Inside Story

The Truss effect

The British PM and her allies have launched an enormous and potentially disastrous experiment

Michael Jacobs London 8 October 2022 2823 words

Ten years in the making: British prime minister Liz Truss outside 10 Downing Street. John Sibley/Reuters

Few prime ministers — of any country, surely — have made such an impact so quickly. The figures tell their own story. Within a fortnight of Liz Truss’s entering 10 Downing Street, the pound had fallen to its lowest ever value against the US dollar, the cost of government borrowing had risen by more than a fifth, and one polling company had Labour’s lead over the Conservatives up from 8 per cent to 33 per cent.

We must assume Truss didn’t intend these outcomes. But she can hardly have been surprised by them. They were the direct and immediate result of her first major policy initiative, a “mini-budget” announced on 23 September by her new chancellor of the exchequer, Kwasi Kwarteng. Describing it as the government’s “Growth Plan,” Truss and Kwarteng declared that it would set the country on a new course for economic growth.

The centrepiece of the statement was a huge package of financial support to cushion households and businesses from the steep rise in energy prices following the Russian invasion of Ukraine. From around £1300 in 2021, the average household energy bill in Britain had already risen to almost £2000, and, had nothing been done, was projected to hit around £6000 next year. So the government announced that it would be capping domestic bills at an average of £2500 for the next two years. At the same time it would subsidise energy use by businesses for at least six months.

The cost of these measures will depend on how far wholesale gas prices rise over this period. But Treasury’s estimate for the first six months was an eye-watering £60 billion. To put this in context: the cost of the government’s furlough scheme to keep people in work for eighteen months during Covid was £70 billion.

The general verdict on these measures, nevertheless, was favourable. Costly, yes, but necessary — with the added bonus, as Kwarteng noted, that they reduced the headline rate of inflation, since the government’s subsidy is defined as cutting the price of energy, rather than adding to households’ incomes.

But it was not this part of the budget that caused such a reaction. It was the rest of it. Alongside the energy measures Kwarteng announced a £45 billion package of tax cuts, the largest made in a single fiscal statement since 1972. They included the repeal of an increase in National Insurance contributions introduced by Boris Johnson’s government just a few months before; the abandonment of another Johnson commitment, an increase in corporation tax; a cut in the stamp duty on house purchases; a cut in the main rate of income tax from 20 per cent to 19 per cent; and — in a move that took everyone by surprise — the abolition of the 45 per cent top rate of income tax, levied on people earning over £150,000 a year.

How was this largesse to be paid for? The government had nothing to say on that topic at all. Not only did the budget contain not a single revenue-raising measure; Kwarteng had explicitly prevented the independent Office for Budget Responsibility from publishing its usual analysis and forecasts. This was indeed why he was at pains to call it a “mini-budget”: had it been a proper budget, the OBR would have been required by law to publish an analysis of its impacts.

The UK’s think tanks, of course, were quick to fill the gap. They calculated that the government’s plans would require over £400 billion of extra public borrowing over the next five years — with no end in sight beyond that. That would represent a 50 per cent increase on last year’s level of borrowing every year — taking annual borrowing to five times its pre-pandemic level.

The response of the financial markets was immediate. The interest rate (or yield) on government bonds shot up, and the pound plummeted. If the government was going to borrow so much more, lenders were inevitably going to charge them more to do so. Indefinite higher borrowing suggested a government with no plan.

In reality, part of the pound’s weakness reflected the strength of the US dollar; but since the pound fell against other currencies too, there was no doubt it was also a verdict on the British government and the country’s future economic prospects.

The shockwaves were rapid. Banks started withdrawing mortgage products, as it became clear that interest rates were about to rise even further and their mortgage offers would soon be unprofitable. Pension funds revealed they could rapidly become insolvent; they were having to sell government bonds to cover heightened risk, but the value of these had plummeted. In response, the Bank of England announced overnight an emergency program under which it would buy up to £65 billion of bonds to shore up their value and prevent financial contagion.

By now — just days after Kwarteng’s fiscal statement — the financial markets were in turmoil. The Bank of England was not meant to be buying bonds — it was in the middle of a “quantitative tightening” program that involved selling bonds to push interest rates up.

A vicious spiral was now in prospect: the combination of tax cuts, monetary loosening and a falling pound would push inflation up, forcing the bank to raise interest rates further and more quickly. As interest rates rose the cost of government borrowing would increase, requiring even more borrowing to cover it. Rising mortgage rates would hit household spending and could lead to a housing market crash, both of which would exacerbate the recession into which Britain was now predicted to fall.

And just to add insult to injury, the IMF at this point decided to flout its usual rule of not commenting on individual fiscal statements in developed countries. The budget, it declared, would have serious negative consequences — not just in Britain but more widely across a still-fragile global economy. It urged the government to reconsider. Former US treasury secretary Larry Summers was just one of several financial commentators who likened Britain to an emerging economy, its currency under speculative attack and being told off by the IMF.

Extraordinarily, Truss and Kwarteng went missing for almost a week while this happened, refusing to calm the markets or reassure voters. When the prime minister did emerge, it was to do a series of local radio interviews, no doubt expecting them to be easier than national TV. Confronted by presenters keen to make their names, her performance was squirmingly bad (and of course, immediately broadcast on national TV).

Truss refused to apologise, frequently seemed stumped by the questions and repeated the same talking points with wooden monotony. Resorting to the classic politician’s defence that the policies were fine, it was all a problem of poor communication, her only concession was that she could have “prepared the ground” better. But that was hardly true — all the budget measures apart from the top rate tax cut had been leaked or announced in advance.

The reaction of the financial markets was only half the problem. The distributional impact of the government’s tax cuts was extraordinarily regressive. Income tax cuts always benefit the rich more than the poor, since the rich pay more in tax; and those below the tax threshold don’t benefit at all. But the abolition of the 45 per cent rate meant the beneficiaries of the budget package were concentrated among the very rich.

Analysis quickly demonstrated that almost half the gains of the overall tax package would go to the richest 5 per cent of households. A person earning a million pounds a year would find themselves £55,000 better off, while someone on £20,000 would gain just £157. Coupled with a separate decision to abolish the cap on bankers’ bonuses imposed by the European Union after the 2008 financial crash, the budget demonstrated a remarkable desire to give money to those who already have it.

In the context of a severe cost of living crisis, with inflation now running at 10 per cent and families on the lowest incomes facing choices about whether to “heat or eat” this winter — the use of charitable food banks has rocketed over the last year — it was a politically tin-eared approach. Radio phone-in programs fairly crackled with public anger.

Tory MPs, in turn, reacted with dismay. Unfortunately timed for the prime minister, this week’s annual Conservative Party conference gave them plenty of opportunity to express their views on TV and radio. Former cabinet members indicated publicly that they would vote in parliament against the abolition of the 45 per cent tax rate. As the revolt spread, it became clear that Truss would not be able to get it through the House of Commons. Nine days after announcing it, the government declared that the cut was to be abandoned. It was never a major part of the package, Kwarteng said, and had become “a distraction.”

But Truss’s travails were still not at an end. Abandoning the top rate cut would save only £2 billion; attention now turned to how the government would pay for the rest. Would it have to inaugurate a new period of austerity, with swingeing public spending cuts to bring borrowing back under control?

The prospect caused further alarm to Tory MPs. The National Health Service faces another post-Covid winter crisis, with long waiting lists and deepening staff shortages, and most other public services have been pared to the bone by a decade of austerity. So the only obvious target for cutting was the welfare budget.

When Liz Truss duly refused to say that welfare benefits would be raised this year by the rate of inflation — a commitment given by Boris Johnson’s government — uproar ensued. Few Tory MPs were prepared to support this; several openly declared that it would be immoral and wrong (not to mention “electoral suicide,” as one put it) to pay for tax cuts for the rich by cutting the incomes of the very poorest. They would vote against this too. Truss loyalists in turn accused the rebels of organising a “coup” against their leader.

As the Conservative Party conference descended into open blue-on-blue warfare, the prime minister made a defiant speech. Truss dismissed her troubles as the inevitable “disruption” caused by a radical program and declared herself determined to take on the “anti-growth coalition” that was now ranged against her.

How did it get to this? To understand that, we need to go back to 2012, two years after both Liz Truss and Kwasi Kwarteng entered parliament. The Conservative leader David Cameron had become prime minister at the head of a coalition with the Liberal Democrats. His pitch to the electorate was that the Tories had changed: no longer the Thatcherite “nasty party” of the rich and selfish, they were now “compassionate Conservatives” in favour of a caring society and protecting the environment.

Truss and Kwarteng demurred. Together with other new Tory MPs they set up a new Free Enterprise Group in the Commons and wrote a pamphlet entitled Britannia Unchained, a strident manifesto of free market economics and libertarian politics. Their solutions to Britain’s economic and social problems were simple: lower taxes, lower public spending, a less interventionist state, more deregulation, fewer workers’ rights, freer enterprise. Two decades after Thatcher left office — and just three years after financial deregulation had almost crashed the global economy — it was Thatcherism on speed.

Truss became a minister in Cameron’s government in 2012, Kwarteng in Theresa May’s in 2018. Now close friends and neighbours as well as colleagues, by 2019 they sat in Boris Johnson’s cabinet together. When Johnson fell earlier this year, Truss seized her chance. Her campaign for the Conservative Party leadership, strongly backed by Kwarteng, proudly boasted of her Thatcherite philosophy. And now she had a receptive audience.

Convulsed by the arguments over Brexit, which has seen almost all senior pro-European MPs kicked out of the parliamentary party — and others on the left and centre abandoning it — the Tories have become much more ideologically narrow. Despite winning the support of fewer than a third of Tory MPs, in the final ballot of party members Truss won convincingly against the “sound money” fiscal conservative Rishi Sunak, architect of the tax rises they so despised.

Truss and Kwarteng see themselves as revolutionaries. The chancellor’s first act in his new job was to sack the chief civil servant at the Treasury, an experienced and respected figure but someone the new Tories demonised as a representative of the old regime. Truss installed as her chief economic adviser the leader of the Taxpayers’ Alliance, a campaign for low taxes and deregulation. Other advisors were brought in from neoliberal think tanks such as the Institute of Economic Affairs.

Announcing his mini-budget in the Commons, the chancellor declared that “we are at the beginning of new era.” For he and Truss the last decade of Conservative rule has not been radical enough. “Treasury orthodoxy” had placed far too much emphasis on balancing the public accounts and reducing public debt. After the huge expenditures to support the economy through the pandemic, taxes had risen to a seventy-year high, which could only stifle enterprise and hold back growth. The state had grown too large.

In her Tory conference speech Truss declared her three economic priorities to be “growth, growth and growth.” In recent years, she declared, there had been far too much emphasis on redistribution and not enough on growing the economy. (As various commentators pointed out, this was a somewhat odd claim, given that the Conservatives had presided over stagnating wages and a huge increase in wealth inequality). And the way to get growth was to cut taxes, and to reform the economy’s supply side.

The government’s supply side reforms have not yet been spelled out in detail. But the Growth Plan indicated the general direction. “Investment zones” will be established across the country, where businesses will have lower taxes and fewer regulatory requirements. The planning system will be reformed to speed up infrastructure construction and housebuilding. The financial sector will be deregulated to make it more globally competitive. Childcare regulations limiting the number of children per worker, and environmental regulations affecting farmers, will be relaxed.

Such policies may or may not work to stimulate economic growth. The economic evidence on investment zones is weak, with most similar schemes simply poaching investment from other areas. Planning reform has been notoriously difficult, with Conservative MPs among the most vociferous opponents of new housing developments and infrastructure (such as windfarms) in their own constituencies. Financial deregulation did not go well last time round.

But the problem for the government is that, even if they are successful, none of these reforms will generate growth in the next couple of years. And while in theory tax cuts might provide a short-term boost, this will almost certainly be overwhelmed by the recessionary forces the government’s fiscal package has unleashed.

On the morning of the budget the interest rate on a typical two-year mortgage was well under 5 per cent. Now it is over 6 per cent. Hundreds of thousands of people whose fixed term deals are ending soon have been on rates between 2 and 3 per cent. So they will see their mortgage payments rise by hundreds of pounds per month, vastly outweighing the tax cut they will receive. Their disposable income will be lower next year, not higher. Many will not be able to pay at all.

Politically, this is disastrous for the Conservatives. Britain’s ten million mortgage holders, and the many young people who want to buy a first home, are among their core constituencies.

Across all polling companies, Labour’s lead has more than doubled to 23 per cent. In a general election, that would translate into a comfortable Labour majority. Keir Starmer, Labour’s leader, is now seventeen points ahead of Truss as “best prime minister,” and Labour leads on every significant policy issue. Truss’s approval rating has dropped to minus 37 per cent, a fall of 28 per cent in a week.

The next general election is still two years away. But it is now almost impossible to find a political commentator who believes Liz Truss can recover from these figures after such a disastrous first month in office. Many are predicting an electoral rout worse than 1997, when Tony Blair won a landslide victory to end eighteen years of Conservative rule.

The mood among Tory MPs has become correspondingly grim. Many are now privately telling journalists that Truss will have to be got rid of. No one thinks it would look good for the Conservatives to impose a fifth prime minister on the country in six years. But the economic turmoil she has precipitated, and the polling deficit the party now faces, make anything better than this. If she doesn’t reverse course, warn some, she could be gone by Christmas.

One veteran Tory, a minister in John Major’s government in the 1990s, put it even more starkly. Without a fundamental change of direction, he said, Liz Truss would be “quite probably the last-ever Tory prime minister.” •