Home / Opinion / Views /  The UK's economic mess is about a crisis of policy credibility

Newly minted Chancellor Kwasi Kwarteng has announced the UK’s mini budget last Friday. The £45 billion of debt-funded tax cuts in it set off a historic sell-off in the government bonds, sending the country’s borrowing costs soaring, and drawing biting criticism from the International Monetary Fund that has warned that the “untargeted" tax cuts will stoke already high and stubborn inflation.

The pound plunged to an all-time low against the dollar. Financial markets panicked.

But it was the mass sell-offs that pushed down the price of bonds, putting pension funds at risk of insolvency, which forced the country’s central bank into full crisis-control mode on Wednesday.

The Bank of England, which was on the verge of launching a quantitative tightening and interest rate hikes, a reversal of the earlier policy of quantitative easing, in an effort to bring 40-year high inflation under control, stepped in with an emergency plan to prop up the gilt market.

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It suspended the programme to sell gilts, and instead pledged to buy long-dated bonds at a rate of up to £5 billion a day for the next 13 weekdays. This emergency £65 billion bond-buying programme and fresh quantitative easing involve injecting newly printed pounds into the economy, potentially fuelling inflation further.

This when Prime Minister Liz Truss lay the blame in her campaign for the Conservative party leadership on the central bank's quantitative easing programme — in which it printed pounds to purchase £875 billion of government bonds to boost the economy — for fuelling inflation.

The UK economy isn't about to collapse like Sri Lanka's that had to default on sovereign debt. What the UK is going through is a severe crisis of policy credibility which is atypical for G7 economies. Widespread concerns over the risky fiscal plan Kwarteng plans to fund only through debt — at a time the UK government's debt levels are already in the red zone — and hopes of growth pick-up, spooked markets, forcing the Bank of England to "pivot" to prioritise financial instability temporarily over the pressing policy objective right now of fighting inflation.

The loss of policy credibility comes from the fact that Kwarteng's inflationary fiscal plan — guided by ideology, not sound economics — will work at cross purposes to monetary policy.

Moody’s has not downgraded the UK’s credit rating over the developments. It has, however, said that the large unfunded fiscal stimulus will prompt more aggressive monetary policy tightening, weighing on the country’s growth in the medium term.

The Bank of England has warned of “material risk to UK financial stability" from the tumult in the bonds market set off by chancellor Kwarteng’s tax cuts and borrowing plan.

Kwarteng, who has a Ph.D. in economic history from Cambridge, is keen to support families and businesses deal with the near doubling of fuel prices expected this winter due to the fallout from the war in Ukraine, and boost the UK’s economic growth with supply-side measures. But the tax cuts are being widely seen to favour high earners.

He is scheduled to present the new government’s full budget on November 23. There are no signs yet that the Truss government will pick fiscal prudence then, with her party colleagues defending the plans and making statements suggesting that it will stick to the strategy aimed at making the UK economy “competitive".

What is needed right now is for the UK government to put markets at ease immediately. Announcing how the Treasury plans to reduce government debt should reduce nervousness. This cannot wait till November, and spending restraint and austerity being hinted at as ways to stabilise the exchequer will be inadequate. There isn't perhaps an option other than burying the tax cuts if confidence is to be restored.

The rise in borrowing costs has drawn anxious responses from business leaders and even supporters of Prime Minister Truss such as Julian Jessop, an economic adviser to her, who wrote on Twitter, “even I cannot put a positive spin on this".

Bank of England's emergency intervention gives the government a breather but reduces the central bank's space and independence, besides complicating the policy transition from the pandemic-era monetary easing to tightening needed in a changed global economic scenario.

That is the lesson for central banks from this big mess in the UK. Ultimately, the notion of central bank independence is limited by what fiscal authorities do and don't do.

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