The Tories’ mini-budget has precipitated the worst financial crisis for decades. rs21 member Kate Deer explores the ideology behind ‘Trussonomics’ and assesses whether it can work.
There has been a gradual paradigm shift in economic policy. After more than a decade of ruthless austerity measures, the new government led by Liz Truss has announced widespread tax cuts and spending measures with the promise of tackling the cost-of-living crisis and restore economic growth. Over the next two years, the government plans to issue more than £200bn in additional debt, the highest level of borrowing since the Barber Budget in 1972. This marks an ideological shift from fiscal discipline, focussed on keeping the deficit in check, to fiscal stimulus, based on the idea that money spent by the government is an investment that will pay off and help cover the debt.
From austerity to spending spree
Immediately after taking office, Liz Truss announced a price cap of £2,500 per average household on energy prices. This will be achieved by compensating energy companies for the difference between the higher wholesale prices and the capped price. This measure alone could set the government back by up to £150bn.
And the spending doesn’t stop there. In the mini budget, chancellor Kwasi Kwartweng announced a series of tax cuts including a reduction of the basic rate on income tax, a reduction of stamp duty and an end to the cap on bankers bonusses. All of which amount to an assault on the incomes of most of the UK population, in favour of the very richest.
In other words, Liz Truss starts with a mini bonfire of all those doctrines of fiscal austerity that conservatives across the world have adhered to for the past decades, but she does so as Thatcherism on steroids in favour of the rich, rather than to tackle economic inequality.
Why have some conservatives changed their mind on the deficit? This change has been years in the making and goes far beyond the new prime minister. For one, it has become increasingly obvious that austerity doesn’t work. After decades of cutting back public spending, Britain is facing a toxic combination of record high inequality, low productivity, inflation, a looming energy crisis and recession. Even the Tories advocating fiscal prudence have seen themselves forced to increase government borrowing: under Rishi Sunak, government borrowing reached a peacetime record of 98% of GDP earlier this year.
MMT: Modern Monetary Tories
But the changing stance on debt is also influenced by the government response to the global financial crisis and the Covid pandemic. In both instances, governments across the world borrowed vast sums of money, without any obvious negative consequences. Over the past two years alone, the ratio of government debt to GDP in the UK has risen from 85% to close to 100%. Similarly, in the USA, government debt has risen from 128% to 137% of GDP.
This has been accompanied by quantitative easing, the process of central banks buying up government and corporate debt, supposedly to reduce borrowing costs and encourage investment. In theory, central banks are supposed to be independent and should not be directly funding government spending.
But in the UK, the increase in government borrowing throughout the pandemic has been matched more or less exactly by quantitative easing, as research by the New Economics Foundation shows. For example, in 2020/2021, the UK government issued £320.5bn in debt and the Bank of England just happened to buy £328bn in debt throughout that same period.
Jacob Rees-Mogg, our new business minister and part time hedge fund manager summed up precisely how this shapes the government’s new approach towards debt by reminding the British public that the Bank of England, which now owns the majority of UK government debt, is part of the government.
In an interview with Sky News, he argued:
If you look at the total level of borrowing by the state at the moment, the total borrowing excluding the quantitative easing of £875bn which is owed by the government to the government, if you net that off then we are under 60 of debt to GDP, which is a perfectly sustainable level.
Or, as Iggy Azalea would put it: ‘This money mine, so I’ma spend it.’
The current approach is closely linked to modern monetary theory, (MMT), which has recently gained traction among right- and left-wing politicians alike. MMT argues that the government is monetarily sovereign, in that they designate their own official currency and as such do not need the public’s money. Because a country can issue its own currency, it doesn’t have to default. MMT believes that the only reason why the government should tighten its purse strings (and increase taxes) is if inflation starts to heat up. Trussonomics, from what we have seen so far, seems to be very much shaped by MMT, while ignoring MMT’s position on inflation.
Why Trussonomics won’t work
There is good reason to believe that Trussonomics will be counterproductive for three reasons. The first reason is that Liz Truss is introducing all these reforms in the context of a global trend of declining corporate profitability. While things are looking bad for the global economy, they look particularly bad for Britain.
The second reason is that the economic theory behind Liz Truss new approach, let’s just call it Tory Monetarism, is flawed.
And thirdly, far from breaking with the neoliberal market-led paradigm, the massive borrowing spree that the Tories are embarking on now is a direct continuation of it. But the Tories are lacking the ideological clarity to justify it.
Britain in a world of declining profitability
This may be counterintuitive but over the last two years, global profit figures have surged. Profits grew by 89% on average in 2021 and are still up by 24% this year because companies were able to hike prices while wage growth did not keep up.
But this trend is about to reverse dramatically. Global inflation is on the rise and central banks are responding to it by hiking interest rates, which is making it more expensive for companies to borrow.
Moreover, rising prices also mean that production costs increase, which further eats in to profit growth. This coincides with a dramatic reduction in spending due to the combination of inflation and rising interest rates. In other words, we are at the beginning of an economic recession.
The UK is particularly poorly positioned to deal with this crisis. Compared to other countries, it has become relatively less competitive, inflation has risen much more sharply than in other countries and it is now facing a sharp deterioration in its balance of payments and a falling pound.
Higher government borrowing as such does not directly lead to higher inflation. For example, governments across the world were able to increase their debt levels dramatically over the past ten years and inflation has only recently emerged.
Over the past two years, Britain has built up quite a significant current account deficit by importing more at higher prices and exporting less. The balance of payments is closely linked to a falling pound and rising inflation. Because the value of the pound is falling, it costs us relatively more to import (though in theory exports could become more competitive). Inflation also has a detrimental impact on the pound because it makes it less attractive to foreign investors. And a worsening balance of payments means the pound might have to be devalued to restore the competitiveness of British exports.
Because of this potential vicious cycle, Deutsche Bank warned in a recent note to its clients that Britain is on track to become like an emerging market. It has the highest level of inflation among the G10 nations. And when factoring in weak GDP growth and foreign direct investment, Britain’s narrow balance of payments is worse than that of developed and emerging markets like Hungary or the Czech Republic. That was before the announcement of the mini budget. The value of the pound has since plummeted to a 37-year low and is close to reaching parity with the dollar.
It is important to note that current account deficits, just like any economic indicator, are political. Government bond yields and the value of a nation’s currency are shaped at least as much by investor’s perception of their political status as they are by the macroeconomic data they produce. The main thing that keeps Britain afloat is its perceived status as former imperial superpower. And describing this status at perilous would be an understatement.
The second reason why Trussonomics is likely to fail is her flawed assumption that tax cuts will automatically generate growth. While large sections of the left have been arguing to increase government borrowing in recent years, that was in the context of record low interest rates, when it was cheaper for the government to refinance the debt. For the past two years, Central Bank interest rates were close to 0%, making it more attractive to take out more debt. Now inflation is rising, and the Bank of England is expected to raise interest rates and sell its holdings of government bonds, making it more expensive for the government to repay the debt.
This could be accelerated by the costs of UK government bonds falling which results in higher yields. When the UK government borrows money, it issues gilts. These have a coupon, a fixed interest the government has to pay to investors. They also have a yield, which varies depending on how risky investors think it is to lend money to the UK government.
The cost of servicing debt is also going up because about a quarter of the UK government’s debt is linked to inflation. Linkers, inflation linked gilts have emerged as one of the most popular asset classes for pension funds to invest in. But with inflation rising, the cost of servicing this debt is also increasing. In June 2022 alone, the government spent more than £19bn on servicing debt. While June was an extreme month, the cost of servicing debt has risen by more than 200% over the past year, the Office for National Statistics said.
What both MMT and the Tories’ take on it fail to acknowledge is that the whole idea of a state being the monetary sovereign is a political concept. States which are perceived to be powerful and have supposedly independent central banks, the United States for example, have been able to effectively print endless amounts of money.
It is not a coincidence that the most famous advocates of modern monetary theory are almost all Americans! You’d be hard pressed finding an Argentinian making the same argument. Countries like Argentina have made the very painful experience what it means if the value of your currency plunges and inflation skyrockets. And right now, Britain is looking a lot more like Argentina than the US. It’s ‘Reaganism without the dollar’, as an FT columnist recently argued. The Bank of England was forced to spend £65bn shoring up pension funds, and may well need further action as the turmoil continues.
Plus ça change: More trickledown economics
Liz Truss’ budget has been presented as a historic paradigm shift in economic theory, a move away from unpopular austerity measures towards fiscal stimulus measures. But a closer look under the bonnet reveals that there is no intention at all to tackle economic inequality. Instead, wide sweeping, very expensive tax cuts will benefit those on salaries of more than £150,000 while people on low and middle incomes have little to look forward to. Even the IMF has criticised it for being likely to increase inequality, in an almost unprecedented intervention.
Two thirds of the tax cuts will benefit the richest fifth of the UK population while the poorest half of the population only receive 12% of the benefits, according to the Resolution Foundation. The measures are also set to hit the upper middle class, people earning between £63,000 and £125,000 the hardest, they will pay an additional £1,500 each year in tax, according to the IFS – and that’s before the near-certain rises in mortgage costs which will follow from rising interest rates. This is unlikely to go down well even in the Tory party, which is already divided on Truss’ budget.
Kwasi Kwarteng even had the cheek to declare: ‘For too long in this country, we’ve indulged in a fight over redistribution.’ But the talk of a cost of living crisis isn’t an indulgence, it is the harsh reality for millions of people across the country and can’t just be brushed aside. To justify tax cuts for the rich with the vague promise that their wealth will eventually trickle down won’t cut it with the British public. They know full well that it hasn’t worked for the past decades and it won’t work now.
What is the alternative? Radical redistribution
The illusion that governments can simply create their own value by printing money, is in large part an attempt to dodge the key question of economic redistribution.
Why do we need to keep creating more money, just so that the rich can get richer while the poor keep getting poorer? Wouldn’t it be much easier to work with the money that we have and distribute it more fairly? Cutting corporate profits and nationalising vital public services such as energy and water supply would not only help to tackle inequality, it would also be a lot cheaper than the indiscriminate tax cuts the government is proposing.
Liz Truss said she isn’t afraid to be unpopular and she really did deliver on that. In one single stroke she managed to piss off not just the British public, but also financial markets and even large parts of the Tory party. This means that the odds are stacked in our favour: we have to defeat this budget and fight for a more equal redistribution of wealth. This is a battle that we can’t afford to lose.