AMAC Exclusive – By Daniel Berman
Virtually the entire global media has turned on Britain’s new Prime Minister, Liz Truss, following the announcement of a new “supply-side” economic strategy centered around lower taxes, fewer regulations, and a smaller state, an effort to break with two decades of stagnating growth. Following announcement of the strategy last Friday, the Pound, which had been trading at $1.17 when she took office, fell to $1.08 by the end of the day, and fell as low $1.03 on Tuesday, before recovering slightly.
For the media, this is a just reaction to an “ideological” economic policy, which the Biden Administration is now pressuring Truss to abandon as a threat to the global economy. Biden had already made his views on this matter clear during Truss’ visit to the United States last week. As Truss extolled the virtues of “supply-side” economics, Biden’s account tweeted out a declaration that he “was sick and tired of trickle-down economics. It has never worked.”
So, what precisely is happening to the U.K.? And is it the fault of Elizabeth Truss and her team’s “supply-side” policies? Wider global events? Or a concerted, partisan attack on the U.K. economy attempting to alter the direction of the new government?
The answer to the question of what Truss and her team did to cause the meltdown is, “not much.” On Friday, the Chancellor of the Exchequer, Kwasi Kwartang, announced a package of supply-side measures estimated to cost around £45 billion. The actual cost was likely to be hypothetical in any case. Only two of the measures–a promise to reduce the U.K.’s top income tax rate from 45% to 40%, and a reduction in the “stamp duty,” a sales tax on home sales–would reduce revenue. Every other proposal involved canceling planned tax increases, including scheduled rises in the corporate tax rate, national insurance (the U.K.’s social security), and green energy levies. The fiscal impact was hypothetical.
Some of the proposals might even have increased revenue. Eliminating the stamp duty would have reduced the costs to transfer property. Lifting a cap on bonuses banks could offer to employees would have eliminated a grandstanding measure which in practice had only encouraged elaborate tax evasion schemes, while creating a competitive advantage for banks that wished to base themselves in London rather than the U.S.
In effect, the legislative package was a restrained pivot towards exactly what Kwartang described it as: an effort to break with the economic policies of retrenchment and decline, where public services consumed more money year-after-year to deliver an inferior service, while real incomes and productivity either stagnated or grew at rates below every other G7 country. In fact, for much of the last decade, real wages in the U.K. have fallen when inflation is taken into account.
Therefore, concerns over the level of spending were ideological, and defenders of the Truss’s government are correct to argue that the “mini-budget” could not have caused the run on the Pound on their own, and that claims they did so were irrational. By contrast, the long-term concerns about the structure of the U.K. economy that Kwartang and Truss raised were very real indeed.
Nonetheless, there were important reasons to be concerned about spending. As described in a prior article, the U.K., much like Europe as a whole, faces an unprecedented energy crisis, with prices having been set to rise almost 400% for the average household between 2021 and 2023. The government had little control over the international factors driving prices. Unlike the U.S. Federal Reserve, which has the dollar to fall back on, direct efforts to compensate for rising energy costs by either increasing wages or throwing money at the problem would cancel themselves out if the money printing caused the Pound to fall against the Dollar, in which most international energy contracts are denominated. This made a proposal by the opposition Labour Party to cover energy price increases hazardous. Nonetheless, Truss’s government concluded, likely correctly, that no alternative choice existed. A look at the price trajectory explains why.
If allowing prices to rise without corresponding wage increases, which would be well-above the level of inflation, would trigger mass strikes, then the government would face the prospect of having transportation and services shut down for weeks, only to be forced to concede a bailout at the end of it. Paying the money first and avoiding social unrest seemed the more economically prudent course than paying the money after social unrest had inflicted damage on the economy. Markets agreed, and responded favorably to Truss’s plan, with a centrist think tank projecting that her move to announce a price cap of £2,500 per household would reduce inflation and improve prospects for growth.
The endorsement, was, however, very much a case of the lesser of two evils. No one could estimate where energy prices would go in the future, what the exchange rate would do, or therefore how much the program would cost. And it would cost a lot. Estimates ranged from £80 billion to as high as £200 billion, the equivalent of $1 trillion and $2.4 trillion scaled to the size of the U.S. economy. That was a wide range, and while markets accepted it, it meant the question mark of that scale hung over the future of U.K. government finances, one which was linked, like the price of energy, to the value of the Pound versus the Dollar.
The prospects for the Dollar were ominous long before Truss took office. Contrary to the predictions of imminent collapse promoted by gold bugs, the Dollar has demonstrated enormous strength this year, through a combination of extremely aggressive Federal Reserve action and the leeway provided by substantial domestic energy production in North America, rendering the United States far less exposed to the supply shocks afflicting the rest of the world. This was reflected in a decline in the value of the Pound from $1.36 at the start of the year, to around $1.23 this summer, and then to $1.17 when Truss took office. In other words, two-thirds of the decline were before Truss had done anything.
It is not only the Pound that has suffered. The Euro also fell below parity with the Dollar.
The most recent fall in the Pound is more dramatic than that in the Euro, but not by much. There is, however, something else that occurred at the end of the last week that was unhelpful. The Bank of England, which sets rates for monetary policy, has been remarkably cautious and slow to raise interest rates. It has repeatedly raised them both by less than markets expected, and less the U.S. Federal Reserve did. On Thursday, it made a .5% increase, despite expectations for, and a recent Fed rate hike of, .75%. Worse, the decision was the product of a strange 3-5-1 vote, with three votes being cast for a .75% increase, 5 for a .5%, and 1 for a mere .25%. The split decision not only made clear the lack of consensus, but that there was a faction on the Board of Governors who wanted an even more dovish approach.
Ironically, both Elizabeth Truss and Kwasi Kwartang have been critical of the Bank’s behavior, especially its slowness in raising rates, something which earned them criticism for “undermining the independence of the Bank.” The key point, however, was that when there was substantial uncertainty in public finances due to the impossible-to-calculate cost of the energy relief package, and that was contingent on maintaining the value of the Pound, the Bank indicated it was not concerned with defending the Pound’s value.
In that context, Kwartang’s “mini-budget” of “supply-side” policies “worsened” the U.K.’s fiscal situation by £45 billion or so, but what mattered is that it worsened it from a starting point that was already defined by grave question marks.
To make matters worse, there was the political calculation about what the package implied the government could and could not do. Markets did not know how the government intended to pay for the gargantuan energy relief scheme, but assumed it would involve reductions in public spending elsewhere. Upon the announcement of the supply-side plan, markets and analysts evidently concluded that a government that claimed it could “afford” £45 billion to cut the top tax rates, and was removing caps on bankers’ bonuses, would find it politically impossible to then justify cuts in public services, or reducing the salaries for medical professionals or teachers.
Here is where the truth of the much-mocked claim that “markets were reacting in fear to the prospect of a left-wing Labour government” lies. It was not Labour winning in 2024 they feared. Rather, by deciding to champion “supply-side” policies now which were perceived as helping the rich, even if they did not cost much, and might generate more revenue in the long run, the Truss government was likely giving the opposition a weapon that will make it politically impossible to impose spending cuts at all anywhere else.
Thus, the markets did not fall because the government is potentially spending, in an absolute worst-case estimate, £245 billion rather than £200 billion. Instead, the markets are panicking because they expected £80-100 billion in savings from cuts, but now expect zero.
Arguably, there is a real risk that rather than spending cuts, the very industrial unrest the energy relief program was designed to prevent will now occur in response to any effort to even freeze public spending when the government is “cutting taxes for the rich,” and spending will increase, meaning the entire rationale for spending on the energy cap in macroeconomic terms is now obliterated.
In short, if the program launched by Truss and Kwartang was an error, it was not an error in economic terms, nor did its economic merits provoke the backlash. Rather, it was perhaps a political error, which caused the markets to lose confidence in the government’s ability to follow through on the second part of its economic plan – reining in spending. It was the conclusion that the U.K. government would be unable to cut public spending at all for the foreseeable future that likely caused markets to conclude that any government action which “cost money,” whatever its merits, was bad.
The Bank of England has continued to be unhelpful to Truss. While flirting with the idea of emergency rate hikes enough to cause panic in mortgage markets, the Bank then ruled out any action before their regularly scheduled meeting next month, a pattern that repeated when the Bank intervened to prevent a meltdown in the pension markets on Wednesday, only to undermine any confidence gains by bragging to the press about how close the market came to a “Lehman Brothers” situation.
Ultimately, however, the problems with the U.K.’s economy are political. This is why Elizabeth Truss has likely concluded that Joe Biden is wrong, and his economic “advice” to her would be disastrous. The markets are concerned not by fiscal weakness, but political weakness. They fear not that the government is spending too much, or on the wrong things, but rather it is too weak to pay for any of it through cuts in other areas. Retreating under the pressure of public opinion and a media revolt would make this situation worse. If markets do not believe Truss has the political strength to push through spending cuts in November now, how could they possibly believe she could do so when a week of bad press and polls caused her to abandon her entire agenda to fire a Chancellor who has been a close friend and ally for more than a decade? It would reinforce all the actual causes of the crisis of confidence.
Politically, Truss is committed to seeing her policy through, because in this case the economic is political. And the U.K. is not alone. The greatest long-term crisis facing virtually every Western government is the belief that it is too hard for politicians to make difficult choices, and that as a consequence those choices will never be made. Confirming that confirms the belief that debt will never be repaid, entitlement reform will never happen, and that things will continue until they no longer can be sustained. That is the quiet world Biden seems to want. Truss has bet everything on trying to break this cycle of decline. She may fail. Most clearly expect her to, and it may have been politically mad to try. But her policies are not “insane” – they are necessary.
Daniel Berman is a frequent commentator and lecturer on foreign policy and political affairs, both nationally and internationally. He holds a Ph.D. in International Relations from the London School of Economics. He also writes as Daniel Roman.