The UK government has spooked the markets in a big way. Can he recover?

When Liz Truss said she was ready to be unpopular, she surely didn’t have market chaos in mind. The combination of a falling pound and rising bond yields has led some analysts to compare Britain to an emerging (or submerged, as Larry Summers told Bloomberg TV) market. A week after the somber and choreographed dignity of Queen Elizabeth’s state funeral, Britain is back to what lately seemed a more familiar state of tipping from crisis to crisis.

On Monday, Chancellor Kwasi Kwarteng tried to contain the damage, promising to unveil a plan to tackle the debt and reveal a fuller 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 has ruled out an emergency meeting but pledged to do whatever it takes to control inflation. And yet, none of the “don’t worry, we get it” statements seem to have reassured the markets. Dan Hanson of Bloomberg Economics explains why the government has dug itself such a credibility hole.

Thérèse Raphaël: Advocates of the Truss-Kwarteng tax bomb – a tiny minority, it must be said – first described the market reaction as “hysterical, almost deranged”. The UK still has the lowest debt-to-GDP ratio in the G7, and its fiscal policy is broadly in line with that of other advanced countries, they noted. Indeed, the punishment doesn’t quite seem to match the sin here. Is there a case where things could be better than most of these initial reactions suggest?

Dan Hanson: I have to admit I was surprised at the reaction. The vast majority of announcements were dragged out ahead of time – the only real surprise was the decision to scrap the 45% income tax rate. Through that lens, I think the reaction was overblown.

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

Even so, it’s hard to see that it ends well. The deterioration in market sentiment towards the UK has been extreme and the BOE will have to react. This means that any short-term growth stimulus – the thing this government has been betting on – could quickly be undone.

TR: Has the fall in the pound changed your assumptions about UK growth and inflation? And where do you see the peak in official interest rates?

This means that the impact on growth, by which I mean the negative impact, will be significant. We see the BOE raising rates to 4.25% in the first quarter of next year, including a huge 100 basis point hike in November.

TR: Some have compared it to hitting the breaks and the gas at the same time. We now have loose fiscal policy in a tighter monetary policy environment. But Truss/Kwarteng (and the economists whose opinions underpinned this new policy) argued that it was a feature, not a bug. They see fiscal stimulus needed, along with regulatory changes, to free up supply from the economy, while an independent central bank will use rates to contain inflation and bring back a more normal yield curve. . Do you find that compelling?

DH: Driving interest rates up from the lows we had grown accustomed to was something that had to happen. It is also reasonable to ease fiscal policy to deal with the energy crisis. It is also true that taxation and spending should be used alongside supply-side reform to try to stimulate the productive capacity of the economy.

So far, so good. But where I struggle is the argument that a big round of unfunded tax cuts is the right way to achieve this goal. They will fuel demand, increase inflation and force the Bank of England to raise rates further to compensate for this.

TR: There is also the small problem of a gaping current account deficit (the UK trade balance and net income from foreign investment and transfers), now at a whopping 8.3%, which you mentioned in our last exchange, echoing the quip of former BOE Governor Mark Carney. that Brexit would leave Britain dependent on the “kindness of strangers”. Is Britain now starting to look like a boon to investors or is it becoming even more problematic?

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

This hasn’t worried investors much so far, partly because of the credibility of UK institutions and partly because the economy’s net external position (the net international investment position) improves when the pound is falling. But the experience of recent days shows 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 considering that the top tax rate of 37% in the US comes in at around $539,900 (£504,681.65) of income, while the 40% rate in the UK hits a just over £37,700 ($39,475.30). Despite all the outcry, these cuts don’t really make Britain a tax haven. Will they make a big difference in people’s spending or investing habits? I also wonder if the increase in mortgage rates will offset any gain in household finances from the tax cut?

DH: Reducing taxes on the rich is probably the least effective way to stimulate demand in the economy. In the jargon used by economists, the rich have a very low marginal propensity to consume additional income. Or, in other words, most of the tax cut will be saved rather than spent.

If the movements in risk-free interest rates that we have seen in response to the mini-budget continue, many households will be worse off as their mortgages are rolled over and the bill soars. The switch to fixed rate mortgages in the UK means that some of the pain will take time to subside; approximately 20% of mortgages are at variable rates. But when it finally bites, homeowners, especially those with high debt-to-income ratios, will see their mortgage bills skyrocket.

TR: I find it hard to see how the UK can have a meaningful supply-side revolution with a universal healthcare system entirely funded by taxpayers whose needs keep growing as the population ages and health care becomes more complex and expensive. . In fact, we see the NHS failing at a number of key goals – not to mention social care, which remains fragmented and underfunded. Can Trussonomics succeed if the NHS fails?

DH: Your question goes to the heart of the challenge facing Liz Truss’ program. If you want to cut taxes and show you’re still serious about fiscal discipline, you also need to cut spending. But spending has exploded during the Covid crisis and should find a new higher state of equilibrium.

If tax cuts are to be accompanied by spending cuts, it’s very hard to argue that you’re only focused on growth because you’re taking with one hand and giving with the other.

TR: There is also a growing debate on the politically explosive topic of immigration. Would a more liberal immigration strategy help the government achieve its growth objective?

DH: It’s quite a movement on the part of a pro-Brexit government. The labor force is likely to grow faster with a more flexible immigration regime, which will close some of the gap between the economy’s current trend growth rate and where Kwarteng would like the either growth. Still, it’s not a silver bullet – it could possibly add 0.2 percentage points to annual growth, which still leaves about a percentage point to catch up.

TR: Labor leader Keir Starmer has made it clear that he will reverse the top tax rate cut and impose higher windfall taxes on energy companies. I wonder, of course, if the markets would be calmer with a Labor government, but also how can companies make long-term investment decisions with such a changing political climate?

DH: Markets are calm when there is a credible plan. If Labor came along and demonstrated they had one, there’s no reason to think there would be a backlash like the one we’ve seen in recent days. The broader point you mention – about longer-term investment decisions – is important. At the very least, I think the major parties of the day should agree on a long-term investment plan for the country, to which both parties commit, regardless of who is in power.

More from Bloomberg Opinion:

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Therese Raphael is a columnist for Bloomberg Opinion covering health care and British politics. Previously, she was the editorial page editor of The Wall Street Journal Europe.

Dan Hanson covers the UK for Bloomberg Economics in London. Previously, he spent seven years at HM Treasury working on a variety of UK macroeconomic issues.

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