Liz Truss's economic-or is it political?- gamble that looks like a boomerang
English original of article published in Italian in today's La Stampa
Two European countries have now chosen right-wing, avowedly radical female leaders, but so far only one of them has caused a financial shock, and it isn’t Giorgia Meloni. Liz Truss became Britain’s new prime minister only three weeks ago, and much of that time was taken up by the Queen’s state funeral. Nonetheless, in the short period available to her, Prime Minister Truss has driven the pound sterling to record lows and may be on course to trigger a downgrading of the UK by credit-rating agencies.
The specific action that has caused this was a very sudden, but dramatic, budget which was announced by her new Chancellor of the Exchequer, Kwasi Kwarteng, last Friday. Both he and his boss have declared themselves believers in a small state and low taxes, calling on the hallowed memory of Margaret Thatcher.
So they decided to implement this vision in a huge hurry, just days after announcing Europe’s most generous package of energy subsidies for households and business, and ignored the inconvenient fact that Maggie Thatcher hated debt, public borrowing and inflation more than anything else.
It was the hurry that most seems to have shocked and alarmed financial markets. The British economy is not yet in a recession, but is experiencing price inflation that is at the high end of the European range. The promise to cap energy prices by paying generous subsidies, if necessary for as long as two years, seemed to have dealt with the worst pressure on the cost of living and on business, albeit at the risk of higher public borrowing.
Yet it wasn’t enough for Ms Truss and Mr Kwarteng. So, with no time for preparation, with no accompanying plan announced for managing the public finances, and with the independent forecasting agency, the Office for Budget Responsibility, forbidden to produce new economic predictions, they announced the biggest round of tax cuts seen since 1971.
The declared aim of this huge fiscal stimulus is to raise the UK’s economic growth, both in the short term so as to avoid a recession, and in the long-term by boosting business investment and productivity. Those seem like noble aims, but they clearly are not believed in by financial markets, which promptly drove the value of the pound down to record lows against the US dollar, leaving it also down by about 7% against the currencies of its main trading partners since the beginning of August.
It is hard to avoid the conclusion that the real aim of this hurried, radical, tax-cutting budget was for Ms Truss to stamp her authority on her own Conservative Party. Her victory in the vote among party members was not as decisive as she would have hoped, and she had fewer votes among MPs than her opponent did. Unlike Ms Meloni, her political position looks weak, and she is probably looking anxiously ahead at a potential general election in 2023 or early 2024.
In that light, the attempt to stimulate economic growth in the short term and to please voters by cutting their taxes might make sense. The first problem, however, is that the tax cuts have only really pleased rich people and businesses, for they benefited far more from this budget than did poor or middle-class people. The second problem could be worse: like a boomerang, this budget could swing round and hit Ms Truss and the British economy, quite hard.
On their own, tax cuts and extra public borrowing could indeed support faster economic growth in the short term, keeping unemployment close to its current very low levels. However, by focusing the tax cuts on the rich the budget risks this benefit being quite limited, as those on high incomes may well put their extra money into savings rather than spending it, and businesses may not invest much more in these uncertain times just because the tax on their profits has been reduced.
The fall in the value of the pound, meanwhile, will add to price inflation by raising the cost of imported goods, and is likely to force the Bank of England to raise official interest rates quite sharply. The combined effect of that inflation, higher borrowing and nervous investors could bring on exactly the recession that Ms Truss has pledged to avoid.
Britain’s new prime minister has certainly defined her political and policy identity very quickly and decisively. This may guarantee her a successful appearance at the Conservatives’ annual party conference, which opens next weekend. But if such a radical move boomerangs, her reputation and party support will disappear quite quickly.
The United Kingdom has the good fortune to borrow mainly in its own currency, so it is not vulnerable to the sort of acute financial crisis that comes when foreign lenders lose confidence and start to bet against a nation’s debt. But it can suffer a slow but tight squeeze, as lenders, whether British or foreign, demand higher interest rates on all their loans to both the government and UK businesses.
As the UK already has the largest balance of payments deficit in Europe after Greece, and the highest budget deficit in all of Europe, it is a country that needs to keep its lenders happy if, to borrow a popular and very British wartime slogan, it too is to “keep calm and carry on”. Ms Truss’s gamble, with tax, borrowing, debt and inflation, is anything but calm.