By Ambrose Evans-Pritchard
Britain’s permanent cuts in income tax are a fatal step too far. The fiscal message of slashing property tax in these financial circumstances is scarcely better.
This unflagged largesse injects demand into an economy already running at full capacity, constrained by a labour shortage and supply-chain disruptions. It draws forward consumption in a nation living beyond its means, with a chronically low savings rate and a structural current account deficit of 4 per cent of GDP (8.3 per cent this year).
There is an elemental difference between borrowing to spend on infrastructure with a high growth multiplier – or to coax capitalists to invest – and naked borrowing to flatter an unsustainable standard of living.
The valuable theme of supply-side reform in Chancellor Kwasi Kwarteng’s “great growth gamble” has become inaudible in this festival of stimulus. The Chancellor has over-egged the pudding.
He has added elements that were not aired by Prime Minister Liz Truss at the leadership hustings, and that have caught international investors by surprise. Markets were relatively relaxed about the broad plan until the Chancellor dropped his cluster bomb on Friday.
They are not relaxed now.
Derivatives contracts have repriced the futures curve violently, betting on a bank rate of 5.5 per cent by next summer. Yields on five-year gilts rose 50 basis points in a morning.
“A textbook example of how not to design and not to sell a fiscal expansion,” tweeted Olivier Blanchard, former chief economist of the International Monetary Fund.
“We are lucky that the UK is not in the euro. Otherwise, we would be facing another euro crisis.” Touche, mon ami.
The package is regressive in its distributional effects and needlessly provocative at a time of social convulsion. It tests the fragile Union almost to political destruction. It is more ideological than Margaret Thatcher’s opening bid and starkly different in fiscal character. The Lady was a budget hawk.
The gamble is more like early Reaganomics but without the “exorbitant privilege” of the world’s reserve currency and without America’s benchmark creditor status. Note, too, that US public debt was at a century low of 31 per cent of GDP (thanks to the Great Inflation) when Ronald Reagan took power in 1981.
“The new government is bidding farewell to any pretence of fiscal probity. It smacks of populism and a return to the outdated 1980s belief that taxes will pay for themselves by spurring growth,” said Moritz Kramer, former head of sovereign ratings at Standard & Poor’s. A harsh verdict, perhaps, but that is what the rating vigilantes think.
Until now, media noise over gilts and sterling has been parochial knockabout stuff, mostly oblivious to comparable gyrations in other parts of the world – or in some cases mischievously distorted by foes of the Tories, or Brexit, or both.
Yields on German bunds, French debt, or US Treasuries have all surged since early August on inflation fears. Michael Hartnett, of Bank of America, says this year’s global bond crash has been the worst since the Marshall Plan in 1949, and before that since the collapse of Credit-Anstalt in 1931.
The Swedish krona has fallen even further against the dollar since January than sterling. So have 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 gilts strike directed at this country, and at this government. The moves were “disorderly” in the understated argot of central banks. The pound rose at first on the usual Pavlovian reflex: traders assumed that the Bank of England would have to counter with tighter money, pushing up the exchange rate. But then something snapped. Sterling went into freefall as investors choked on the enormity of the fiscal striptease.
This is a rare sort of move in a developed OECD economy with deep markets.
Sterling behaved on Friday like a Latin American currency. If the Prime Minister is not worried, she should be.
Evercore ISI in Washington said the tax cuts fail the standard test of fiscal credibility. The Swiss wealth bank Pictet said the British economy risks falling into a “negative macroeconomic equilibrium” – another of those sotto voce terms that 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 stabilise the pound. That is overblown. A drastic rate rise would make matters worse. It would be self-defeating to engineer a housing crash in an attempt to defend a floating currency.
Such a move would set off a vicious circle. It would be a little like the bank’s desperate and useless measures in the exchange rate crisis of 1992 (to defend a fixed rate, in case we forget). The UK authorities will have to ride out the storm and let the currency take the strain. At the end of the day, the UK has the second lowest debt to GDP ratio in the G7 (IMF data). Its cyclically adjusted fiscal policy over the early 2020s is not that different from the rest of the pack even after this mini-budget. Bargain hunters will at some point come back into gilts and pounds.
Nevertheless, this is an invidious situation for a country that requires 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 us separate matters to avoid confusion. The Chancellor’s original plan – as markets understood it, and as I understood it – was to reverse ill-timed and pro-cyclical tax rises going into a global downturn. The UK was the only G7 country pushing through such early retrenchment following the shock of COVID. The OECD had warned that Rishi Sunak’s austerity policy was “contractionary”.
The market thought the central thrust of Trussonomics was to tackle the supply-side and productivity woes of the British economy. Bond vigilantes were not unduly alarmed by Mr Kwarteng’s plan to reverse the 1.25 per cent rise in national insurance since that move rewards work and production. It alleviates the strain on small business.
They were certainly not worried about the freeze in corporation tax at 19 per cent. The mystery was the Treasury’s earlier plan to lift the rate to 26 per cent on the cusp of recession, saddling the UK with one of the highest rates in the OECD just as the post-Brexit transition economy is trying to attract investment.
Nor were markets dismayed by the energy bailout. Most of Europe is doing the same thing in one way or another because there is no alternative. We are at total economic war with Vladimir Putin’s Russia.
The estimated £60 billion cost for the UK Treasury over the first six months is irrelevant in the larger geopolitical picture. Those talking up the cost to £150 billion a year seem unaware of how fast the global gas market has already adjusted to Putin’s energy blackmail. Average TTF futures contracts for the winter have fallen 40 per cent since late August.
Personally, I would have preferred the German, Austrian, or Polish model of freezing the cost of energy up to a certain level of KWh, while exposing wasteful use to market reality. Nevertheless, the UK’s £2500 cap is sufficiently high to preserve the price signal. The Government is compensating the vulnerable through other means. The Truss scheme has the virtue of “smoothing” the inflation shock.
This one-off subsidy is not what worries markets. Nor was the original Truss package anything like the reckless Barber budget of 1972, unless you mix apples with oranges – and count a cancelled tax rise as a tax cut. Friday changed everything. The Chancellor came close to validating the Barber narrative in just 25 minutes in the Commons.
There is a silver lining of sorts. The stimulus may prove to be a timely buffer if – as I fear – monetary overkill by central banks drives the global economy into a deep recession over the winter. But permanent income tax cuts are not the right tool to fight recessions.
The government must now convince global bondholders and investors that “Britannia Unchained” is more than pious rhetoric. It must show that its plan to shake up the supply side of the economy really can lift the speed limit of GDP enough to outgrow the extra debt.
The Prime Minister and the Chancellor say they are willing to take unpopular decisions. Excellent. My advice is to find some plausible pretext for a tactical retreat on income tax cuts. Bite the bullet early. Move on.
Source: Thanks smh.com