Liz Truss came to power promising to reboot the UK’s growth prospects. To this end, she made clear that she was willing to challenge the existing policy orthodoxy. While her radical fiscal policy agenda helped her win the Tory leadership race, her “mini-budget” – and its focus on unfunded tax cuts to spur growth – imploded spectacularly, as the markets took fright and laid bare the inherent flaws in some of her proposals. The resulting chaos drained her political authority and ultimately precipitated her rapid downfall.
There are a number of lessons that stand out from her short-lived tenure:
1. “Policy adventurism” can erode market and policy credibility
Credibility is paramount in the eyes of the market. Liz Truss and her chancellor, Kwasi Kwarteng, lost it at a stroke with their Sept. 23 mini-budget. It included tax cuts for top earners, a removal of the cap on bankers’ bonuses, and the cancellation of a planned corporate-tax hike. Taken together, these measures amounted to GBP 45 billion. The fiscal easing was much larger still if viewed in conjunction with Truss’s energy bailout package (GBP 150 billion).
It wasn’t just the size of this package that troubled the market. It was also the lack of information about how such tax pledges would be funded.
Additionally, for an economy that has only recently recouped its pre-Covid level of output, the focus on current expenditure (e.g. tax cuts), as opposed to investment in infrastructure and the like – which could potentially generate long-term efficiency gains – also played its part in the market reaction.
It’s not surprising, then, that the markets delivered a vote of non-confidence. As the next chart shows, bond yields spiked past 4%. The pound also took a battering – approaching parity with the dollar at one point – leading to unflattering parallels with emerging-market currencies such as the beleaguered Turkish lira. (Truss's tenure is marked by the dotted lines on this chart.)
Long-term investors also started to express concerns about the policy trajectory – and by implication the viability of investing in the UK.
This shouldn’t be downplayed, given that the UK has long-prided itself on business-friendly policies and its track record as a leading destination for global foreign direct investment. As the next chart shows, an index of policy uncertainty soared during Truss’s government, more than closing the gap with its worldwide equivalent.
2. Institutional independence matters
Aside from the scale of the Truss government’s spending pledges – the largest since the Barber budget in the early 1970s – her disregard for the UK’s institutional framework played a key role in the loss of market confidence. In particular, she did not solicit an independent forecast from the Office for Budget Responsibility prior to the mini-budget.
This, coupled with her history of ambivalent statements on the Bank of England’s mandate and independence, helped spook the markets. The second-order effects of the market turmoil spread to the mortgage market, with lending rates spiking sharply upwards and some lenders opting to withdraw certain products from the market.
Against this backdrop, the UK drew an unlikely rebuke from the IMF about its fiscal trajectory. The rating agencies also joined the fray and marked down the outlook for UK debt.
3. Fiscal and monetary policies need to work in tandem
At a time when the UK economy faces runaway inflation, the Truss government’s attempt to turn on the fiscal taps was profoundly misguided and ran counter to the Bank of England’s efforts to tame the problem of rising prices through interest rate hikes. Indeed, not only did the mini-budget increase policy uncertainty, but it also reinforced the impression that fiscal and monetary policy were running at cross purposes to each other.
Fiscal and monetary policy must be coordinated for another reason. Government debt issuance is set to spike in the UK and other developed markets over the next couple of years. In the absence of such coordination, there's a risk that markets may struggle to absorb the increased amount of debt.
Key takeaways and the lessons learnt
In an environment where the global economy is challenged and central banks have stepped back from providing unlimited liquidity and policy support, markets have become much more discerning in how they view the prospects of different countries. Given this, the “policy adventurism” of the sort the Truss government exhibited was firmly punished.
While it’s encouraging to see a pivot back to orthodoxy under the new Conservative leader and prime minister, Rishi Sunak, this is not to say that the UK is in the clear.
Rather, the shift towards austerity that the Sunak government introduced, with a view to winning over the markets, may have pushed the policy pendulum too far in the other direction. In particular, his fiscal plans threaten to extinguish growth for a prolonged period. That could undermine public finances through lower tax receipts, and act as an impediment to private consumption – the mainstay of the economy.