Opinion Liz Truss’s attempt at market correction

Last week, after much speculation, UK Prime Minister Liz Truss fired her Chancellor of Exchequer, Kwasi Kwarteng, while reversing in part the set of policies that had caused mayhem across British and global financial markets. Kwarteng’s mini budget, which promised a “new approach for a new era, focused on growth”, had opted for a two-pronged approach based on large tax cuts and high government spending. Investors, however, were worried about the fiscal implications of these announcements. While Kwarteng vociferously defended the proposals, it left many unconvinced about the prospects of the British economy. Ultimately, the markets forced the prime minister’s hand.

Kwarteng’s proposals were ostensibly designed to revive the British economy. The measures announced included the decision to cut taxes including the top rate of income tax, reducing duties on home purchases, and abandoning the hike in corporate taxes, while subsidising the energy bills for both households and businesses. However, this strategy of unfunded tax cuts which relied on borrowing heavily raised concerns over fiscal management. In fact, the Institute of Fiscal Studies noted that government borrowing was on an “unsustainable path”. This only ended up spooking markets. The Pound collapsed, hitting a low of $1.03 in the days after the mini budget, and bond yields rose following a sell off. The ensuing financial dislocation caused the Bank of England to buy government bonds to stablise the market and prevent them from falling further, which would have put some pension funds at risk.

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While the government is rolling back some of the more contentious measures in an attempt to soothe the market — it has already set aside its decision to do away with the top tax rate, and plans to raise corporate taxes, after pledging not to do so — such measures are best avoided considering the current economic environment. The UK economy is already in the midst of an economic crisis: Economic activity has slowed down even as inflation remains high. The Bank of England is likely to continue to tighten policy rates further to tackle inflation. In September, it had hiked rates by 50 basis points to 2.25 per cent, even as it noted that the economy was now in recession. As the prime minister fights for her survival — there are many in her party that have begun to raise questions over her continuing in office — the policy framework should be guided by the objective of ensuring fiscal sustainability and preserving macroeconomic stability.