How should we interpret the U-turn on the abolition of the 45p rate for high income earners?
‘This is more a political move than one based on economic policy considerations.’ writes Miguel Leon Ledesma ‘The abolition of this rate would have cost £2bl, a small fraction of the £45bl package. The unprecedented low ratings of a new PM in their first month in office after the mini-budget required a gesture. The 45p rate abolition was seen as unpopular and an election liability for the Conservative Party and the pressure mounted to ensure a U-turn. In order to understand the backlash and almost immediate U-turn away from the mini-budget, we must look to the arguably foreseeable effect that it had on the UK economy.’
The Gilt Trip
‘The mini-budget, announced on 23rd September, led to a dangerous increase in market turbulence in both the foreign exchange market and the gilt markets. The damage resulting from this economic plan can be attributed to three factors.’
Fundamentally, unfunded tax cut policies are expansionary. This happens at a time when the Bank of England is raising interest rates to tame the highest inflation rates we have seen for a generation. This means that the interest rate increases that markets expect from the Bank are now much higher after the mini-budget, which will cause more unnecessary pain.
Furthermore, the package included temporary spending measures such as energy support for households and firms but also permanent tax cuts. It is normal and desirable, to borrow to cover the cost of temporary emergency spending. However, a permanent tax cut cannot be credibly financed in the future by borrowing. Markets clearly did not believe that the productivity boost of these measures would be enough to fund the tax cuts, leading to unsustainable levels of debt.
Fire Sales
And finally, the fact that the government rejected the Office for Budget Responsibility (OBR) offer to provide forecasts of the impact of the mini-budget was seen by markets as an attempt to ignore expert advice and disregard institutions.
Subsequently, foreign investors dropped Sterling leading to a depreciation against the US Dollar. But, more importantly, it led to a rapid decline in the market value of UK government debt. For a given interest on maturity on that debt, investors were willing to pay much less to buy it. In other words, for current generations to raise one extra pound to pay for the tax cuts, future generations would have to pay back much more than a pound.
Pension funds also suffered as a consequence, due to their reliance on complex financial instruments that are in place to ensure they have the cash flow available to pay for their defined benefit schemes. As the price of government bonds dropped, banks required more collateral to offset the liabilities of pension funds which were forced to sell assets to raise cash. Unfortunately leading to a process known as “fire-sales”, where their price falls further, leading to the need for more sales to raise cash. Several funds faced serious liquidity problems which led to the rapid intervention of the Bank of England as a lender of last resort.