hand, the tax cuts are aimed at high earners, perhaps inevitably given that they pay the lion’s share of tax revenue, and I doubt they are suddenly going to use their tax cuts to splash out on British goods.
Foreigners are probably Kwarteng’s first choice. There is greater recognition of the risks which come with globalisation, as well as significantly higher frictions to trade, and the result may well be a move to ‘on-shoring’ i.e. building supply chains nearer to home. Following the falls in sterling and the Government’s establishment of tax-free zones, I can see how Britain might in theory become an attractive place to invest. However, markets to export to will be needed, most obviously in Europe, and that is not obviously in place. In a much more competitive global environment, the country would need to regain the ability to manufacture which it has lost over the past forty years. And other countries may view the new policy as unfair competition.
The third possibility is the Government. It has worthwhile projects to spend on to generate growth e.g. infrastructure and the NHS. However, they do not deliver a direct financial return, and ultimately have to be paid for by today’s or the next generation’s taxpayers. Even when borrowing was cheap, the Treasury’s arcane financing rules produced an incentive to push the spending onto the private sector. With gilt yields at 4%, I cannot see that behaviour changing.
Markets don’t like it
The City’s reaction is crucial to the Government’s plan. The Bank of England, if it has any spine, should be raising interest rates sharply both as a signal of its commitment to fight inflation and to defend sterling. But I have always questioned the independence of central banks*, and I suspect the Old Lady may not wish to pick an immediate fight with the new government. Higher interest rates would be negative for the property market, which in turn might well be a political own goal for Truss and Kwarteng. However, acting at the Government’s behest would be another blow to investors’ confidence in the U.K.
This leads on to sterling. If hedge funds get a whiff that the Bank of England cannot raise interest rates for political reasons, they will sell sterling short as George Soros famously did in 1992, leading up to Black Wednesday, almost exactly 30 years ago. The Government (before the days of central bank ‘independence) raised rates from 10% to 12% and then announced a further rise to 15% in a single day. Markets called their bluff, and John Major had no choice but to back down.
Financing and refinancing – between a rock and a hard place
If currency is the Government’s Scylla, refinancing and financing are its Charybdis. The mean maturity of gilts issued by the Government is fifteen years. However, the median maturity - i.e. the tenor at which 50% has been repaid - is eleven years, and if all Government financing is included, it collapses to less than one year. This is because over the last 15 years the Government has relied heavily on the Asset Purchase Facility, which now accounts for a third of total debt**. The implication is that the Government is effectively financed through short-term borrowing, which makes it vulnerable to interest rate volatility. In this context, I would remark that the true cost of money is set by markets, and not by the Bank of England, and I shall watch closely for divergence between the overnight SONIA and the Bank of England’s discount rate. The Bank can always finance the Government’s debt by issuing more paper and debt, but at what price?
In 1992 long-term gilt yields did not react to the currency crisis, because the mean maturity was far longer, investors believed the U.K. was solvent, and the Government reversed course quickly. Even so, Black Wednesday damaged the Conservative party’s reputation for economic confidence to the extent that in 1997 Labour’s Brown was seen as more competent. 2022 appears much less benign.
Perhaps commentators are missing something
In summary, the challenges to the new direction are substantial. It has elements of almost all the major financial crises of the last fifty years combined. However, before completely writing Trussonomics off, I remind readers that in 1981 364 economists wrote to the Times to denounce the Thatcher/Howe policy of deflating demand to control inflation. They wanted to go back to the failed policies of price control, but in hindsight their views were largely wrong. Today inflation is again the problem, and the Government’s solution is the diametric opposite to 1981’s. I do not doubt that a similar number of commentators, maybe more, can be found today to condemn Truss and Kwarteng, but before passing judgement remember it is still just possible that we could all be wrong.
*See my 2021 article in Room 151’s quarterly here
**The Office of Budgetary Responsibility has a good explanation of how the Bank of England has financed the country’s debt here.