Kwarteng's plan

The Growth Plan as a do-or-die moment

Safe to say Kwasi Kwarteng’s Growth Plan does not seem to have gone down very well.

The markets didn’t appear best pleased:

And neither did news outlets you might usually expect to be sympathetic, like the Wall Street Journal:

Of course, Twitter is even angrier.

The consensus view seems to be that the sudden drop in the pound reflected a complete lack of confidence in Truss and Kwarteng’s economic strategy. Their plan is taken to amount to a horribly expensive attempt to do frivolous, unfunded tax cuts for the rich at the worst possible moment — which is to say, while debt-financing an absolutely enormous energy subsidy, during a potential downturn, despite Britain having already used up most of its debt headroom on the pandemic.

So I appreciate this blog will not be popular. But I think this consensus gets it wrong.

It is wrong to suggest that the Growth Plan is to blame for the pound’s fall. And more damagingly, the centre-right press has chosen the utterly wrong moment to lose trust. Far from a disaster, Kwarteng’s plan could be transformative. It just needs to be delivered.

First things first:

Did Kwarteng destroy the pound?

To begin with some fairly basic economic theory: if currency traders expect bad news at some point in the future, they will expect the price of the pound to fall in future too. This means it’s in their interest to sell the pounds they own prior to that fall. As the supply of pounds on the market therefore goes up, the sale price falls, such that by the time whatever negative event they were anticipating then happens, prices hardly move at all. This is how things get ‘priced in’.

After the Growth Plan, the pound fell sharply. This implies traders reacted because they where surprised by something that happened around that time. The question is: what?

I tweeted this:

Keir Bradwell @keirbradwell

confess I don’t really understand the market reaction. The biggest fiscal element of the package was already announced, and tax cuts were loudly advertised throughout the campaign. Did nobody believe Truss would actually follow through, or is the ‘surprise’ in all this the BoE?

The enormous energy spending within the Growth Plan had already been announced, without causing a market reaction like this one. So that can’t have been the surprise.

What about the tax cuts? I don’t see how that makes sense either. Lowering taxes was the main distinguishing factor in the leadership election, and ‘wot won it’ for Truss. It would seem naive not to have expected her to deliver on them.

Perhaps then, as some suggested to me, the cuts were just much bigger than the market could have foreseen. To which I can only respond: really?

Here is a breakdown of the tax cuts in the Growth Plan, and their costings in year one.

These two were explicitly promised in the leadership election:

1. Reversing Sunak’s rise in national insurance contributions: £19bn

2. Reversing Sunak’s rise in corporation tax: £19bn

Meanwhile, these were announced for the first time in the Growth Plan:

1. Reversal of IR35 laws: £2bn

2. Abolishing the 45p income tax rate: £2bn

3. Increasing the stamp duty threshold: £1.7bn

4. Keeping the annual investment allowance at £1m: £1.3bn

(Thank you to Sam.)

£38bn of tax cuts had already been explicitly promised by Truss, but Truss’s victory triggered nothing like the same market reaction as we have now seen. So believing that the market’s reaction was caused by a ‘larger-than-expected’ tax cut package requires you to believe that the additional cuts, only worth around a quarter of that, were enough to produce a seismic market response.

I struggle to see how that makes much sense, although if this really did come as a surprise to some, then there is a fair critique to make here about communication strategy. In retrospect it would have been much better to signpost pre-announcement that Truss's major campaign commitments were going to be announced here and now, rather than later, and to reassure everyone that Kwarteng is still interested in fiscal responsibility. In other words, the Treasury's wonderfully euphemistic ‘Update on Growth Plan Implementation’ should have been released before, not after, the Growth Plan itself.

But suboptimal communication surely can't explain all of it. So what might?

My working theory is a less succinct and less well-explained version of this tweet:

Mike Bird @Birdyword

My basic take: Markets take the minibudget as a clear sign that govt doesn't care about generating inflation. They think the BOE will offset a lot (surging yields) but not enough (declining £). All compounded by believing lower supply potential for the UK (Brexit, mostly)

What the Growth Plan represents is a fundamental reversal of the economic strategy of the last twelve years. Truss and Kwarteng want much looser fiscal policy, reined in by tighter monetary policy, as Kate Andrews reports. They are of the view that the British economy cannot go on like it is, with key public services getting ever worse while costing ever more money, productivity going nowhere, and growth completely flat. They believe this new strategy offers an escape from the spectacularly stagnant, slightly depressing status quo.

But the Bank’s monetary policy committee revealed last week it is yet to fully accept its role in all this. It raised interest rates by less than some expected, and, we might infer, by less than Truss and Kwarteng had been assuming too. This clearly reflects some lack of co-ordination between the Bank and the Treasury on their new roles. Understandable jitters on this point therefore might explain some of the market’s response.

Not all of it, granted. As Mike says, yields have surged, implying the market thinks the Bank will play its part next time around. Nonetheless, it seems reasonable to believe that markets fear that a historically fairly dove-ish MPC might remain more dove-ish than is necessary to make the fiscal strategy work and keep inflation reined in.

If the Bank can’t wholly be trusted to keep a lid on inflation, as Truss and Kwarteng want it to be, then how worried should we get? This comes to the latter part of Mike’s tweet. The market’s reaction suggests it is very worried. It is worried because it thinks the British economy has hardly any immediate ‘supply potential’ — meaning very little ability to absorb increases in demand without prices going up.

The exchange rate fell to the extent it did because Britain’s ability to supply more goods and services is exceptionally poor.

Which leads to a second question. In the long run, if this assessment of what caused our currency depreciation is correct, the way to fix it is to do two things:

• Raise interest rates more quickly than the Bank is used to doing;

• Radically reform the supply side of the British economy, so that it can cope with increases in demand much better.

One of these two is the purview of the Bank — though it now should be obvious why Truss once thought about reviewing the Bank’s mandate. But the other is entirely within the government’s control.

So the second question is this:

How badly does the government want economic growth?

If the Growth Plan’s spending decisions are to work without causing massive inflation and baking in the currency depreciation, they need to be met with a more ambitious supply-side reform agenda than anything we have seen for the last three decades.

Fortunately, the Growth Plan sets out exactly this. As very helpfully summarised by Ryan Bourne, it says that:

This is a long list, and even then it is only really a start on the work that the economy needs. It is also vague: it equivocates about the most important supply-side reform of all — housing reform — promising merely that more detail will be announced soon.

But it is a start. And if it is implemented properly (and followed up with more), it would allow Kwarteng’s plan to succeed, and with it, bring to end the awful bind that British policymaking has been stuck in since 2008.

The plan is therefore a do-or-die moment.

To commit to the Growth Plan’s tax-and-spend decisions without the structural reforms to go along with them would be a disaster. It would represent the worst of the status quo, but with a new layer of ‘bad’ added on top.

And there are lots of reasons for pessimism. Getting a supply-side reform through Parliament is much more difficult than doing new spending, especially with special interest groups doing their absolute utmost to block progress. Truss is already light on political capital, given how few MPs originally voted for her, and the response to our currency trouble will only have made that worse. Worst of all, there is very little time: it is less than two years until a general election.

Getting this right could hardly be more difficult. But doing what is right even when it is unpopular or poorly understood is often what defines the best Conservative MPs. Recall Geoffrey Howe:

Matthew Lesh @matthewlesh

In March 1981, an astonishing 364 economists wrote a letter to The Times opposing Geoffrey Howe's budget. The CBI and many big businesses were also unsupportive. The budget, along with many other Thatcherite policies, disrupted the status quo. The budget was a turning point:

And if they do get this right, despite everything in their way, the consequences will be vast.

Government after government has failed to do nearly enough about the supply side of the British economy. Reams have been written, far more eloquently than I can manage, about how this inaction has trapped us, time and time again, into choices we don’t want to have to make, on public services and elsewhere. It has trapped us into falling ever further behind America in our living standards. And it has nudged us into accepting relative decline as the norm and the future of Britain.

Until now, nobody has truly dared tackle this head-on. But we have finally found a PM and chancellor willing to do so. And yet for whatever reason — perhaps simply because we cannot get our heads around the reorganisation they have in mind — we are risking making it politically impossible before they have even begun to try.

In other words:

Sam Bowman 🇺🇦 @s8mb

I think this is a "gamble" in the same sense that quitting a job that hasn't given you a pay rise in 10 years is a "gamble". The idea that something will come along eventually, without us doing anything different, seems at least as foolhardy as trying to change course like this.

Do-or-die: it is a scary choice. But it is far better than having no choice at all.

Whether Kwarteng will be remembered as a Barber or a Howe is still to be decided. In taking this challenge on, he must have made himself one of the least popular people in Britain. And if he fails to follow through on the hard part, he might deserve to be.

But if he succeeds, he will have achieved, in under two years, more than any other chancellor has done in my lifetime. We will all owe him a strong pint.

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This post marks the return of my blog, after a long period of procrastination. From approximately now on there should be much more regular content on the way. Please leave a comment or get in touch if you have any thoughts about this post, my blog in general, or anything else!