Liz Truss government in crisis mode

Liz Truss was selected as the new UK prime minister less than a month ago by party members who saw her as a safe pair of hands. Yet her government is already facing a potential full-scale loss of market confidence in its economic strategy.

Last week, Kwasi Kwarteng, the new finance minister, unveiled an extraordinary emergency budget that turned on the fiscal taps, including massive levels of new spending and tens of billions of pounds of tax cuts in what was the largest program of unfunded stimulus since at least the 1970s.

The markets gave his proposals a big thumbs down in dramatic fashion, delivering the most negative reaction to any UK fiscal event in living memory.

The crisis deepened in recent days as a Bank of England decision to rule out any emergency increase in interest rates prompted fresh selling of the pound in currency markets. Financial markets remain far from clear about how the UK’s central bank will now respond, as reflected by the shifts in sterling as optimism about a potential interest rate intervention gave way to disappointment at the failure to deliver this.
As of Friday, sterling was trading only marginally above parity with the US dollar — its lowest-ever rate against the US currency.

The Bank of England will hope that initial market panic, as investors unpick the implications of Kwarteng’s budget, eventually subsides. Yet there is a significant risk that the bank, and the government, could lose control of the fast-moving events.

In a sign that international policymakers are growing increasingly alarmed by the recent turmoil in the UK, Raphael Bostic, president of the Federal Reserve Bank of Atlanta, spoke out this week. He said that the sell-off in the pound reflected growing uncertainty about the direction of the British economy. This added to similar concerns raised last week by former Treasury Secretary Larry Summers.

While Kwarteng must have anticipated a negative reaction by markets to his budget, he clearly did not appreciate the full extent of investor angst. This was a big oversight on his part; it had been clear for some time that his announcement could trigger a serious financial meltdown.

Take, for example, Deutsche Bank foreign exchange strategist Shreyas Gopal, who warned on Sept. 7, the day Truss was formally appointed prime minister, that the risks of a “sterling crisis” should not be underestimated.

There is significant angst among Conservative MPs about the political and economic judgment of both the new finance minister and the prime minister.

Andrew Hammond

He said the “risk premium on UK gilts (government debt) is already rising … a crisis may sound extreme but it is not unprecedented: A combination of aggressive fiscal spending, severe energy shock, and a slide in sterling ultimately resulted in the UK having recourse to an International Monetary Fund loan in the mid-1970s.”

Gopal was far from alone within the financial market community in issuing warnings. Moreover, Truss was also very clearly warned, on many occasions, by former UK Finance Minister Rishi Sunak, her defeated rival in the Conservative leadership contest, that her economic plans were “comforting fairy tales.”

It is not 100 percent clear why Kwarteng refused to listen to such warnings. Nor, indeed, why he decided to sack Treasury Permanent Secretary Tom Scholar, who might have been a key person to give the new government constructively critical counsel about its fiscal options.

Having dug himself into a deep political hole, Kwarteng now faces a massive challenge to get out of it. In recent days, he has failed to reassure jittery markets with a promise that he will outline the government’s debt reduction strategy in a statement at the end of November.

Many in the financial markets appear now to believe that talking tough will not be enough, however, and that official borrowing costs will need to rise more sharply and faster than previously anticipated, in an effort to reverse sterling’s slide. The irony is that this might well wipe out any boost from Kwarteng’s growth push.

Politically, the budget debacle is the worst possible start to Truss’s prime ministership. There is already significant angst among Conservative MPs about the political and economic judgment of both the new finance minister and the prime minister.

In this context, Kwarteng could find his political future in jeopardy over the coming months. While Truss will not throw him overboard without a real fight, it nonetheless remains a significant possibility unless his budget package delivers clear growth dividends.

The chief beneficiary of Truss’s travails is likely to be the Labour Party, which held its annual conference in Liverpool this week. The results of a YouGov poll published on Friday put the opposition more than 30 percentage points ahead of the ruling Conservatives, the highest lead Labour has had since Tony Blair’s first landslide election victory 25 years ago.

While the party will take nothing for granted, given the volatile political mood, there is a growing sense within Labour that the tide might be turning against the prospects of the Conservatives winning a historic fifth-straight term in office. Indeed, some comparisons have been drawn between events this month and the so-called Black Monday crisis in September 1992, when the Conservative government of Prime Minister John Major was forced to hike interest rates after the failure of his economic strategy.

No one political era is identical to another and there are key differences, as well as similarities, between 1992 and now. However, the odds appear to be growing that the Conservatives could lose a significant number of seats at the next election, and that Labour might once again emerge as the largest party in the House of Commons for the first time since the governments of Blair and Gordon Brown.

• Andrew Hammond