‘Morning after’ reflections on the mini-Budget…

It may well take some time for the dust to settle on Kwasi Kwarteng’s first Budget (yes, ‘Budget’: if it looks like a duck, walks like a duck and quacks like a duck, then it’s fair to call it a duck).

The initial reaction from most economic commentators and in the financial markets has been a loud boo! There are some things I would have done differently. But the overall strategy is sound and sentiment should recover as the economic benefits become clearer.

There are two aspects I particularly liked. One is the emphasis on breaking the ‘doom loop’ of weak economic growth and rising taxes, both with tax cuts and – at least as importantly – structural reforms on the supply-side.

The second is the willingness to take decisions that are unpopular but still right for the economy, such as scrapping the cap on bankers bonuses and abolishing the additional 45% rate of income tax. Policy should not be based on opinion polls or focus groups.

This is not about ‘trickledown economics’. If trickle down means anything it is about giving rich people more money in the hope they will spend it, boosting demand. Instead, Trussonomics is about improving the supply-side performance of the economy.

It is right to worry about the reaction in the markets, but not to panic. Much of the commentary here is increasingly OTT. In my view, the fall in the pound is less of a concern than the rise in gilt yields (the cost of long-term government borrowing).

The slump in sterling is still primarily about dollar strength. The US currency has been strong across the board, reflecting the relatively aggressive Fed tightening (three ¾ point rate hikes in a row), the lower exposure to Europe’s energy crisis, and safe-haven demand.

On a trade-weighted basis against a basket of currencies, the recent fall in the pound is still large (about 5% since the start of August, which might add 0.5% to inflation – if sustained), but this is not disastrous. The UK does not have an exchange rate target and should not intervene.

The rise in gilt yields is more worrying. Unlike a weaker pound, which at least helps exporters, everyone loses from higher long-term interest rates. There is a risk of an alternative ‘doom loop’ of rising interest costs and more borrowing, offsetting the good done on the supply-side.

My advice would have been to delay the announcement of the cuts in income tax (which is what seems to have most spooked the markets) until a full Budget later in the year. These cuts are the right thing to do, but would not come into effect until April anyway.

This would have allowed Kwasi Kwarteng more opportunity to set tax cuts in the context of a full medium-term plan for the public finances, with a full OBR analysis. (The fiscal documents published yesterday do go into more detail, but few read beyond the speech.)

Nonetheless, the surge in gilt yields is not disastrous, either. Like the fall in the pound, it partly reflects a global rise in interest rates. UK 10-year yields have risen nearly 3%-points in the past 12 months, but French yields are also up 2½%, and the US and Germany 2¼%.

To some extent too this reflects a long-overdue adjustment – and probably an overshot. The markets are now speculating the Bank of England may have to raise official rates (still only 2.25%) to as high as 5%. That would be right at the upper end of what might be the ‘new normal’ (4-5%, based on 2% inflation and the new target of 2.5% for real growth).

But I suspect that UK rates will still peak out between 3-4%, partly because higher levels of debt make the economy more sensitive than usual to higher rates. UK bond yields have now also risen to levels that should attract international buyers, especially with an under-valued currency.

In short, talk of ‘market meltdown’ and a ‘sterling crisis’ is still overdone. It may take more time to win over investors and the general public, but the most important thing is to get the economics right. This is a good start, despite the negative headlines.

4 thoughts on “‘Morning after’ reflections on the mini-Budget…

  1. It would be useful for us ordinary folk of you could explain in layman’s terms exactly where the growth comes from. So far I am seeing higher energy bills ( less for me to spend) an impending massive increase in my monthly mortgage costs when we come off our current fixed rate ( massively less money for me to spend) due to a collapse in Sterling much more expensive family holiday to Europe if we can afford to go. Yes we will get a tiny cut in our income tax. So if most ordinary folks are like me and have a massive cut in their spending where does growth come from as presumably we have to spend more to buy stuff so companies produce more etc etc


    1. In layman’s terms, the Growth comes from the increased spending power of older, well-off southerners (specifically, the Tories who voted for Truss).

      The beauty of our measures of ‘economic good’, namely GDP and Growth, is that they are blind to the individual: Growth – even as the result of top-earners earning more and everyone else being worse-off – is still growth.


  2. Julian – what proof do you have that a lower sterling is beneficial for growth in the UK?

    We tend to export price insensitive services which we price in GBP, and we tend to import energy and food, priced in USD.
    Weaker currency does not equal improved terms of trade for the UK – this hypothesis has zero proof since 2008. On the contrary I believe a stronger currency would actually allow us to ‘grow’ more in real terms, as basic resources would consume less of our income.
    The new ‘ultra loose Fiscal policy’ and a better long term energy policy are the urgent problems in the UK today.


  3. In amongst all the hysteria, it is good to read a well-balanced analysis. I disagree that this was a “budget” though. It was a) to provide help with the CofL and energy crisis and b) an early indication of the fiscal path this government intends to take. The fault lies in the fact that KK did not make that clear. A proper budget balances expenditure against proposed govt. savings and potential economic growth. In any event, KK has not had time to formulate a budget yet, so let’s be patient.


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