TRUSS-KWARTENG MINI-BUDGET

Key points 

• Even before the speech was over, the pound sterling had plummeted to a 37-year low against the US dollar even as the UK government bonds yield was skyrocketing.
• Commentators around the world have warned of dire consequences for the British economy.
• The International Monetary Fund (IMF) said the budget would likely "increase inequality" in Britain and could undermine the monetary policy.
• The budget was utterly irresponsible and warned that the ensuing financial crisis in Britain will affect London's viability as a global financial centre.
• The budget is moronic and a small open economy that seems to be run by morons gets a wider risk premium on its assets currency down yields up.

Immediate implications

• A weaker pound will make the UK's imports costlier and further fuel inflation because of costlier energy imports.
• Sharply rising yields of gilts will raise the borrowing costs for the government just as it wants to throw money at kick-starting the economy.

UK Economy before the Mini-Budget

Historic inflation 

• Currently trending over 9 per cent. Gas Prices shot up from 38 pence per therm (a measurement of gas consumption) in February 2021 to 655 pence per therm in August.
• Even now, they are at 255 pence.

Economic stagnation

• The UK GDP has grown from $ 2.73 trillion in 2007 to only $2.89 trillion in 2020.
• Covid made matters worse and the British economy has still not recovered to its pre-pandemic level.

Mini-Budget

• To contain inflation, Kwarteng announced a freeze on energy bills.
• This is expected to reduce inflation by as much as 5 percentage points.
• To overcome stagnation, Kwarteng will provide the biggest tax cuts of the past 50 years that will benefit all taxpayers individuals and companies to varying degrees.
• The government's idea is to leave people and companies with more money in their hands.
• It hopes that doing so will, on the one hand, boost consumer spending and on the other, incentivise businesses to invest in the economy.
• This will create a virtuous cycle of rapid economic growth.

Backlash

• Truss and Kwarteng do not fully adhere to the conservative dictum of fiscal rectitude. 
• So, while they have announced massive tax cuts and a freeze on energy bills, these giveaways are unfunded.
• In other words, the government hopes to plug this loss of revenue through additional borrowings from the market.
• In addition to fiscal imprudence, the tax cuts are being perceived as unfair.

Growth and inflation

• The new budget may flater on both growth and inflation.
• Typically, when governments give tax breaks to spur an economy, they also reduce their spending or else, they give a tax break to the less well off by taxing the rich a tad more.
• This allows the government's borrowings to not spiral out of control.
• The private sector gets to borrow from the investible pool of savings at low-interest rates, while consumers spend more since they have lesser taxes to pay.

Truss-Kwarteng model

• In the Truss-Kwarteng model, the government's borrowings will go up sharply. This suggests that interest rates will rise.
• Ordinarily, in a developed economy such as the UK, this should not create a worry.
• Often, when interest rates go up in rich economies such as the UK or the US, they end up attracting money from all over the world.
• That's because everyone trusts that the governments of these countries will never struggle to repay their debts.
• But the UK's economy has been stagnant for almost 15 years and is facing the prospects of stagflation (high and persistent inflation with little or negative economic growth).
• Under the circumstances, the markets are treating the UK like any emerging economy, such as India and punishing it by demanding higher interest rates.

Tax cuts 

• The UK government claims that tax cuts will lead to a massive surge in economic activity and that, in turn, will bring down the debt-to-GDP ratio.
• But the markets are not convinced that growth will happen at the pace the government hopes.
• For instance, what stops businesses from pocketing the relief from tax cuts instead of investing?
• Investors doubt the government's ability to pay back the debt.
• This is why they are unwilling to lend to the UK, Which, in turn, is reflected in the selling of UK government bonds and as a consequence, gilt yields going through the roof.
• As Chart 1 shows, a year ago, the UK government could get a loan for 5 years for an interest rate of around 0.5 per cent; today it is at well over 4 per cent.

Cost of living crisis

• The other problem is that the mini-budget may end up worsening inflation and the cost of living crisis. 
• The Bank of England (BoE) has been raising interest rates to curb consumption and inflation.
• But there are two ways in which this flight against inflation may be undermined.

1. More money in the hands of the people could fuel spending and inflation.
2. The sharp weakening of the pound's exchange rate will make imports (especially energy) costlier.

BoE Response

• Rising gilt yields and the falling pound forced the central bank on Wednesday to start buying gilts (instead of its earlier plan to sell them).
• BoE buying gilts release money in the economy while selling them soaks it up.
• The Purchases are expected to bring down yields (by raising bond prices) and thus exhort investors to retain their faith in the UK's economy and currency.
• However, this U-turn militates against the BoE's goal to bring down inflation.

For Prelims & Mains