European Fiscal Policy Week, Part IV: Bad U.K. Monetary Policy Leads to Bad U.K. Fiscal Policy

I was excited about the possibility of pro-growth tax policy during the short-lived reign of Liz Truss as Prime Minister of the United Kingdom.

However, I’m now pessimistic about the nation’s outlook. Truss was forced to resign and big-government Tories (akin to big-government Republicans) are back in charge.

As part of my “European Fiscal Policy Week,” let’s take a closer look at what happened and analyze the pernicious role of the Bank of England (the BoE is their central bank, akin to the Federal Reserve in the U.S.).

Let’s start with a reminder that the Bank of England panicked during the pandemic and (like the Federal Reserve and the European Central Bank) engaged in dramatic monetary easing.

That was understandable in the spring of 2020, perhaps, but it should have been obvious by the late summer that the world was not coming to an end.

Yet the BoE continued with its easy-money policy. The balance sheet kept expanding all of 2020, even after vaccines became available.

And, as shown by the graph, the easy-money approach continued into early 2021 (and the most-recent figures show the BoE continued its inflationary policy into mid-2021).

Needless to say, all of that bad monetary policy led to bad results. Not only 10 percent annual inflation, but also a financial system made fragile by artificially low interest rates and excess liquidity.

So how does any of this relate to fiscal policy?

As the Wall Street Journal explained in an editorial on October 10, the BoE’s bad monetary policy produced instability in financial markets and senior bureaucrats at the Bank cleverly shifted the blame to then-Prime Minster Truss’ tax plan.

Bank of England Governor Andrew Bailey is trying to stabilize pension funds, which are caught on the shoals of questionable hedging strategies as the high water of loose monetary policy recedes. …The BOE is supposed to be tightening policy to fight inflation at 40-year highs and claims these emergency bond purchases aren’t at odds with its plans to let £80 billion of assets run off its balance sheet over the next year. But BOE officials now seem confused about what they’re doing. …No wonder markets doubt the BOE’s resolve on future interest-rate increases. Undeterred, the bank is resorting to the familiar bureaucratic imperative for self-preservation. Mr. Cunliffe’s letter is at pains to blame Mr. Kwarteng’s fiscal plan for market ructions. His colleagues Jonathan Haskel and Dave Ramsden —all three are on the BOE’s policy-setting committee—have picked up the theme in speeches that blame market turbulence on a “U.K.-specific component.” This is code for Ms. Truss’s agenda. …Mr. Bailey doesn’t help his credibility or the bank’s independence by politicizing the institution.

In a column for Bloomberg, Narayana Kocherlakota also points a finger at the BoE.

And what’s remarkable is that Kocherlakota is the former head of the Minneapolis Federal Reserve and central bankers normally don’t criticize each other.

Markets didn’t oust Truss, the Bank of England did — through poor financial regulation and highly subjective crisis management. …The common wisdom is that financial markets “punished” Truss’s government for its fiscal profligacy. But the chastisement was far from universal. Over the three days starting Sept. 23, when the Truss government announced its mini-budget, the pound fell by 2.2% relative to the euro, and the FTSE 100 stock index declined by 2.2% — notable movements, but hardly enough to bring a government to its knees. The big change came in the price of 30-year UK government bonds, also known as gilts, which experienced a shocking 23% drop. Most of this decline had nothing to do with rational investors revising their beliefs about the UK’s long-run prospects. Rather, it stemmed from financial regulators’ failure to limit leverage in UK pension funds. …The Bank of England, as the entity responsible for overseeing the financial system, bears at least part of the blame for this catastrophe. …the Truss government…was thwarted not by markets, but by a hole in financial regulation — a hole that the Bank of England proved strangely unwilling to plug.

Last but not least, an October 18 editorial by the Wall Street Journal provides additional information.

When the history of Britain’s recent Trussonomics fiasco is written, make sure Bank of England Governor Andrew Bailey gets the chapter he deserves. …The BOE has been late and slow fighting inflation… Mr. Bailey’s actions in the past month have also politicized the central bank…in a loquacious statement that coyly suggested the fiscal plan would be inflationary—something Mr. Kwarteng would have disputed. …Meanwhile, members of the BOE’s policy-setting committee fanned out to imply markets might be right to worry about the tax cuts. If this was part of a strategy to influence fiscal policy, it worked. …Mr. Bailey may have been taking revenge against Ms. Truss, who had criticized the BOE for its slow response to inflation as she ran to be the Conservative Party leader this summer. Her proposed response was to consider revisiting the central bank’s legal mandate. The BOE’s behavior the past month has proven her right beyond what she imagined.

So what are the implications of the BoE’s responsibility-dodging actions?

• First, we should learn a lesson about the importance of good monetary policy. None of this mess would have happened if the BoE had not created financial instability with an inflationary approach.
• Second, we should realize that there are downsides to central bank independence. Historically, being insulated from politics has been viewed as the prudent approach since politicians can’t try to artificially goose an economy during election years. But Bailey’s unethical behavior shows that there is also a big downside.

Sadly, all of this analysis does not change the fact that tax cuts are now off the table in the United Kingdom. Indeed, the new Prime Minister and his Chancellor of the Exchequer have signaled that they will continue Boris Johnson’s pro-tax agenda.

That’s very bad news for the United Kingdom.

P.S. There used to be at least one sensible central banker in the United Kingdom.

P.P.S. But since sensible central bankers are a rare breed, maybe the best approach is to get government out of the business of money.

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The Big Question for Tories (and Republicans): What’s the Alternative to “Free-Market Fundamentalism”?

Because of her support for lower tax rates, I was excited when Liz Truss became Prime Minister of the United Kingdom.

Especially since her predecessor, Boris Johnson, turned out to be an empty-suit populist who supported higher taxes and a bigger burden of government spending.

But I’m not excited anymore.

Indeed, it’s more accurate to say that I’m despondent since the Prime Minister is abandoning (or is being pressured to abandon) key parts of her pro-growth agenda.

For details, check out this Bloomberg report, written by Julian Harris, about the (rapidly disappearing) tax-cutting agenda of the new British Prime Minister.

Westminster’s most hard-line advocates of free markets and lower taxes are looking on in despair as their agenda crumbles… When Liz Truss became prime minister just over five weeks ago, she promised to deliver a radical set of policies rooted in laissez-faire economics — an attempt to boost the UK‘s sluggish rate of growth. Yet her chancellor of the exchequer, Kwasi Kwarteng, faced a quick reality check when his mini-budget, packed with unfunded tax cuts and unaccompanied by independent forecasts, …triggered mayhem… Truss fired Kwarteng and replaced him with Jeremy Hunt as she was forced into a dramatic u-turn over her tax plans. …Truss conceded…and dropped her plan to freeze corporation tax. …Still, some believers are sticking by “Trussonomics”…Patrick Minford,..a professor at Cardiff University, said..“Liz Truss’s policies for growth are absolutely right, and to be thrown off them by a bit of market turbulence is insane.” …Eamonn Butler, co-founder of the Adam Smith Institute, similarly insisted that Truss “is not the source of the problem — she’s trying to cure the problem.”

Eamonn is right.

The United Kingdom faces serious economic challenges. But the problems are the result of bad government policies that already exist rather than the possibility of some future tax cuts.

In a column for the Telegraph, Allister Heath says the U.K.’s central bank deserves a big chunk of the blame.

Liz Truss and Kwasi Kwarteng have been doubly unlucky. While almost everybody else in Britain remained in denial, they correctly identified this absurd game for the con-trick that it truly was, warned that it was about to implode and pledged to replace it with a more honest system. Instead of a zombie economy based on rising asset prices and fake, debt-fuelled growth, their mission was to encourage Britain to produce more real goods and services, to work harder and invest more by reforming taxes and regulation. What happened next is dispiriting in the extreme. …Truss and her Chancellor moved too quickly and, paradoxically, given their warnings about the rottenness of the system, ended up pulling out the last block from the Jenga tower, sending all of the pieces tumbling down. …they didn’t crash the economy – it was about to come tumbling down anyway – but they had the misfortune of precipitating and accelerating the day of reckoning. …Andrew Bailey, the Governor of the Bank of England…, has been deeply unimpressive in all of this, helping to keep interest rates too low… The idea, now accepted so widely, that the price of money must be kept extremely low and quantitative easing deployed at every opportunity has undermined every aspect of the economy and society. …Too few people realise how terribly the easy money, high tax, high regulation orthodoxy has failed.

Allister closes with some speculation about possible alternatives. If the Tories in the U.K. decide to reject so-called “free-market fundamentalism,” what’s their alternative?

He thinks the Labour Party will take control, and with very bad results. Jeremy Corbyn will not be in charge, but his economic policies will get enacted.

If Truss is destroyed, the alternative won’t even be social democracy: it will be Labour, the hard Left, the full gamut of punitive taxation, including of wealth and housing, and even more spending, culminating rapidly in economic oblivion.

That is an awful scenario. Basically turning the United Kingdom into Greece.

I want to take a different approach, though, and contemplate what will happen if the Conservative Party rejects the Truss approach and embraces big-government conservatism.

Here are some questions I’d like them to answer:

• Do you want improved competitiveness and more economic growth?
• If you want more growth, which of your spending increases will lead to those outcomes?
• Which of your tax increases will lead to more competitiveness or more prosperity?
• Will you reform benefit programs to avert built-in spending increases caused by an aging population?
• If you won’t reform entitlements, which taxes will you increase to keep debt under control?
• If you don’t plan major tax increases, do you think the economy can absorb endless debt?

I’m asking these questions for two reasons. First, there are no good answers and I’d like to shame big-government Tories into doing the right thing.

Second, these questions are also very relevant in the United States. Even since the Reagan years, opponents of libertarian economic policies have flitted from one trendy idea to another (national conservatism, compassionate conservatism, kinder-and-gentler conservatism, common-good capitalism, reform conservatism, etc).

To be fair, they usually don’t try to claim their dirigiste policies will produce higher living standards. Instead, they blindly assert that it will be easier to win elections if Republicans abandon Reaganism.

So I’ll close by observing that Ronald Reagan won two landslide elections and his legacy was strong enough that voters then elected another Republican (the same can’t be said for big-government GOPers like Nixon, Bush, Bush, or Trump).

Switching back to the United Kingdom, Margaret Thatcher repeatedly won election and her legacy was strong enough that voters then elected another Conservative.

The bottom line is that good policy can lead to good political outcomes, whereas bad policy generally leads to bad political outcomes.

P.S. To be sure, there were times when Reagan’s poll numbers were very bad. And the same is true for Thatcher. But because they pursued good policies, economic growth returned and they reaped political benefits. Sadly, it appears that Truss won’t have a chance to adopt good policy, so we will never know if she also would have benefited from a similar economic renaissance.

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The International Monetary Fund’s Tax-Free Bureaucrats Trying to Sabotage Better Tax Policy in the United Kingdom

It is disappointing that the bureaucrats at the International Monetary Fund routinely advocate for higher taxes and bigger government in nations from all parts of the world (for examples, see here, here, here, here, here, and here).

It is disturbing that the IMF engages in bailouts that encourage bad fiscal policy by governments and reckless lending policies by financial institutions.

And it is disgusting that those IMF bureaucrats get tax-free salaries and are thus exempt from the damaging consequences of those misguided policies.

One set of rules for the peasants and one set of rules for the elite.

The latest example of IMF misbehavior revolves around the bureaucracy’s criticism of recently announced tax cuts in the United Kingdom.

A BBC report by Natalie Sherman and Tom Espiner summarizes the controversy.

The International Monetary Fund has openly criticised the UK government over its plan for tax cuts…In an unusually outspoken statement, the IMF said the proposal was likely to increase inequality and add to pressures pushing up prices. …Chancellor Kwasi Kwarteng unveiled the country’s biggest tax package in 50 years on Friday. But the £45bn cut has sparked fears that government borrowing could surge along with interest rates. …Lord Frost, the former Brexit minister and close ally of Prime Minister Liz Truss, criticised the IMF’s statement. …”The IMF has consistently advocated highly conventional economic policies. It is following this approach that has produced years of slow growth and weak productivity. The only way forward for Britain is lower taxes, spending restraint, and significant economic reform.” …Moody’s credit rating agency said on Wednesday that the UK’s plan for “large unfunded tax cuts” was “credit negative” and would lead to higher, persistent deficits “amid rising borrowing costs [and] a weaker growth outlook”. Moody’s did not change the UK’s credit rating.

So what should be done about the IMF’s misguided interference?

Writing for the Spectator in the U.K., Kate Andrews has some observations about the underlying philosophical and ideological conflict..

…the International Monetary Fund has weighed in on the UK’s mini-Budget, offering a direct rebuke of Liz Truss and Kwasi Kwarteng’s tax cuts. …its spokesperson said…‘Given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture’… But this rebuke from the IMF is the kind of battle the Truss camp might be happy to have. …The IMF takes a political stance on inequality, viewing its reduction as a good thing in itself. Truss and Kwarteng reject this premise – summed up in the Chancellor’s statement last Friday when he called for the end of redistribution politics – and think it’s far more important to focus on ‘growing the size of the pie.’ The IMF’s ‘intervention’ is likely to become an example of the ‘Treasury orthodoxy’ that Truss was so vocal about during the leadership campaign: her belief that a left-wing economic consensus will not tolerate any meaningful shake-up of the tax code or supply-side reform.

Truss and Kwarteng are correct to reject the IMF’s foolish – and immoral – fixation on inequality.

All you really need to know is that the IMF publishes research implying it is okay to hurt poor people if rich people are hurt by a greater amount.

Let’s close by addressing whether tax cuts are bad for Britain’s currency and financial markets

Paul Marshall explained the interaction (and non-interaction) of fiscal and monetary policy in a column for the U.K.-based Financial Times.

Since 2010, the G7 policy framework has been one of tight fiscal and loose monetary policy. …This combination of fiscal austerity and monetary largesse has not been a success. Austerity has not prevented government debt ratios steadily climbing to historic highs. …Meanwhile quantitative easing has fuelled asset inflation for the super-rich and has more or less abolished risk pricing in financial markets. And…it has produced inflation which is still out of control. But now the global policy consensus is in the process of pivoting… A distinctive feature of the UK’s fiscal pivot is the emphasis on reducing the burden of tax on work and business. This is sensible. …the bigger problem for Liz Truss’s government is the Bank of England. It seems that the governor, Andrew Bailey, did not get the memo. Our central bank has been behind the curve since inflation first started to rise sharply in 2021. …The Bank of England effectively lost control of the UK bond market last Thursday when it raised interest rates by 50 basis points, instead of the 75bp that the US Federal Reserve and the European Central Bank raised by. Its timidity is now having an impact on both the gilt market and sterling. That is the essential context for the market reaction to the mini-Budget. Once you lose market confidence, it is doubly hard to win it back. …a more muscular stance from the BoE to underpin financial market confidence in the UK, even at the expense of some short-term pain.

He is right.

The Bank of England should be focused on trying to unwind its mistaken monetary policy that produced rising prices. That’s the approach that will strengthen the currency.

And Truss and Kwarteng should continue their efforts for better tax policy so the economy can grow faster.

But better tax policy needs to be accompanied by much-need spending restraint, which is what the United Kingdom enjoyed not only during the Thatcher years, but also under Prime Ministers Cameron and May.

P.S. The IMF also interfered in British politics when it tried to sabotage Brexit.

P.P.S. One obvious takeaway is that the IMF should be eliminated.

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The Much-Needed Reincarnation of Thatchernomics

I strongly supported Brexit in part because I wanted the United Kingdom to have both the leeway and the incentive to adopt pro-market policies.

Imagine my disappointment, then, when subsequent Conservative Prime Ministers did nothing (Theresa May) or expanded the burden of government (Boris Johnson).

Where was the reincarnation of Margaret Thatcher? Didn’t the Tory Party understand the need to restrain big government?

Perhaps my prayers have finally been answered. After jettisoning Boris Johnson (albeit for scandal rather than bad policy), the Tories elected Liz Truss to lead the nation.

And she appointed Kwasi Kwarteng to be Chancellor of the Exchequer (akin to U.S. Treasury Secretary). The two of them have just unveiled some major changes in U.K. fiscal policy.

Allister Heath’s editorial for the Telegraph has a celebratory tone.

…the best Budget I have ever heard a British Chancellor deliver, by a massive margin. The tax cuts were so huge and bold, the language so extraordinary, that at times, listening to Kwasi Kwarteng, I had to pinch myself to make sure I wasn’t dreaming, that I hadn’t been transported to a distant land that actually believed in the economics of Milton Friedman and FA Hayek. …The neo-Brownite consensus of the past 20 years, the egalitarian, redistributionist obsession, the technocratic centrism, the genuflections at the altar of a bogus class war, the spreadsheet-wielding socialists: all were blown to smithereens by Kwarteng’s stunning neo-Reaganite peroration. …All the taboos have been defiled: the fracking ban, the performative 45pc tax rate, the malfunctioning bonus cap, the previous gang’s nihilistic corporation tax and national insurance raids. The basic rate of income tax is being cut, as is stamp duty, that dumbest of levies. …Reforms of this order of magnitude should really have happened after the referendum in 2016, or after Boris Johnson became Prime Minister in 2019… Truss..has a fighting chance to save Britain, and her party, from oblivion.

The Wall Street Journal‘s editorial has a similarly hopeful tone while also explaining the difference between good supply-side policies and failed Keynesian demand-side policies.

This is a pro-growth agenda that is very different than the tax-and spend Keynesianism that has dominated the West’s economic policies for nearly two decades. …Mr. Kwarteng axed the 2.5-percentage-point increase in the payroll tax imposed by former Prime Minister Boris Johnson, and canceled a planned increase in the corporate income tax rate to 26% from 19%. …Kwarteng also surprised by eliminating the 45% tax rate on incomes above £150,000. The top marginal rate now will be 40%… A frequent complaint is that there’s no evidence tax cuts for corporations or higher earners will boost demand. Maybe not, but that’s also not the point. Britain doesn’t need a Keynesian demand-side stimulus. It needs the supply-side jolt Ms. Truss is trying to deliver by changing incentives to work and invest. A parallel complaint from the same crowd is that Ms. Truss’s policies—which they just said won’t stimulate demand—will stimulate so much demand the policies will stoke inflation. This has been the experience with debt-fueled fiscal blowouts since the pandemic, but Ms. Truss’s plan is different. She’s not throwing around money to fund consumption. She’s using the tax code to spur production.

The editorial concludes with a key observations.

Britain has become the most important economic experiment in the developed world because Ms. Truss is the only leader willing to abandon a stale Keynesian policy consensus that has produced stagflation everywhere.

Here’s a tweet that captures the current approach, with “liberal” referring to pro-market classical liberalism.

This is the “Singapore-on-Thames” approach that I’ve been promoting for years. Finally!

In a column for Reason, Robert Jackman gives a relatively optimistic libertarian assessment of what to expect from Truss.

…will her arrival in Downing Street bring an end to the big-state, big-spending style of her predecessor? …Within the Westminster village, Truss has long been regarded as a torchbearer for liberty—a reputation that stretches back to her days working at various small-state think tanks. Since entering Parliament in 2010, she has been a member of the Free Enterprise Group… As trade secretary, Truss was responsible for delivering on the good bit of Brexit—jetting around the world to sign tariff-busting trade deals. She was good at it too, quickly securing ambitious agreements with Australia and Japan. …But will Liz Truss’ premiership put Britain back on track to a smaller state? Some things aren’t that simple. …Truss has long been an advocate of relaxing Britain’s punitive planning laws, which would make it easier to build much-needed homes and energy infrastructure.

As you might expect, the analysis from the U.K.-based Economist left much to be desired.

Liz Truss, Britain’s new prime minister, is now implementing Reaganomics…comprising tax cuts worth perhaps £30bn ($34bn) per year (1.2% of gdp)… The fuel that fiscal stimulus will inject into the economy will almost certainly lead the boe to raise interest rates… No matter, say Ms Truss’s backers, because tax cuts will boost productivity. Didn’t inflation fall and growth surge under Reagan? …Ms Truss’s cheerleaders seem to have read only the first chapter of the history of Reaganomics. The programme’s early record was mixed. The tax cuts did not stop a deep recession, yet by March 1984 annual inflation had risen back to 4.8% and America’s ten-year bond yield was over 12%, reflecting fears of another upward spiral in prices. Inflation was anchored only after Congress had raised taxes. By 1987 America’s budget, excluding interest payments, was nearly balanced. By 1993 Congress had raised taxes by almost as much as it had cut them in 1981.

By the way, the article’s analysis of Reaganomics is laughably inaccurate.

Meanwhile, a report in the New York Times, writtten by Eshe Nelson, Stephen Castle and Mark Landler, also has a skeptical tone.

But I’m surprised and impressed that they admit Thatcher’s policies worked in the 1980s.

Britain’s new prime minister, Liz Truss, gambled on Friday that a heavy dose of tax cuts, deregulation and free-market economics would reignite her country’s growth — a radical shift in policy… the new chancellor of the Exchequer, Kwasi Kwarteng, abandoned a proposed rise in corporate taxation and, in a surprise move, also abolished the top rate of 45 percent of income tax applied to those earning more than 150,000 pounds, or about $164,000, a year. He also cut the basic rate for lower earners and cut taxes on house purchases. …It is hard to overstate the magnitude of the policy shift from Mr. Johnson’s government, which just one year ago had announced targeted tax increases to offset its increased public spending… The chancellor’s statement in Parliament on Friday underscored the free-market, small-state, tax-cutting instincts of Ms. Truss, who has modeled herself on Margaret Thatcher, who was prime minister from 1979 to 1990. Thatcher’s economic revolution in the 1980s turned the economy around.

The article includes 11 very worrisome words.

…so far there has been no indication of corresponding spending cuts.

Amen. Tax cuts are good for growth, but their effectiveness and durability will be in question if there is not a concomitant effort to restrain the burden of spending.

Truss and Kwarteng also should have announced a spending cap, modeled on either the Swiss Debt Brake or Colorado’s TABOR.

P.S. In addition to worrying about whether Truss will copy Thatcher’s track record on spending, I’m also worried about her support for misguided energy subsidies.

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