Blain’s Morning Porridge, September 26th 2022: The UK’s Monumental Policy Mistake – how bad will it get?
“This is the man who bet it all on Red and it came up Black…”
This morning – What a mess. Kwasi Kwarteng’s Special Fiscal Operation failed to stabilise UK markets and has zero prospect of driving growth. The new government stumbled at the first jump. How bad will it get? What are the implications? Who is next for the Chancellor’s job?
There are policy mistakes, and there are Policy Mistakes, but few compare to the market Judder on Friday morning…. In terms of screaming, all-in POLICY MISTAKES new UK Chancellor Kwasi Kwarteng’s not-a-budget, his “Special Fiscal Operation”, went down about as well as a battalion of Russian chocolate tea-pots on the road to Kyiv. It was moment confidence in the UK’s Virtuous Sovereign Trinity snapped. Sterling Crashed. Gilt yields capped wider.
It ain’t over yet, this morning Sterling traded below 1.03 for the first time ever during an Asian flash crash. I will post regular updates on the comments page and Twitter as this crisis unfolds. The working assumption is even if Gilts and Sterling stabilise – the damage is already done. Expect… volatile politics and markets.
This is going to be a critical week for sterling. There are calls for the Bank of England to jump in with a 100 bp rate hike and currency intervention to stem the crippling currency losses. There are even rumours of yet another internal Tory coup being scoped in Westminster. Ministers trying to talk up export prospects on the back of the currency collapse knew they were defending the indefensible – the UK is a re-exporter and is importing further inflation at speed.
I warned three weeks ago that new UK Premier Liz Truss and Kwarteng had “5 days to Avert a Confidence Crisis in the UK”. She got a time extension because of the Royal Funeral. Turns out I was right to worry about markets. On Friday morning it happened – a 0.7% jump in Gilt Yields and the 3% tumble in Sterling. The response to the not-a-budget confirmed just how badly market confidence in the UK’s political competence, sterling stability and gilt market sustainability has been shaken.
Kwarteng’s response to the mayhem? “I don’t comment on market movements.”
Fair enough. When you know nothing and people suspect you are an idiot it’s best to stay quiet so as not to confirm it.
But is he aware of the consequences of what he’s done? The UK’s reputation for fiscal prudence has been sacrificed on the altar of political expediency. This is going to hurt. The weekend analysis was harshly critical – it was right to be so. Dr Doom, Nouriel Roubini, tweeted “Truss and her cabinet at clueless.” Former US Treasury Secretary Larry Summers said the UK will be remembered for the “worst macro-economic policies of any major country in a long-time..” He called the policies naïve, and the UK was an emerging market turning into a submerging market. I could fill the rest of this morning’s Porridge with similar negative punditry and doomster soundbites from analysts presenting variations on the same thing.
If there is a single positive economic comment written by someone not called Patrick Minford or Gerald Lyons – please post it in the comments section, because I can’t find it.
Of course, there is always a chance events may yet bail Kwarteng out. Dollar strength might suddenly reverse if the Fed joins other banks to scale back the Greenback’s inexorable rise, or maybe things may suddenly change re Ukraine/Russia to reduce energy crisis pressures.. but these are hopes.
Its best to know where the lifeboats are before the iceberg, rather than looking for them while swimming.
Kwarteng’s budget failed on two critical elements. First, it was incredibly tone deaf – and likely to prove an unforgivable electoral mistake by a new chancellor who, by his comment about his new government only being in office 19 days, seems to have forgotten it’s been his party running the nation for the last 12 years. Secondly, the policy choices were largely for show to create a sense of shock and awe. He succeeded in making himself look stupid and inexperienced. Hubris.
Let’s start off by making a number of things clear:
- The new UK government of Liz Truss and Kwasi Kwarteng had to act. There was no alternative but to alleviate the massive consumer and business crisis triggered by inflation and the energy crisis. The market’s sell off on Friday reflects how badly they got the solutions wrong. Mistakes of Friday’s degree are not easily forgiven or quickly forgotten.
- Political instability will likely remain at crisis level in the UK. Already there are rumours of a no-confidence motion. Kwarteng and Truss were not the first choice of the majority of Tory MPs. Tory grandee Kenneth Clark was one among many criticising the budget. When (if) Truss realises the scale of the market debacle its not inconceivable we’ll get yet another New Chancellor.
On the other hand:
- The UK is not going to default.
Although the UK’s credit default swap price has gapped wider in recent weeks, (up 170% last week!) the UK retains control of its financial sovereignty. The vast bulk of the national debt is denominated in Sterling. If the worst happens, we can simply print more money to repay current debt – which will have massive consequences on the currency and interest rates, but confers enormous advantages and likelihood of long-term stability – unlike nations that have borrowed in currencies not of their own control.
- The UK is not a financial basket case.
Despite what analysts were saying about Blighty now being doomed by political incompetence, we are actuall a thriving, inventive, innovative, well-educated and vibrant economy.. Ignore Dr Doom’s weekend prediction of an imminent trip to the IMF – the UK’s sovereign finances aren’t so dire. Yet.
- The UK will muddle through. We always do. This is a political and economic crisis. We can solve the second one after we solve the first. We may have to shoot a Chancellor pour le encourage les autres, but at some point UK Inc stocks and UK Sov Plc debt are going to be massive buys.
However, before we get to that stage, lets reflect on the reality of what really happened last week?
Kwarteng’s plan was to deliver two goals:
- Stability and confidence through cogent and coherent policies.
- Growth to stall a recession through a tax giveaway.
He failed massively on the first, and will fail on the second. He chose to grandstand the policies and spin confabulations about growth prospects. He has utterly lost the trust of the market – impressive after only three weeks in office. More to the point, the Bank of England and the Treasury will struggle to conceal their delight in Kwarteng being brought low after he browbeat BOE Governor Andrew Bailey and sacked the Treasury secretary for not being radical enough. Hubris indeed.
Kwarteng played politics – the Banker Bonus a desperate attempt to gas-light a Brexit dividend, while the abolition of the top tax rate played to Tory faithful (who will benefit most). They were pointless, tone-deaf political signals. He thought he was being clever. What the market saw was the cost to the UK of financing the energy bailouts and stimulating recovery through increased borrowing being used to back pointless tax bribes, an unnecessary increase in the national debt, regressive taxes and no attempt to look at better alternatives. 2/10 on his test paper.
In terms of UK Financial Stability:
Friday increased the potential for the UK to enter a destructive cycle of economic instability. Using the Virtuous Sovereign Trinity analogy: as confidence in the politics weakens, then the currency and bond market will wobble.
Gilt Yields jumped – interest rates rose, even as the currency crashed. As the currency falls, inflation via imported goods rises, causing the Bank of England to further raise interest rates, causing the bond market (Gilts) to sell off. The UK is a re-exporter, meaning a lower currency does nothing to boost exports. At the same time, the cost of debt funding rises, the market worries more, and the currency continues to fall, reflect the market’s distrust of policy and consequences.
The UK is now caught in a negative feedback loop that could spawn a bunch of secondary consequences. Not the least of these is chronic currency instability will cause investors to switch out of sterling – including the folk who got the biggest tax breaks last week. They will be investing their tax windfalls outside the UK. So much for the trickle-down effect. (I wrote about the trickle-down fallacy last week.) Meanwhile, corporates retain their increased profits from lower corporation taxes and decide the prospect for returns in the UK are less than more stable economic zones.
The second aspect is growth:
Truss and Kwarteng have told us this was budget for growth, putting money into the economy to engender a boom. That is not going to happen. Unlike the Barbour Boom of the early 1970s – which was founded on the back of a rising economy, this budget “giveaway” was money thrown into an already tumbling economy. The opportunity to boost growth was many many months ago. In effect Kwarteng threw good money after bad.
The average UK household has an pre-tax income £36,000 will see a £526 reduction in their tax and national insurance. (68% of UK households earn less than the average.) But, their average energy bill has risen from last year’s Energy Price Cap of £1277 to £2500. Inflation has already cut the purchasing power of the average salary by over £1500 in the last 12 months. Their mortgages and credit card debt is already more expensive. In real terms “average” UK households have seen their net post tax spending power of nearly £29,000 reduced down to £26,000 from £28,000 last year – even after their tax bribe from Kwarteng.
That’s a massive real cut to real income – and leaves the bulk of the UK population with significantly less discretionary spending power to instigate the boom Kwarteng has promised. There is no consumer money to fuel a boom. It’s a similar story in UK SMEs.
At the other end of the spectrum, the top 1% of UK households, those with yearly earnings in excess of £160k, will see a £2720 tax cut, which will also be more than swallowed by higher energy costs and inflation. Higher mortgage rates and rising bills, (I not our Virgin Media internet bill has just gone up by 53%!) will hit their discretionary spending.
I was in Wales over the weekend – the BBC Welsh news observed less than 9,000 Welsh Citizens out of a nation of 3.2 million pay the higher 45% tax rate. The abolition of the 45% Higher Earners Tax Rate was hailed by Tories as the showstopper, Rabbit out the Hat, icing on the cake of Kwarteng’s tax bonanza. It was a slap in the face with a rancid halibut to most citizens.
What should the Tories have done?
At the end of the day, the tax cuts in Stamp duty, Income Tax, National Insurance and Corporation taxes will cost £45 bln. He will borrow a further £30 bln plus to cover energy bailouts. The costs of funding that debt have doubled in recent months. There are no figures on just how much we expect the energy bailout liability to cost long-term. The tax cuts and bailout will not stop a recession that is already upon the UK – and will be little more than a minor alleviation. While £525 a year will be welcome for the average family it will be swallowed by rising bills. Effectively the tiny sums lower earners will not pay in taxes will make zero difference to their diminishing discretionary spending.
The ending of the Banker bonus restrictions is pointless. Most bankers saw their salaries increased years ago to compensate lower bonuses. The optics of banker bonuses are terrible – no matter how much the City applauds it.
The abolition of the 45% tax rate will make the top 1% of the population smile, and buy a few more bottles of Bolly. The marginal worth to them is meaningless. If they are clever enough to be earning that much, they will be clever enough to be investing outside sterling. Again, the optics are beyond terrible.
In brutal terms the tax cuts to stem a recession that is already here were pointless. Kwarteng would have been better to have never mentioned them – and reduced the amount to be borrowed. Kwarteng was wrong. Rishi was right. The Government would have been better to have refocused tax cuts solely on supporting the lowest earners. A considered statement about raising the tax threshold to start paying taxes, while raising high earner taxes would have had milage in terms of the market, and widespread political acceptance..
Funding the energy bailouts via Gilt funding, rather than a windfall tax was political largesse from Truss and Kwarteng to their supporters and a clumsy attempt to differentiate themselves from Labour and Rishi Sunak. Although a windfall tax on Energy companies would have consequences, the massive increase in funding Truss and Kwarteng have committed themselves to – over £250 bln in the next three years – could have been significantly lower, and would have taken the future tax burden off households.
Kwarteng’s Growth Offensive was a massive fail.
When the new Government came in 3 weeks ago they promised to sort the economy and the NHS. I will write about the NHS later this week. Based on the ABCD Health Plan announced last week – it’s going to be another massive disapointment.
What would sort the UK? A snap election…. Oh dear… Instead, Kwarteng will try to brazen this out… oh dear squared.
Five Things to Read This Morning
Out of time, will be watching this unfold….
Strategist – Shard Capital