Loss of Truss

by
Robert Waldmann
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I really have to write about macroeconomics given the drama across the Channel in the UK. The story so far is that New Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng have managed to spook money managers by threatening to cut their taxes

. Kwarteng proposed a mini budget cutting the top marginal tax rate (etc). The Pound depreciated not quite reaching parity with the dollar (fell bellow 104 cents though) and the 10 year Gilt (UK treasury) rate briefly shot up over 5% (on Wednesday).

This is a fairly dramatic effect of a tax cut which will cost his majesty’s Treasury about 45 billion pounds next year. Compared to GDP that is about like $ 400 billion in the USA. No doubt a large sum, but dwarfed by US stimulus bills which did not spook markets.

I should have some professional expertise on this topic, but I feel as ignorant as usual. Oddly I think one thing I can bring is some experience with living in Europe (in the Union Brexited by the UK).

I think a key aspect of the mini-budget is that it is very radically heterodox and involves breaking norms which are have been stronger than mere norms. Except during the height of the Covid epidemic, there has been an obsession with budget deficits which are condemned as not only a mistake but also a sin. In the UK this was, in particular, an obsession of earlier Chancellor Osborne. Importantly, Kwarteng dodged the OBR

“Unusually, the Office for Budget Responsibility, the government’s fiscal watchdog, was not asked to provide forecasts for how the package would affect government borrowing and economic growth in coming years. Kwarteng has requested that the OBR sets out a full forecast alongside the medium-term fiscal plan, on 23 November.” This is fairly shocking.

Another reason the mini budget alarmed people whom it directly benefited is that a stimulus bill makes no sense now. The UK economy is overheated with 8.6% consumer price inflation over the past 12 months. Truss and Kwarteng also promised to shield consumers from the Putin energy price shock. This is a (vague?) liability which is not sterling denominated.

The mini budget demonstrates Laffer level ideological commitment, which is alarming. Now Truss talked about tax cuts during the leadership contest. It should not have been a surprise that she meant it. I think it is clear that Truss and Kwarteng aimed to shock and awe and convince people that there had been a change of policy regime. The tax cuts remind me of Reagan but definitely not any Tory — I think ever (certainly not Thatcher).

So my story is all psychological/sociological. I haven’t mentioned intertemporal budget constraints, effects on aggregate demand, the Phillips curve or any of that. In this I am not at all original. The dramatically huge effect of a very large policy shift suggests this kind of story.

I think bond traders are alarmed that they have no idea what Truss and Kwarteng might have been thinking. I guess that they assumed that everyone knew that supply side Laffer curve stories were BS used to support upper class war, and only now realize that Truss and Kwarteng actually believe what they have always said.

But I should talk as economists normally do (after talking as all economists currently have been doing).