Can Kwasi Kwarteng Claw Back Credibility?: Raphael and Hanson

When Liz Truss stated that she was prepared to be unpopular, she surely didn’t have market mayhem in mind. The combination of a falling pound and rising bond yields led some analysts to liken Britain to an emerging market (or submerging one, as Larry Summers put it to Bloomberg TV). One week after the somber, choreographed dignity of Queen Elizabeth’s state funeral, Britain is back to what lately has seemed a more familiar state of lurching from crisis to crisis.

On Monday, Chancellor Kwasi Kwarteng tried some damage control, promising to unveil a plan to tackle debt and reveal a more complete list of reforms over the next two months. He also promised an independent analysis from the Office for Budget Responsibility on Nov. 23. Meanwhile, the Bank of England ruled out an emergency meeting but pledged effectively to do whatever it takes to control inflation. And yet neither statement of “don’t worry, we got this” seems to have reassured for markets. Bloomberg Economics’ Dan Hanson explains just why the government has dug itself such a deep credibility hole.

Therese Raphael: Defenders of the Truss-Kwarteng fiscal bombshell — a tiny minority, it must be said — initially called the market reaction “hysterical, almost deranged.” The UK still has the lowest debt to GDP in the G7, and its fiscal policy is broadly in line with other advanced countries, they noted. Indeed, the punishment doesn’t seem to quite match the sin here. Is there a case that things could go better than most of these initial reactions suggest?

Dan Hanson: I must admit I was surprised at the reaction. The vast majority of the announcements were trailed beforehand — the only real surprise was the decision to scrap the 45% rate of income tax. Through that lens, I think the reaction was overdone.

I think part of why the market reaction has been so negative is the assertion that this will be a game changer for the economy when most of the tax cuts simply take rates back to the levels that prevailed in 2019. It was likely the lack of emphasis on fiscal sustainability and laser focus on tax cuts that spooked the market.

Even so, it’s hard to see this ending well. The deterioration in market sentiment towards the UK has been extreme, and the BOE will need to respond. That means any near-term growth boost — the thing this government has banked on — could quickly be quashed.

TR: Has the pound’s decline changed your assumptions about UK growth and inflation? And where do you see the peak for official interest rates?

DH: The fall in sterling using Bloomberg’s Pound Index is about 4% since Friday (as of Monday evening). Our in-house model of the UK economy (SHOK<GO> if you have a Bloomberg terminal) suggests that could add 0.4 percentage point to inflation next year. The growth impact is more ambiguous. A weaker pound will boost net trade but it will slow the decline in inflation next year, prompting a response from the BOE.

That means the growth impact, by which I mean the negative impact, will be material. We see the BOE raising rates to 4.25% in the first quarter of next year, including a jumbo 100 basis-point hike in November.

TR: Some have likened this to hitting the breaks and the gas at the same time. We now have a loose fiscal policy amidst tightening monetary policy. But Truss/Kwarteng (and the economists whose views have underpinned this new policy) have argued this is a feature, not a bug. They see fiscal stimulus as necessary, along with regulatory changes, to liberate the supply side of the economy, while an independent central bank will use rates to keep a lid on inflation and bring a return to a more normal yield curve. Do you find that compelling?

DH: Getting interest rates up from the rock-bottom rates we had become accustomed to was something that needed to happen. Loosening fiscal policy to deal with the energy crisis is also reasonable. It’s also true that taxation and spending should be used alongside supply-side reform to try and boost the economy’s productive capacity.

So far, so good. But where I struggle is the argument that a big round of unfunded tax cuts is the right way of achieving that goal. They will stoke demand, lift inflation and force the Bank of England to lift rates further to offset that.

TR: There’s also the small matter of a yawning current account deficit (the UK’s trade balance and net income from foreign investment and transfers), now at a huge 8.3%, which you mentioned in our last exchange, echoing former BOE Governor Mark Carney’s quip that Brexit would leave Britain reliant on the “ kindness of strangers.” Does Britain now begin to look like a bargain for investors or does this become even more problematic?

DH: The combination of a falling pound and rising interest rates should make the UK look more attractive so it can finance its massive external deficit. It also slows import growth and bolsters exports, narrowing the gap over time. The UK’s current account deficit has historically been very sticky, suggesting it is insensitive to changes in the exchange rate.

Up to now that hasn’t been a huge worry to investors, partly because of the credibility the UK’s institutions and partly because the economy’s external net asset position (the net international investment position) improves when sterling falls. But the experience over recent days shows just how fragile the UK’s position is and how quickly that hard won credibility can be lost.

TR: I have to wonder what the cut really achieves. Especially when you consider that the top income tax rate of 37% in the US kicks in at around $539,900 (£504,681.65) of income while the 40% rate in the UK kicks in at just over around £37,700 ($39,475.30). For all the outcry, these cuts don’t really make Britain a low-tax haven. Will they make much of a difference in people’s spending or investment habits? I also wonder whether the increase in mortgage rates will offset any gain in household finances from the tax cut?

DH: Cutting taxes for the rich is probably the least effective way of stimulating demand in the economy. In the jargon used by economists, the wealthy have a very low marginal propensity to consume extra income. Or, put another way, most of the tax cut will be saved rather than spent.

If the moves in risk-free interest rates that we have seen in response to the mini-budget stick, many households will find they are worse off as their mortgages roll over and the bill skyrockets. The shift towards fixed rate mortgages in the UK means some of the pain will take time to feed through; around 20% of mortgages are on a variable rate. But when it does finally bite, homeowners, particularly those with elevated debt-to-income ratios, will see their mortgage bill skyrocket.

TR: I find it hard to see how the UK can have a meaningful supply-side revolution with a completely taxpayer-funded universal health-care system whose needs are growing all the time as the population ages and as health care becomes more complex and expensive. In fact, we’re seeing the NHS failing a number of key targets — not to mention social care, which remains fragmented and underfunded. Can Trussonomics succeed if the NHS is failing?

DH: Your question goes to the heart of the challenge facing Liz Truss’s agenda. If you want to cut taxes and show you are still serious about fiscal discipline, you need to cut expenditure, too. But spending ballooned during the Covid crisis and is likely to find a new, higher steady state.

If tax cuts need to be accompanied by spending reductions, it’s very hard to argue that you are focusing solely on growth because you’re taking with one hand and giving with another.

TR: There’s also a growing debate over the politically explosive subject of immigration. Would a more liberal immigration strategy help the government meet its growth target?

DH: It’s quite a move from a pro-Brexit government. The workforce is likely to grow more quickly with a looser immigration regime and that will bridge some of the gap between the economy’s current trend rate of growth and where Kwarteng would like growth to be. Still, it’s no silver bullet — it could perhaps add 0.2 percentage point to annual growth, which still leaves around a percentage point to make up.

TR: Labour leader Keir Starmer has made clear he’d reverse the cut to the top rate of tax and impose bigger windfall taxes on energy companies. I wonder, of course, whether the markets would be calmer about a Labour government, but also how businesses can make long-term investment decisions with such changing policy weather?

DH: Markets are calm when there is a credible plan. If Labour came in and demonstrated it had one, there is no reason to think there would be a negative reaction like the one we have seen in recent days. The broader point you mention — about longer-term investment decisions — is an important one. At the very least, I think the main parties of the day should agree on a long-term investment plan for the country, which both parties commit to no matter who is in power.

More From Bloomberg Opinion:

Truss’s Economic Plan Isn’t the Disaster Everyone Says It Is: Tyler Cowen
Get Ready for the Great British Fire Sale: Chris Hughes
Trussonomics May Be a Gift for Labour: Martin Ivens

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To contact the authors of this story:
Therese Raphael at traphael4@bloomberg.net

Dan Hanson at dhanson41@bloomberg.net

To contact the editor responsible for this story:
Joi Preciphs at jpreciphs1@bloomberg.net

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