In the first three weeks of her Prime Ministership, UK Prime Minister Liz Truss has exploded a pair of bombs under UK capital and currency markets. Her first policy was to announce a cap on prices paid by all UK households for energy, to be funded by the issue of £100 billion or so of new government debt. We’ll call this the energy price cap. The next policy was announced by the new finance minister in his so-called ‘mini-budget’. (Calling it a mini-budget, which it wasn’t, dispenses with the need for various forms of consultation in advance.) The mini-budget abolished the UK’s highest rate of income tax, paid by those earning more than £150,000 per year, reducing it from 45% to 40%, and also abolished some planned tax and social security increases, together with a small cut to the basic rate of tax, paid by those on incomes of less than £50,000, from 20% to 19%.
Normally when UK governments announce such tax cuts they tend to be funded, in expectation at least, by cuts in government spending so that the effect on the budget deficit is roughly zero. Not this time. The chancellor promised to explain what spending cuts were going to be made to pay for these tax cuts later (at the end of November). He also announced that in the meantime the government would be issuing a further £46 billion of debt to finance these tax cuts, on top of the £100 billion already pencilled in to pay for the energy price cap.
Somewhat earlier in the year, and somewhat reluctantly I sense, the Bank of England (the UK’s independent central bank) embarked on a path of interest rate rises in order to curb inflation which has been galloping along at over 10%, higher than any other developed country in 2022. As part of the same programme, the Bank had recently announced that it would embark on ‘Quantitative Tightening’ (the opposite of Quantitative Easing) by starting to sell its £758 billion stock of UK government bonds.
To put these numbers in context, the UK’s GDP is roughly £2.2 trillion and its net government debt (i.e. the debt not owed by the UK government to some part of itself, such as the Bank) is about 100% of UK GDP (up from 85% in 2019 and 41.2% before the 2008 financial crisis). Thus the mooted increase in debt from the government’s proposed new issuance represents an increase in the UK’s government debt to GDP ratio to about 107%. In an influential study, Reinhardt and Rogoff (2010) estimated that countries with debt-to-GDP ratios above 90% usually experience serious financial crises sooner or later, and although flaws have been found in their methodology, other researchers have reached similar conclusions, notably Olivier Blanchard.
The reaction from currency and bond markets was swift: Last Monday the pound fell to its lowest level against the dollar ever, and UK bond yields surged, causing vicious systemic problems in esoteric but important pension fund insurance markets. The Bank of England stepped in with an announcement of a bond-buying programme (and abandoning for now its Quantitative Tightening) and things have stabilized somewhat, for now. The government remains adamant that it will not be turned from its path, and various influential commentators, including Larry Summers and the IMF, have condemned the two policies as irresponsible and endangering the stability of the British economy.
Curiously the critics have focussed mostly on the tax-cutting plan and less on the Energy Price Cap. Had the government announced a hypothecated, temporary tax on higher incomes to fund support for poorer households facing large increases in their heating bills, I suspect no one would have minded about the tax cuts, which may well help at the margin with increasing direly needed GDP growth. Instead the government has announced it plans to borrow 6% of GDP to fund half of everyone’s fuel bills this winter. This feels like an expensive giveaway when UK debt is already stretched, and will do little to reduce energy consumption by households (see previous columns).
The sad irony is that if the Tories, in power since 2010, had announced they planned to raise £100 billion to build renewable energy generation capacity in the UK, for example, at any point in the years between 2010 and 2021, it would have been able to issue 100-year bonds at a 2% coupon and the same critics who now condemn it would have applauded. Now that inflation has returned (due to higher gas prices caused by sanctions on Russia, the pandemic and geopolitics), that kind of debt-funded infrastructure investment is no longer easy to achieve. What we really learn from all this, is that the UK government has not been interested in solving long-term problems for a very long time and are only willing to take large-scale actions to solve short-term political problems. While perhaps not surprising, it is sobering. The UK has sunk a long way since the Victorians.
Can the Energy Price Cap achieve any lasting good? It’s hard to see how. Just possibly improved consumer confidence will sustain higher consumer spending which will in turn sustain higher investment than would otherwise have happened. Certainly the UK needs faster economic growth, higher investment, and in particular higher productivity growth than it has seen in the past 15 years. This will not happen if the country experiences a sustained currency crisis or a run on UK government debt (essentially the same things in many ways). So the current policy is a big gamble, and a risky one.
Who knows? Although worried, I won’t write Truss off just yet. Politicians who take risks sometimes win. Reagan’s chief economic advisor Martin Feldstein famously told him that policies were risky because they had only a 50% chance of success, and Reagan would retort that 50% was great odds. Liz Truss may be as great as Reagan, or not, but the UK in 2022 is not America in 1980: The US was much less indebted then than the UK is now, and the dollar is the world’s reserve currency (for now). People who hate America still need dollars. No-one needs pounds except the British. We’ll see, but I wish she’d spend the £100 billion on something more enduring than a warmer winter.