‘Reversal of Truss policies will worsen recession, she was right’

Reversal of Truss policies will worsen recession (Image: Getty)The Truss government policies used the concept of long-term sustainability to replace the short-term fiscal rules previously in use; this was a new approach which permitted both tax reform and active fiscal policy. The concept was correct; fiscal solvency commits a  government to ‘balancing the books’ in the long term. In practice, this translates into projecting the debt/GDP ratio as falling over the next decade or so to a sustainable and moderate level.However this has to be demonstrated to occur with the planned policies being followed; whatever assurances are given about the future, demonstration with plausible arithmetic is necessary.However,  the policies were not demonstrated to satisfy it by the Treasury after Mr. Kwarteng’s mini-budget; there were no Treasury projections verifying that the sustainability condition was met.This meant that when a variety of attacks on the budget’s sustainability were made, Mr. Kwarteng had no ready answer other than an assurance that he would ensure it was met via future policies (eg on spending).These assurances were not regarded as sufficient and market opinion, already made anxious by fast-rising US interest rates, became increasingly nervous, precipitating the rise in gilt yields with a rising risk-premium, and the resulting political crisis as mortgage rates rose.This was the first and probably the main reason why the Truss policies crashed and burned: terrible implementation, connived at by the civil servants involved.The Budget speech itself was clear enough, especially to supporters of the new policies; but it was provocative to their numerous opponents and failed to give a full explanation of how the new long-term fiscal rules would work out.Detailed projections for the public finances should have been routinely done by Treasury officials, even if normally done by the Office for Budget Responsibility.Using the OBR itself was ruled out by its hostility and the lack of time to get it onside after all the implied arguments/adjustments needed for agreement/sign-off.  But the Treasury civil servants/economists could have updated the last OBR workings from March – no doubt with informal consultations with OBR staff- and produced some respectable financial projections implementing the new long-term rules – viz that the debt/GDP ratio would come down over time.  They knew from our recent Centre for Brexit Policy Report (https://centreforbrexitpolicy.org.uk/publications/delivering-a-new-growth-strategy-for-britains-economy/) what we thought these would look like and could have tried to replicate that with their more detailed calculations OBR-style.But instead, there was nothing. On the Treasury Budget website one finds a long piece of text, more or less replicating the Chancellor’s speech; no arithmetic or projections, just an elegant essay.The result should have been obvious to anyone. Kwarteng would emerge into a world of enemies with their knives out, shorn of any defensive armour against the accusations that he was wrecking the finances.In short order, the IFS/Citibank partnership produced their own ‘Green Budget’ projections ‘showing’ that there was a huge fiscal hole looking five years ahead. Liz Truss’ policies “crashed and burned” (Image: Getty)To manufacture this result they used the easiest means – simply assuming the economy would tank. This of course destroys tax revenues.  But even the OBR never used such output projections for the medium-term assessments they made, because these are supposed to look at the trend behaviour of the economy and abstract from business cycle fluctuations.  Hence the IFS Green Budget was basically fraudulent in that it substituted a forecast of a recession followed by long stagnation for a medium-term trend value of output in examining the trends in the public finances.This method is quite wrong as it effectively means that you kick the economy with tax increases and spending cuts when it is down; which runs counter to good economic evaluation of trend prospects.But it was open season for doubters of the government arithmetic because there was none.An MP with no economics was quoted as saying you could see it was no good using ‘the back of a fag packet’.To these and similar assertions in many major organs of financial opinion such as the FT and the Economist, all viciously opposed to the new policies, the Chancellor had no answer because the Treasury provided none for him to quote.The Bank’s mistakes turned the Treasury’s presentational errors into a debacle. The package could still have survived until October 31 when due to be followed by a full Budget complete with OBR arithmetic, had the Bank pursued the right monetary policies.But instead, it made egregious mistakes. First, the day before the mini-budget which had been widely trailed, and whose contents it could easily anticipate, it raised interest rates by a weak 0.5 percent, seen as inadequate to get on top of inflation given much tougher moves by the Fed and the European Central Bank.This created market perceptions that the Bank would allow inflation to remain uncomfortably high.Then the mini-budget on September 23 undermined fiscal credibility as just explained, and gilt rates rose sharply on lack of market confidence.The Bank should have resisted this rise because it caused a major unplanned tightening of monetary conditions: the rise in interest rates the market now expected to counteract what it saw as too loose a budget, translated into both these higher gilt yields and also higher mortgage rates.   Kwasi Kwarteng mini budget plan had been heavily criticised (Image: Getty)A sensible monetary policy plan, which the Bank may well have had, but should have made clear through its statements, would be to raise rates to the 3-4 percent range which would be tight enough to crush inflation given the worldwide slowdown and falling commodity prices.But gilt rates went well above this range, reaching five percent at one point.Because this caused the crisis in leveraged pension funds, the Bank was forced to intervene with gilt purchases (QE) at this point, the end of September; and it successfully pushed gilt rates down.But an extraordinary failure to follow through occurred in the week ending October 14 when the Governor announced its cessation by the end of the week.  Hence there was no ongoing effort to reduce the tightening that was badly hurting the housing market and so to support government policy; indeed the Bank made clear informally that it thought the mini-budget pushed up inflation, forcing it to tighten policy more than it planned- see its chief Economist’s speech on September 28.Thus it too opposed the government’s policies, and effectively reinforced the market expectations of much higher rates, even though these were plainly excessive.The net effect has been a huge unintended monetary tightening via long-term rates that could have been subdued by Bank Quantitative Easing.This would have given Mr Kwarteng time to have a second attempt at his Budget plans. As it was this tightening was lethal politically through the effects on the mortgage market and voter sensitivity to this.  Had the Bank cooperated with the Chancellor over policy as it did during Covid, the economic outcome would have been very different.What the Bank should have done to keep monetary policy at its required tightness was to raise Bank Rate, signalling its tough approach to inflation, while at the same time buying gilts in the market (i.e. resuming QE) until long-term rates settled at the level of 3-4 per cent which would be about right in the longer term for seeing off inflation while not crashing the economy.Meanwhile, it should have deferred its plans for selling off its gilts until rates had settled down at these appropriate levels. Thus it was that the Bank gave the coup de grace to the Truss programme by the pursuit of bad monetary policies.Could Liz Truss have fought back and still implemented her policies?In spite of this massive opposition and the mistakes in both Treasury communication and Bank monetary policy, Liz Truss could still have delivered her programme.She needed to survive until the new fiscal arithmetic agreed with the OBR was to be unveiled. The new government must learn from Truss’s mistakes (Image: Getty)This date could have been brought forward and also the contents leaked ahead of time to calm market opinion; in the process, the Chancellor should have stopped paying interest on bank reserves, which are money, so withdrawing a massive (£30 billion-plus) windfall subsidy to banks.Then she needed to force the Bank to use QE to bring down the long-term interest rates in the market until the new budget arithmetic had settled market opinion down; the Treasury has ample power to instruct the Bank on gilt purchases, much as it did during the Covid period.If unwilling to force the Bank in this way, she could have simply explained that once inflation had come down, interest rates and mortgage costs would settle at a lower rate; but that they had been too low for too long.But by sacking Kwasi Kwarteng as Chancellor and appointing Jeremy Hunt, an ally of the wide opposition both in and outside Parliament, she in effect gave up on her policies and it was only a matter of time before she would be forced to resign, defined as she was by those policies.The reversal of Liz Truss’s policies will worsen the recession and stunt growth. Monetary policy will now need to be sharply revised as well.The new government must learn from all these mistakes as it creates its new policy programme.