UK tax cuts are a reckless gamble

The package is regressive in its distributional effects and unnecessarily provocative at a time of social upheaval. He tests the fragile union almost to the point of political destruction. It is more ideological than Margaret Thatcher’s inaugural offer and fundamentally different in fiscal character. The lady was a budget hawk.

The venture is more akin to early Reaganomics, but without the “exorbitant privilege” of the world’s reserve currency and without America’s benchmark creditor status. Also note that when Ronald Reagan took power in 1981, the US national debt was at an all-time low of 31 percent of GDP (thanks to the Great Inflation).

“The new government says goodbye to any claim to fiscal probity. It smacks of populism and a return to the outmoded belief of the 1980s that taxes pay off by boosting growth,” said Moritz Kramer, former head of sovereign ratings at Standard & Poor’s. A harsh judgment perhaps, but that’s what the protectors think.


Until now, media hype about gilts and sterling has been narrow-minded stuff, mostly unaware of comparable swings in other parts of the world – or in some cases mischievously distorted by enemies of the Tories or Brexit or both.

Yields on German Bunds, French debt securities and US Treasuries have risen sharply since the beginning of August due to fears of inflation. Bank of America’s Michael Hartnett says this year’s global bond market crash was the worst since the Marshall Plan in 1949 and before that, the 1931 Credit Institution collapse.

The Swedish krona has fallen even more against the dollar than sterling since January. So does the Japanese yen and the Korean won. The dollar index (DXY) is close to the extreme levels of the mid-1980s.

But what happened on Friday felt like a guild strike directed against this country and against this government. The moves were “disorderly” in the understated argot of central banks. The pound initially rose on the usual Pavlovian reflex: traders assumed the Bank of England would have to counter with tighter funds, which pushed the exchange rate higher. But then something cracked. Sterling went into freefall as investors choked on the enormity of the fiscal striptease.

This is a rare type of move in a developed OECD economy with deep markets.

The pound sterling behaved like a Latin American currency on Friday. If the Prime Minister isn’t concerned, she should be.

Evercore ISI in Washington said the tax cuts failed the standard test of fiscal credibility. Swiss wealth bank Pictet said the UK economy was at risk of slipping into “negative macroeconomic equilibrium” – another of those sotto voce terms no finance minister ever wants to hear. It warned of a head-on collision between the Government and Threadneedle Street.

Deutsche Bank says the Bank of England may have to call an emergency meeting this week to stabilize the pound. That’s exaggerated. A drastic interest rate hike would make the situation even worse. It would be self-destructive to engineer a housing crash to defend a floating currency.


Such a move would set in motion a vicious circle. It would be a bit like the bank’s desperate and useless actions in the 1992 exchange rate crisis (to defend a firm course in case we forget). UK authorities need to weather the storm and let the currency take the strain. At the end of the day, the UK has the second lowest debt ratio in the G7 (IMF data). Its cyclically-adjusted fiscal policy in the early 2020s isn’t much different from the rest of the pack, even after this mini-budget. Bargain hunters will eventually turn to gilts and pounds again.

Nonetheless, this is an awkward situation for a country that needs constant inflows of foreign capital to fund borrowing and relies on the approval of central bank asset managers and Asian sovereign wealth funds. The UK has a net international investment position of minus £742 billion ($1208 billion).

Let’s separate things to avoid confusion. Chancellor Merkel’s original plan – as the markets understood it, and as I understood it – was to reverse ill-timed and pro-cyclical tax hikes against the backdrop of a global recession. Britain was the only G7 country to push through such an early cut following the COVID shock. The OECD had warned that Rishi Sunak’s austerity policies were “contractual”.

The market felt that Trussonomics’ key thrust was to address the UK economy’s supply and productivity issues. Bond vigilantes were not unduly alarmed by Mr Kwarteng’s plan to reverse the 1.25 percent increase in Social Security because the move rewards labor and production. It relieves small businesses.

The corporate tax freeze at 19 percent certainly didn’t worry them. The mystery was the Treasury’s earlier plan to raise interest rates to 26 per cent on the cusp of recession, which would leave Britain with one of the highest interest rates in the OECD as the post-Brexit transition economy seeks to attract investment.

Markets were not dismayed by the energy bailout either. Most of Europe is doing the same thing in one way or another because there is no alternative. We are in an all-out economic war with Vladimir Putin’s Russia.

The estimated £60bn cost to the UK Treasury in the first six months is irrelevant in the larger geopolitical picture. Those who inflate the cost to £150 billion a year seem unaware of just how quickly the global gas market has already adapted to Putin’s energy blackmail. Average winter TTF futures contracts are down 40 percent since the end of August.

Personally, I would have preferred the German, Austrian or Polish model, freezing energy costs up to a certain KWh level and exposing wasteful consumption to market reality. Still, the UK cap of £2500 is high enough to maintain the price signal. The government compensates the weak in other ways. The truss scheme has the virtue of “smoothing out” the inflation shock.

This one-time subsidy is not what is worrying the markets. The original Truss package also didn’t compare to the ruthless 1972 Barber budget, unless you mix apples and oranges – and count a canceled tax increase as a tax cut. Friday changed everything. The Chancellor almost confirmed the Barber narrative in just 25 minutes in the House of Commons.

There is a kind of silver lining. The stimulus could prove to be a timely buffer if – as I fear – central bank monetary overkill drives the global economy into a deep recession over the winter. But permanent income tax cuts are not the right tool to combat recessions.

The government must now convince global bondholders and investors that “Britannia Unchained” is more than pious rhetoric. It needs to show that its plan to shake up the supply side of the economy can actually raise the GDP speed limit enough to outpace the additional debt.

Prime Minister and Chancellor agree to make unpopular decisions. Excellent. My advice is to find a plausible excuse for a tactical retreat on income tax cuts. Bite the bullet early. Go on. UK tax cuts are a reckless gamble

Brian Lowry

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